Select Committee on Environment, Food and Rural Affairs Written Evidence


Memorandum submitted by Dr Neil Summerton CB

  1.  This evidence is given on my own behalf. In 1991-97, I was Director Water, and then Water and Land, in the Department of the Environment. In 1998-2002, I was Director of the Oxford Centre for Water Research and I am an Emeritus Fellow of Mansfield College. I am one of the independent non-executive directors of Three Valleys Water and Folkestone and Dover Water Services, both of which are subsidiaries of Veolia Water UK.

SUMMARY

  2.  It is essential to be realistic in recognising the overall position of the industry, the urgency of present cost pressures, and the financial implications of political aspirations to improve standards of service and environmental quality. In general, the price levels in the recent draft business plans reflect these pressures. There are, too, real limits as to the extent to which price pressures can be mitigated by manipulating financial variables like the cost of capital and financial ratios, and efficiency assumptions.

  3.  There is reason for concern about the implications of these price pressures for some customers, particularly in some areas. But overall price decisions should not (and legally cannot) be driven wholly by such concerns. Those customers are however less protected by the charging system than they were in former times. Consideration should be given to means of assisting a wider range of customers with the prices they face. But that should be done transparently and not by artificially holding prices down across the board, nor by cross-subsidy between companies, nor by sharply increasing cross-subsidies between customers within companies.

BASES OF PRICING, CROSS-SUBSIDIES AND IMPACTS ON POORER CUSTOMERS

 (a)   Unmeasured charging

  4.  When networked water services were introduced in the 1800s, the basis of charging was the rateable value of the property served. While meters were increasingly introduced for larger commercial customers after 1945, on privatisation in 1989 almost all domestic customers and very many smaller commercial customers continued to be charged on the basis of rateable values last fixed in 1973.

  5.  The effect of charging by rateable value is that customers with higher values meet a proportionately larger share of the company's costs than those with lower values: those with higher values therefore subsidise the services received by those with lower values. The great majority of customers have been unaware of this effect of the traditional charging basis.

  6.  Further, it was the norm for local authority rents to compound housing and water and wastewater charges. Typically, the local authority as landlord would make a single payment to the water and/or wastewater supplier (who before 1974 might have been the same authority) on behalf of all their tenants. In some cases, this arrangement continued up to 1989 and beyond. The effect was to obscure payment for water and wastewater services. Changes in both housing and water arrangements in the last two decades have resulted in many customers, particularly in social housing, receiving water and sewerage bills direct for the first time.

 (b)   Area cross-subsidies

  7.  Up to 1974, when many water and wastewater services were in the hands of local authorities, they had the benefit of subsidy both from central and local taxpayers in various ways. The creation of the 10 large regional water authorities in 1974 brought this possibility to an end. From that point, prices became reflective of costs in the particular operator's area. Average charges varied from region to region as costs varied (though between 1976 and 1979 there was a statutory equalisation scheme entailing transfers of funds between regional authorities). The large areas of the regional water authorities did, however, open up the possibility of cross-subsidy between customers in different parts of an authority's area: in summary, urban areas, where network costs were lower because of economies of scale, subsidised rural areas. This remains in the post-1989 arrangements.

  8.  The post-1989 structure does not in principle preclude subsidisation of customers and, as indicated, there is extensive cross-subsidisation of different kinds within the area of each company.

 (c)   Drainage of highways and open spaces

  9.  Wastewater charges to customers include the costs of draining highways and other public space. This is in effect a concealed tax for a public service which might more transparently be met within public expenditure. Transfer of these costs to the public purse would be a way of containing water prices. It would however increase pressure on local taxation unless means were found of passing the costs to motorists who are the main beneficiaries.

 (d)   Metering

  10.  Since 1989, an increasing proportion of the costs of water and wastewater [11] services has been met charged by metering, as in most other developed countries. Initially, the change was driven by the need for a method of charging for new properties which did not have rateable values. Increasingly, however, the motive has been demand management, particularly in areas of water scarcity in the south and east of England, where meter penetration is rising rapidly.

