House of Commons - Ofwat Price Review 2009 - Environment, Food and Rural Affairs Committee

Ofwat Price Review 2009 - Environment, Food and Rural Affairs Committee Contents

1 Introduction

1. The Water Services Regulation Authority (Ofwat) is the water industry's economic regulator for England and Wales.[1] Every five years, Ofwat sets limits on the prices the water companies can charge their customers.[2] The 2009 price review (PR 09), which will set price limits for customers' bills for each year between 2010 and 2015, is the fourth price review since privatisation of the water industry in 1989.

2. Most people in this country take a constant and unlimited supply of clean, affordable water for granted. In 2008-09, the average water and sewerage bill was £331—£700 less than the average energy bill.[3] What may not be apparent to the average customer is that only a third of their bill pays for the operating costs of supplying drinking water and removing waste water—the remaining two thirds of their bill covers: return to debt and equity investors (30%); capital charges (charges for depreciation and infrastructure renewal) (28%); and business taxes (6%).[4]

3. PR 09 has four phases; Phase 1 began in March 2007, when Ofwat began consultation with water companies and other stakeholders. The price review is currently in its third phase, which concludes in November 2009 when Ofwat publishes its final determinations of price limits. Ofwat's memorandum sets out the process in some detail.[5] The regulator's website provides links to the various sets of guidance issued to the companies during the course of the price review.[6]

4. Defra's role in the price review is to ensure that the regulator has a clear statement of the relevant legal obligations and to provide guidance on the social and environmental matters that the regulator should have regard to in the price review.[7]

5. In their draft business plans, submitted to Ofwat in August 2008, the water companies estimated that water bills would need to be increased by just under nine per cent in real terms for the period 2010-2015 to cover costs and provide an adequate return. Table 1 sets out how key cost elements, based on the companies' draft business plans, would contribute to predicted changes in bills.

Table 1: Drivers of change in average bills 2010-2015 (2007-08 prices)[8]

Average bill in 2009-10 Total (£) (£)

326

Less (1) past efficiency savings -6

Plus (2) maintaining base services 4

of which:
changes in revenue
changes in operating costs
changes in capital maintenance
changes in impact of taxation
changes in the cost of capital

-7

12

16

-5

-12

(3) maintaining and enhancing security of supplies to all consumers 17

(4) the impact of improvements in services 25

of which:
drinking water quality
environmental improvements
improvements in service performance

5

16

4

Less (5) scope for reduction through future efficiency improvements -11

Average Bill at 2014-2015 355

Change from end of last period 29

Source: Ofwat, Setting Price Limits for 2010-2015: Overview of companies' draft business plans, September 2008.

6. The Committee announced this inquiry on 29 January 2009. We invited views on the price review and in particular: how it was being conducted; planning for climate change; how environmental improvements should be paid for; the affordability of water services; and how the price review related to the Cave and Walker reviews[9] and the draft Flood and Water Management Bill.[10] In parallel with this inquiry, we have conducted pre-legislative scrutiny of the draft Bill. Some of the evidence taken during that inquiry has been relevant to the price review and some of our conclusions in this report relate to the draft legislation.

7. We received 27 written submissions and held six oral evidence sessions. We are grateful to all those who provided us with evidence—a full list of witnesses is appended to this report.

Key challenges for PR 09

8. Ofwat told us that it put "customers at the heart" of its approach to PR 09 and that at the same time it had to "ensure that water companies can deliver their services, including the statutory improvement programmes, efficiently and effectively".[11] It considered its key challenge was to reconcile these two objectives, in the context of water companies' "biggest ever" proposals for capital investment.[12]

9. The water industry is usually considered a stable sector of the economy, which enables investors in the industry to have a degree of confidence.[13] However, there are several sources of uncertainty surrounding this price review. The Minister for the Natural and Marine Environment, Wildlife and Rural Affairs, Huw Irranca-Davies, told us that PR 09 was going to be rather unusual because of the number of "quite big" things with potentially "big bills" that could come up between this and the next price review in 2014.[14] The Minister identified some of those factors, including: the outcome of the Walker review into household water charging; the climate change projections; water resource management plans prepared by the water companies; the Water Framework Directive; the Flood and Water Management Bill; and infraction of the Urban Wastewater Treatment Directive proceedings.[15] In addition this price review is taking place against the background of a considerably more challenging economic situation, which has an impact both on the ability of customers to pay water bills and the ability of water companies to finance the necessary investment.

