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.
— 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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