Memorandum submitted by Environmental
Industries Commission (EIC) (Ofwat 15)
INQUIRY INTO
THE CURRENT
PERIODIC REVIEW
2009 OF WATER
PRICE LIMITS
BEING CONDUCTED
BY THE
OFFICE OF
WATER SERVICES
(OFWAT)
EIC welcomes the opportunity to respond to this
Inquiry as the issues under discussion are of particular interest
and relevance to our Members.
EIC would also be pleased to provide further information
in the planned oral evidence sessions.
ABOUT ENVIRONMENTAL
INDUSTRIES COMMISSION
(EIC)
EIC was launched in 1995 to give the UK's environmental
technology and services industry a strong and effective voice
with Government.
With over 300 Member companies, EIC has grown to
be the largest trade association in Europe for the environmental
technology and services (ETS) industry. It enjoys the support
of leading politicians from all three major parties, as well as
industrialists, trade union leaders, environmentalists and academics.
EIC's Water Pollution Control Working Group
includes over 80 Member companies including leading suppliers
of services and equipment to the water and sewerage companies
and to the water only companies.
This response is based on EIC's recent submission
to the Cave Review Interim Report consultation (January 2009).
HOW LONG-TERM
PLANNING FOR
CLIMATE CHANGE
AND ENVIRONMENTAL
IMPROVEMENTS SHOULD
BE PAID
FOR
The water sector faces a period of huge challenge
in coping with the implications of climate change—and in
reducing its own carbon emissions. It can ill afford to be locked
into a short-term investment cycle, which inhibits innovation.
EIC Members are concerned that the current structure
of the water industry is not leading to the level of innovation
needed to meet the challenges of climate change and water stress.
EIC believes that changes are required to make the water industry
"fit for purpose" and, therefore, supports the Cave
Review's position to commission additional research on the level
of innovation, identify the current barriers and propose changes
to better support innovation which will lead to improved efficiency
and cost savings.
AFFORDABILITY OF
WATER SERVICES
EIC has consistently argued that the current
regulatory regime for the Periodic Review creates a "boom
and bust" financial climate for the supply chain serving
the water industry in the UK as the bulk of capital expenditure
tends to be concentrated into relatively short intervals (two
to three years) within the current five year cycle rather than
being spread out evenly over the entire period.
This situation leads to financial and managerial
inefficiencies and instabilities in the supply chain and ultimately
leads to higher costs for consumers.
HOW THE
PRICING REVIEW
RELATES TO
THE CAVE
AND WALKER
REVIEWS AND
THE DRAFT
FLOODS AND
WATER BILL
EIC welcomes the Cave review's investigations
on the link between competition and innovation in the water industry
as innovation is key to improving productivity and delivering
value to customers. The Cave review's interim report proposed
further enhancements to retail competition and this is where innovation
is likely to occur in the short term through improvements in the
retail experience.
EIC's view is that competition can stimulate innovation
in some areas. This has been well documented in the gas and electricity
sectors. However, the main innovation in the water sector currently
occurs in the upstream processes in the form of treatment processes,
energy efficiency and leakage and water efficiency activities.
Competition in these "upstream activities" is a long
way off and therefore EIC believe that companies need greater
incentives to invest in innovation in these types of innovation
in the short to medium term. Comparative efficiency has delivered
some innovation in the sector but this is limited to company's
requirements for short term pay backs, the preference for capital
investment and individual company's attitude to risk.
EIC believe the approaches detailed in the Cave
review's interim report outline a more flexible approach to regulation
as it proposes staggering investment programmes and running them
over longer periods. EIC believes that this approach needs to
be adopted to ensure a viable and sustainable water industry,
which invests in asset infrastructure over the long term.
The approaches suggested will potentially provide
Ofwat with a challenge in establishing comparator information
between the companies. Additionally, since companies inevitably
have more resources and reward their employees more highly than
the regulator there is also the risk of a serious regulatory failure,
which could undermine confidence in an essential public service.
Theses concerns aside, EIC believes flexible
regulation should be investigated as the benefits would outweigh
the disbenefits of comparator loss and mechanisms could be put
in place to reduce the risk of regulatory failure.
EIC believe that the current risk reward ratio
has a negative impact upon innovation. In the current investment
period companies are looking for tried and tested technologies
which payback within 3 years. Companies have also disbanded their
R&D departments as these are not currently funded by the price
review. This has meant that research and development is now conducted
on an adhoc basis in companies, rather than in a co-ordinated
manner.
EIC also supported the Cave Review's position
to support early stage public research and development with a
ring fenced budget, which allocates funds on a competitive basis.
However EIC believe this would be better situated within Defra
rather than Ofwat, which may be in a better position to review
the outcomes of this research rather than allocate funds.
EIC also supported the Cave Review's view of
an "innovation fund", particularly co-ordinated through
Defra in areas such as the future delivery of flood and coastal
risk management by promoting innovative approaches, to cover other
aspects of climate change adaptation and mitigation. Other areas
for inclusion include innovations that reduce water industry emissions
of greenhouse gases, such as technologies to reduce the production
of non-CO2 greenhouse gases from biosolids management, would be
prime candidates for such an extension.
The scope and the deliverables of this "innovation
fund" need to be clearly defined and managed to avoid market
failure. This could potentially be achieved by having a number
of stakeholders including companies, government, suppliers and
customers involved within the process.
An apparent obstacle to innovation, particularly
for small companies, is the financial burden of process guarantees
that the water companies require before they will accept new technologies.