10. In this report we consider the three fundamental questions for Ofwat:

Does the regulatory framework encourage a sustainable water policy;
Can the consumer afford the resulting increases in charges; and
Are the companies able to raise the required capital on the money markets and at what cost to the consumer?

11. On 17 June 2009, Defra published the UK's climate change predictions up to 2080. The predictions illustrate the likely future climate within which the water industry and its regulatory framework must operate. The predictions suggest that areas of the UK will be subject to greater water scarcity in the summer, other areas will have increases in winter rainfall, and across the country severe weather events will occur with increasing frequency and intensity.[16] The regulator said that it did not expect the companies to factor in climate change predictions in their draft business plans since publication of the new scenarios had been delayed until a late stage in the PR 09 process, but Ofwat would "facilitate any investment justified before 2015 in terms of the latest evidence when it becomes available".[17]

12. Defra requires Ofwat to contribute, through the price review, to the Government's sustainable water objectives set out in the 2008 water strategy, Future Water.[18] Future Water acknowledges the UK's obligation to meet the requirements of EU Directives such as the Bathing Water Quality Directive, Water Framework Directive and Urban Waste Water Directive.[19] These Directives set higher standards for water and waste water and, in many cases, require significant investment by the industry over many years.

13. The challenge for Ofwat is to balance the requirement for sustainable water supplies, delivered by water companies able to pay for necessary environmental improvements, with bills that are affordable for consumers. This must be delivered against the background of the current economic recession and the predicted impacts of climate change.

14. In this report we consider some of the potential outcomes of policy work still in progress, such as the recommendations arising from Professor Martin Cave's review of competition;[20] Anna Walker's review of household charging;[21] and the draft Flood and Water Management Bill.[22] Ofwat will publish its final determination for PR 09 before the full implications of these three documents are clear. Within the regulatory regime, the companies can apply to Ofwat for an interim price determination if there has been a substantial change of circumstances. In this price review that mechanism has been augmented by a 'change protocol'. Defra's submission explains that:

As part of PR 09, Ofwat is developing a Change Protocol. This provides a mechanism for water companies and Ofwat to take account of significant factors that may arise during a price review period which are identified or defined too late to be included when water price limits are determined. This will enable, for example, relevant outcomes from the Cave and Walker Reviews and any relevant legislation in the forthcoming Floods and Water Bill, to be addressed before the next price review.[23]

15. The Government's decisions on implementing the Cave and Walker reviews' recommendations and the content of the Flood and Water Management Bill will still be unresolved when Ofwat comes to make its final determinations for this price review. The uncertainty generated may affect the companies' ability to raise money on the capital markets. Despite the 'change protocol' mechanism, we conclude that Defra should set out the probable timing of its full responses to the Cave and Walker reviews; and to what extent and how the regulation of the water industry will be altered by the Flood and Water Management Bill.

TRANSPARENCY AND BURDEN OF PROCESS

16. This Committee published two reports into the 2004 Price Review.[24] In the second report we found the process to be open to accusations of "horse trading'" as the regulator "cuts the price limits in response to companies overstating their likely costs".[25] Dame Yve Buckland, Chair of the Consumer Council for Water (CC Water), told us that in the past the price review had sometimes been seen as "the opening of the sweetie shop and everyone dashes in and grabs as much as they possibly can and then dashes out again".[26]

17. Innovations in the process such as the Strategic Direction Statements (SDS) and Capital Expenditure Incentive Schemes (CIS),[27] have both improved the ability of companies to plan for the long term and provide the public with a clearer understanding of the basis for those plans. This price review's methodology has placed more information about the water companies' plans in the public domain. This greater transparency has enabled stakeholders, including consumers, to take a view on the merits of the water companies' business plans and to see the likely impact on water prices. Water UK, which represents the UK's water companies, described Ofwat's PR 09 methodology as lacking transparency and engagement with the industry. It considered that its guidance had been "piecemeal" and "fallen short of the degree of transparency and consistency of process that had been established during the PR 04 process".[28] The Minister noted that transparency was a "genuine issue", although not one on which he considered he should dictate, but noted that the public were more likely to accept price rises if the reason for those increases was clearly articulated and transparent.[29] Greater levels of transparency in the long-term planning of the industry should have reduced the inclination for 'horse trading'.