  11.  The justification for metering is that it encourages domestic customers towards more efficient water use, eg, in relation to garden-watering. And where meters are installed at the point of connection between the company's and the customer's pipe, metering encourages customers to cure leakage on their supply pipe (on average, supply pipe leakage accounts for 30% of total leakage). Metering would be the more effective as a demand management tool if effective means can be found of introducing peak-time tariffs aimed at peak-lopping.

  12.  But one by-product of metering is to increase prices for unmeasured customers because of the way in which the so-called tariff basket works. In current circumstances, it tends to be customers in higher-rated properties who opt for meters, to gain financial benefit from their relatively low usage. The effect is loss of income to the supplier. This is recouped across all customers, thus increasing charges disproportionately for unmeasured customers. Price increases for unmeasured customers can be significantly above the K factor as a result. This may be justified overall in providing a further incentive towards metering, and it may be right that prices for unmeasured customers should increase a little faster than those for measured customers because unmeasured water usage is tending to increase more quickly than metered usage. But it does need to be borne in mind that, as metering is extended under the current policies, unmeasured customers will increasingly be the poorer customers.

 (e)   Protection of vulnerable customers

  13.  The present Administration has introduced, through the Water Act 1999, a degree of protection for vulnerable customers. The water company is required to assist large families in receipt of certain public benefits and customers with certain medical conditions which require high water use. They are charged a bill equal to the average household bill, even though their actual water use is much higher than average. This shelters them from the cost of their high water needs, but they are still faced with a significant bill. (If they occupy a low-rated dwelling, it is better for them not to apply for the protection, of course. More generally, take-up under these provisions is low.)

 (f)   Uncollected debt and assistance of those in difficulties

  14.  Another form of cross-subsidy results from non-payment of water bills. Water debt is rising sharply. Companies use a variety of methods to facilitate payment and it may be possible to do more. But at present some 1.5% of monies due are written off annually. Paying customers bear this cost in the longer run. Some companies have created charitable trusts to assist a limited number of customers who are in severe need.

PRICING PRESSURES SINCE 1989

 (a)   Price increases

  15.  Since 1989, average household bills will by 2005 have increased in real terms by 20%. This represents an annual rate of increase of a little over 1.3%. Economic growth over the period is likely to be of the order of 2.0% a year, so water charges are currently taking a declining share of the national cake.

  16.  There are wide variations by area around the average—from 42% in South West Water to 9% in Anglian. This results from the differential demands of waste water treatment, reflecting the fact that historically, inland waters have long been protected by two-stage sewage treatment, whereas discharges to coastal waters often had no treatment at all.

  17.  The extent of variation between company's prices is important as benefit rates are fixed at a single rate nationally. So water prices take a much larger slice of benefit or pension in some areas than others.

 (b)   Efficiency gains

  18.  These price increases are seen by some as a consequence of the need to pay "fat-cat" salaries and a profit margin to private companies. Privately-raised debt and, still more, equity funding requires higher coupons than does public borrowing. But the basic justification for private involvement is that efficiency and quality of service gains outweigh these extra costs. In the medium run, the regulator ensures that these gains, over and above the cost of attracting private operators, are captured for the benefit of customers in lower prices.

  19.  The industry has since 1989 made major gains in efficiency. The successive price settlements have assumed an overall efficiency gain of 24% in operating expenditure and 22% in capital expenditure by March 2005. And outperformance by the companies has enabled the regulator to make more demanding assumptions price review by review.

 (c)   Reasons for price increases

  20.  The main reason for rising prices in real terms since 1989 has been the cost of investment to raise standards of performance in a number of ways:

    —  Improvements in drinking water quality, in particular investment to deal with nitrates, pesticides, lead and parasites such as cryptosporidium. This investment has been necessary to enable regulatory standards to be met. This has also entailed extra operating costs.

    —  The costs of protecting the environment in two ways:

      —  Dealing with the effects of abstractions, including improving flow in low-flow rivers and protecting and enhancing wetland habitats;

      —  Reducing environmental impacts of sewage discharge and sludges. Here, a very wide range of regulatory requirements have had to be met, ranging from the bathing waters directive, the freshwater fish and shellfish waters directives, and the urban wastewater treatment directive. These requirements have been exceptionally heavy.