One proposed approach is for Defra to provide direct funding for
these guarantees or, alternatively, funding could be provided
from savings achieved against Ofwat targets.
Competition in the water sector, by its nature
has to be formally introduced through changes in legislation.
Under these conditions the incentive mechanisms are critical and
if set up wrongly could potentially stifle innovation
For these reasons, EIC has welcomed the increased
emphasis that OFWAT gives to a long-term framework for setting
price limits and the introduction of strategic direction statements
that will help focus water companies on a 25 year planning horizon.
However, in order for the water industry and
its supply chain to be fit for purpose in tackling the key challenges
of climate change and affordability a more significant shift in
the structure of investment is required.
In the short term as part of the Periodic Review
2010-15 Government should:
— Require Ofwat to ensure the 25 year
strategic direction statements contain clear targeted investment
priorities which requires water companies to maintain investment
progress across the five-year cycles.
— Require Ofwat to actively assess
water companies' proposals for their encouragement of environmental
innovation.
— Promote more "joined up"
thinking between the key regulators, particularly Ofwat and the
Environment Agency.
— Require Ofwat to review the data
it currently collects in the June Return and work with companies
to improve the management of information, particularly in the
area of water and wastewater operational efficiency.
Following the current Periodic Review Government
should:
— Transition the water industry to
a longer-term investment programme of twenty years or more.
— Stagger the investment programmes
within the water industry so that all the water companies in England
and Wales are not working to concurrent cycles. Staggered cycles
will help the supply chain and hence there wouldn't be the "boom
and bust" approach. Better performing companies could have
their plans approved over a longer period seven or 10 years. Poor
performing companies could be reviewed every three years. This
in the context of a 25 year plan. June return data can still be
collected and analysed on a annual basis for performance.
— Require OFWAT to promote and provide
incentive mechanisms to companies to invest in carbon efficient
technologies, which may have longer paybacks than the Asset Management
Periods currently allows for. This will lead to longer term cycles
which means that companies can go for longer paybacks. This will
help to look for longer term solutions that may still be economically
viable. This will allow for potentially more innovation.
— Require the Environment Agency to
introduce smart consenting for water abstraction and sewage discharges,
which takes account of the carbon impacts.
— Require Ofwat to provide companies
with incentives to consider operational efficiency innovations
in addition to the preferred capital solutions. This may involve
a review of the approach to assessing Regulatory Capital Value.
RCV could have an approach where there are rewards for deferment
of capital based on demonstrated operational efficiency. This
doesn't mean running the assets into the ground. This would require
a lot of thought as companies are masters at pouring concrete
to add more to their RCV. OFGEM have recently consulted on their
price review and some useful options suggested in the document
"Electricity Distribution Price Control Review" could
be applied to water. EIC believe that similar options suggested
in the excerpt paragraphs below could be applied to water
2.55 Under the current regulatory framework
the DNO has less financial exposure when spending is classified
as capex rather than opex. This may create a potential barrier
to commercial innovation (for example, contracting with DG or
with customers for DSM to solve network constraints) if DNOs think
the expenditure will be classified as opex. Additional spending
on capex is shared between customers and shareholders while opex
is borne wholly by shareholders. This means that DNOs are more
likely to adopt a conventional asset based network investment
solution to any network constraints rather than exploring more
efficient solutions involving people or other costs classified
as opex.
2.56 We received several responses to the
initial consultation document advocating the removal of this barrier
to encourage DSM and non-network solutions. This could be done
either by applying a common capitalisation policy to all categories
of network related costs or by allowing non-network solution costs
to be added regulatory asset value (RAV).
4.56 There are currently imbalances between
in the incentives for costs that are classified as opex and costs
that are classified as capex under the DPCR4 RAV rules. These
imbalances may distort real economic trade-offs between capex
and opex solutions and create boundary issues. DNOs bear the full
cost if they spend £1 of additional opex but only 29p to
40p if they spend £1 of additional capex. The diagram below
sets out the proportion of costs that are capitalised to RAV for
each of the groups of activities under the current cost reporting
rules.
4.58 The balance of incentives is particularly
important in the context of forecasts for large increases in opex
and capex. We are looking to ensure that DNOs have given appropriate
consideration to innovative solutions including potentially deferring
greater volumes of work and doing more to actively manage and
monitor levels of risk or adopt non-network solutions such as
demand-side management or contracting with distributed generation
to manage constraints.
4.60 We are considering a number of potential
options for moving towards more equal incentives:
— We could treat the costs for all
activities the same way and capitalise the same percentage of
all costs into the RAV. This would remove the costs boundaries
and reduce any distortions to the economic trade-offs we are encouraging
DNOs to make. It may be appropriate to apply the IQI mechanism
to all costs.
— We could treat all direct costs,
engineering indirect costs, networks investment support costs
and any constraint payments (eg DSM or payments to DG) in the
same way. A fixed proportion of all such costs would be allocated
to RAV but business support costs would be fully expensed. This
may capture the key economic trade-offs and significantly reduce
boundaries but there may be some distortions remaining under such
an approach.
— We could identify where the key trade-offs
are between activities such as faults and asset replacement and
ensure that such costs are included in the RAV using the same
fixed percentage. This would reduce but not remove all boundary
issues.
I trust that you will find these comments useful.
EIC would welcome the opportunity to provide
further information as part of the oral evidence process.
EIC
February 2009
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