18. Mr Martin Hurst, Defra's Director of Water, explained that the Government's guidance to Ofwat included reference to the desirability of "proportionality and transparency".[30] This guidance also states that Ofwat should develop a simplification plan and "consider ways in which to reduce or streamline the information requirements placed on companies. The Government expects Ofwat to justify any new burdens on compelling cost-benefit grounds".[31]

19. Economic regulation of a monopoly utility is necessarily complicated. In our Water Pricing report we quoted the National Consumer Council, which said "one of the difficulties with the price setting process is the, largely necessary, complexity of the process, which makes it difficult for those outside the industry to assess the merits of companies' plans".[32] The water companies also sought to persuade us of the burdensome nature of the process. For example, United Utilities' draft business plan was 4,000 pages long and Thames Water's ran to "several thousand pages".[33] The Minister accepted that it was necessary to ensure the information relating to the price review was "translated in an easily readable way".[34]

20. We recognise that economic regulation of a monopoly utility will be complicated and welcome the improvements in transparency in this price review. We commend Ofwat and the companies' determination to place more information in the public domain and recognise that Ofwat will need to publish a series of guidance and information as the process develops through consultation and discussion. Nevertheless, the current regime's complexity risks hampering the regulator's wish to increase transparency. We recommend that Ofwat and Defra seek ways to rationalise, and make more comprehensible, the process to companies. We further recommend that Ofwat and Defra consider what further information relating to the price review can be placed in the public domain, and ensure that such information is comprehensible and comprehensive. The volume of a submission is no substitute for the quality of its content.

CONSUMER ENGAGEMENT

21. Ofwat's framework and methodology for the price review emphasises that companies must take into account the impact their plans will have on consumers.[35] Companies are encouraged to understand what customers want and are prepared to pay for. This price review has had greater consumer input and we welcome the formal role of the Consumer Council for Water (CC Water), including undertaking research into consumer priorities for PR 09.[36] CC Water found that 64% of customers are positive about the service and value for money they receive from water companies.[37] Some companies, such as Yorkshire Water, have secured the overwhelming support of consumers for their business plan; others have, as yet, failed to convince the majority of their consumers of the acceptability of their plans. Consumers need to be aware that some of the water companies' investments are mandated by statute and the companies are therefore limited in the extent to which they can reduce their investment plans. The companies need to be clear what is required of them as part of any price review and, equally, consumers need, as a minimum, to accept the costs involved. We therefore welcome the recommendations (numbers 14 and 15) made by Professor Cave in his review of competition in the industry that there should be negotiated settlements between customers and other stakeholders over quality and service standards.

22. We recommend that Ofwat require companies to demonstrate how consultation with their consumers has informed their business plans. We further recommend that it be a condition for Ofwat's approval of a company's business plan that the company demonstrate that its plan is understood by the majority of its consumers.

1 Ofwat regulates 21 monopoly private water companies in England and Wales. Ten, including Welsh Water (the single, not-for-profit water and sewerage company in Wales) are water and sewerage service providers, and 11 are water only suppliers. Scotland and Northern Ireland each have a single, publicly owned, water and sewerage company, subject to separate regulatory regimes. Back

2 In this report the term "water companies" refers to both water only suppliers and water and sewerage suppliers. Back

3 Ev 70. In 2008-09, companies' average water bills ranged from £90 to £204, with an overall average of £157. Average sewerage bills ranged from £115 to £293, with an overall average of £174. Ofwat web page, How Customers are Charged 2008-09. www.ofwat.gov.uk/regulating/reporting/rpt_tar_2008-09headlines#2 Back

4 National Audit Office break-down of water customers' bills in 2008-09. Back

5 Ev 68 Back

6 www.ofwat.gov.uk/pricereview/pr09phase1 Back

7 Ev 88. Defra submitted two key documents to Ofwat in 2008: A Statement of Obligations covering the legal requirements that the companies should fulfil; and Social and Environmental Guidance covering how Ofwat might contribute to wider social and environmental matters. Back

8 Figures are from draft submissions and are liable to change in the final submission summary. Ofwat, Setting Price Limits for 2010-2015: Overview of companies' draft business plans, September 2008. Back

9 Professor Cave's final report, Independent Review of Competition and Innovation in Water Markets, was published in April 2009. Defra published the interim report from the Walker Review on 29 June 2009, Anna Walker, The Independent Review of Charging for Household Water and Sewerage Services: Interim Report, June 2009. Back

10 Draft Flood and Water Management Bill, Cm 7582, April 2009. Back

11 Ev 68 Back

12 Ibid Back