    —  Costs of raising quality of service in a variety of ways—nothing equivalent to levels of service requirements existed under the previous nationalised regime.

PROSPECTS FOR THE 2005 REVIEW

  21.  At privatisation, there was a tendency to regard extra investment as a hump that could be surmounted within a decade or so. Thereafter, it was expected, cost pressure would reduce, allowing water prices to fall back to a pattern of RPI - X rather than the RPI + X needed in the first phase. It is already clear however that this happy position will not be achieved in the next review.

 (a)   Continuing cost pressures

  22.  There continues to be a wide variety of pressures requiring further new investment, pressures which will also result in new operating costs. Among the more important are:

    —  Achieving the requirements of existing EU directives.

    —  The Water Framework Directive.

    —  Protection of SSSIs and other EU and domestic environmental areas.

    —  Climate change and water scarcity, coupled with rising demand from domestic users.

    —  Leakage control.

    —  Ending sewer flooding.

    —  Eliminating lead from drinking water.

    —  The requirements of the Security and Emergency Measures Directive.

  Beyond this, is the risk of newly-perceived health threats resulting from water re-use. There is also a variety of other variables over which neither the industry nor regulators have any control, such as levels of business rates after the next revaluation, tax and NI changes, the prospect of statutory lane rental charges for works in the highway, abstraction charges, pensions costs, energy costs, general insurance costs, and so on.

 (b)   Replacement and renewal

  23.  Additionally, replacement and renewal cannot continue to be neglected. Water companies have to invest in replacing underground networks and above ground plant. At replacement cost, the total value of water assets now exceeds £204 billion. While the life of some categories of this investment is long, it does not and cannot last for ever. That provided in former generations varied in quality through time and geographically. Some old networks need surprisingly little maintenance; others do not last as long or otherwise need replacement in order to provide a good standard of service and reduce maintenance costs. In general, above ground plant needs replacement more frequently than networks.

  24.  Adequate levels of replacement are essential if customers of the future are to receive good service. Assets worth over £200 billion presuppose an annual replacement cost in excess of the current peak rate of £1.7 billion, if an appropriate spread of asset lives is assumed. As noted by the Environmental Audit Committee in 2000, there was a tendency in earlier reviews for OFWAT to neglect this aspect of investment. Since 1999 there have been improvements in the system for identifying these needs. It is important that regulators should recognise the implications for investment levels.

 (c)   Implications for prices

  25.  These investment requirements are not well understood by the public. Nor is it appreciated that, while there is no charge for water as a raw material, the costs of networks and treatment plants and operating them are inevitably substantial. Price pressures derive from the extra costs of the service rather than from profits per se, though the costs of capital must be met (as they would have to be met in a publicly-funded service).

  26.  Many of the price pressures are on the wastewater side. What is of particular concern to water suppliers is the possible temptation to achieve environmental improvement at the expense of investment in water supply, and replacement and renewal generally—that the needs of the clean water sector will be crowded out by the wastewater side. The regulator must discharge his statutory duty company by company and he must guard against the possibility of successful appeal to the Competition Commission if he were to allow the needs of the wastewater side to cloud his judgment about those of water suppliers. But it is possible to contain pressures by taking a narrow view of the functions of water suppliers.

FINANCIAL AND EFFICIENCY VARIABLES

  27.  Prices also depend on assumptions about a number of financial and other variables. Here again there are limits to the regulator's room for manoeuvre. . .

  28.  First, the economic regulator has statutory duties which cannot be ignored and have implications of price levels:

    —  To ensure that water companies carry out their functions; there is little room for manoeuvre to manipulate interpretations of those functions.

    —  To ensure that these functions can be financed, particularly but not exclusively as regards the cost of capital. This is determined by the markets. If efforts are made to squeeze margins below the level that the markets deem acceptable, they will react accordingly. This is in essence what happened following the 1999 price determination.

  29.  Since 1999 there has been extensive revision of the financial structure of companies, increasing levels of debt finance and reducing equity. To some extent, this has been in the longer-term interests of customers, that is, if the level of equity exceeded that necessary for entities with the risk-profile of water companies. However, the result of squeezing returns may have been to cause a reduction of equity beyond the level that is wise. Equity capital in water companies represents a buffer which protects customers from unforeseen or miscalculated risks. If equity has been reduced to below the "right" level, risks will have been increased for customers. These considerations need to be borne very carefully in mind in the present price review, especially in considering the temptation to keep down prices by manipulating financial variables in the face of unavoidable investment pressures.

  30.  A further variable which may be prayed in aid to keep prices down in the face of other pressures is assumptions on the efficiency gains which companies can be expected to make in the next price period. Insofar as private companies can be expected to be more efficient than nationalised companies (or than the former statutory private companies), the period since 1989 ought to have been sufficient to enable the implicit step change to have been completed. Henceforth, it is questionable whether water companies can make greater efficiency gains than private sector companies generally. In this context, two points need to be borne in mind:

    —  The RPI subsumes the underlying rate of efficiency gains across the economy as a whole. If there was no extra investment and prices were restricted to the increase in the RPI, companies would need to achieve at least the average efficiency gain across the economy as a whole. The RPI - X formula therefore requires regulated companies to achieve an additional efficiency gain over and above the underlying average.

    —  As in the case of any company, water companies have costs that they can control and costs (like tax, rates and so on) which they cannot control or even influence. The ratio of controllable to uncontrollable costs is roughly 80:20. Efficiency gains must be concentrated in the area of controllable costs. This means that if the regulator's efficiency assumption is 4% overall, water companies must actually achieve a gain of 5% on controllable costs. This point is of significance if the level of uncontrollable costs is comparatively high compared with the activities which the regulator uses as the benchmark.

  31.  All this emphasises the need for the Committee to be realistic both about the cost pressures on the industry and the extent to which there is freedom nevertheless to hold down prices in the face of these pressures.

THE PROTECTION OF POORER CUSTOMERS

  32.  It is important that the means of assisting poorer customers should not be general action which jeopardizes either the UK's obligations as a member state of the European Union to achieve environmental and drinking water improvements which are required by European law, or the need for asset replacement and refurbishment, or the financial stability of companies as the deliverers of essential services.

  33.  The question arises whether it is necessary to widen support for poorer customers. The provisions in respect of vulnerable customers are comparatively narrow. They do not cover poorer customers in general, on whom the cost of water and wastewater services can be expected to bear more heavily. That they are experiencing difficulty already is evident from the growing incidence of non-payment of water bills.

  34.  It is possible to imagine that with ingenuity ways could be devised of supporting such customers at the expense of other customers. This might be tempting for the Government since it avoids implications for public finances. Those on benefits might be charged a comparatively low flat fee for water and waste water services. Or, more elaborately, tariffs might be altered to provide an initial block of water for a flat fee, with additional water being charged for by volume (possible only for those on meters). But it would be more transparent to provide public help rather than to increase confusing cross-subsidies from other water customers. [12]

  35.  Differential cost pressures between regions may also reach unsustainable levels. In that case, the mechanism of assistance should be public help to reduce prices for hard-pressed customers in the particular company, not extensions of cross-subsidies between companies and therefore customers. Alternatively, particular environmental improvement measures could be financed through public subsidy. This would however be objectionable because it infringes the "polluter pays" principle (domestic customers do not see themselves as polluters, though they are). Moreover, all consumers would benefit from support for particular types of investment and this is not necessary. Mechanisms to assist poorer customers specifically could automatically deal with the pressure of regional differentials on those customers. All such measures would need to bear in mind alsothe requirements of the Water Framework Directive on cost-reflective pricing.

  36.  The effect of the tariff basket rules in transferring the financial consequences of metering to unmeasured customers could also be looked at (see paragraph 12). This will become more important as metering penetration increases and unmeasured customers become more and more the poorer customers.

17 October 2003




11   Wastewater services are charged for by volume, normally on the assumption that 95% of the water which is drawn by a property leaves it by the sewer and is subsequently treated. Back

12   In New South Wales a rapid introduction of metering with demand management objectives was facilitated by providing a state subsidy to the public water operator, to provide rebates to a substantial minority of customers. Back


 
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