Examination of Witnesses (Questions 188
- 199)
WEDNESDAY 10 JUNE 2009
MS REGINA
FINN AND
MR KEITH
MASON
Q188 Chairman: May I formally welcome
you to a further evidence session on the Committee's inquiry into
the Ofwat Price Review 2009 and the Draft Flood and Water Management
Bill pre-legislative scrutiny. For the record I would like to
welcome Regina Finn, Chief Executive of Ofwat, supported by Keith
Mason, the Director of Regulatory Finance for Ofwat. May I thank
Ofwat for its briefing, its written evidence and obviously for
being here today and on the record. The Committee did its best
to produce a report for the Price Review which is coming to an
end, and I think it might be quite useful to ask Ofwat for a commentary
on basically how water companies performed financially compared
with what they were going to do in the light of last time's settlement.
Have they done better or worse than expected in terms of their
financial performance?
Ms Finn: Thank you, Mr Chairman,
and thank you to the Committee for the opportunity to be here.
We are very pleased to have the opportunity to talk both about
PR09 and the Flood and Water Management Bill because I think from
our point of view it is important to note that while the regulatory
regime has delivered a lot we are facing challenges that are new
and I think those challenges are something that we want to rise
to and we want to do that both within PR09 and in the longer term
context of the Flood and Water Management Bill. That is the challenge
of ensuring that we have a sustainable water sector now and in
the long term. I am sure we will want to go back to that as we
go through this discussion, so we are happy to start straight
into your questions, which are around how the companies have performed
so far under the recent price settlement, and I will ask Keith
to answer that question. Keith, as well as being Director of Regulatory
Finance is heading up the PR09 process for Ofwat so he has quite
a lot to contribute to this discussion.
Mr Mason: We have had three years'
worth of results essentially because we have not quite had 2008-09
yet—we have had up to 2007-08. On average, looking at a
return on capital—a post tax return on capital—the
companies have earned around 5.6% post tax. At the last Price
Review we allowed something of the order of 5.8%, so on average
the companies have not done quite as well as we allowed when we
last set the price limits in 2004. That 5.6% is a range; some
companies have done slightly better and we probably expect some
companies to do slightly better because the more efficient companies
you would expect, in the regulatory regime, have the incentive
to outperform or do better than we allow and some have done less.
On average companies have done slightly worse than we assumed
they would—this is in the first three years.
Q189 Chairman: So you would argue
strongly then that the last process was in no way over generous
to the companies? I say that against the background that the Consumer
Council for Water when they came before the Committee said that
something like £130 million had been returned to customers
in the form of either reduced charges or other payments which
the companies had made. I have subsequently discovered, for example,
that some of the returns of this £130 million are charitable
donations from companies to appropriate charities. I do not know
whether in the context of that you would consider £130 million
as a significant sum to indicate that the last settlement was
perhaps a little generous?
Ms Finn: To start off on that
I think that is not the case and I think it is important to look
back and see what has been achieved by the settlement and the
regime in general. In global terms it has ensured £80 billion
worth of investment in the sector, significant improvement in
services and bills that are on average about £100 lower than
they would otherwise have been. On that last point, in the last
five-year period—when this five-year period is completed—the
efficiency challenge in that price settlement will have amounted
effectively to a return to customers of something in the region
of £2.2 billion; so £130 million obviously is much smaller
in the context of that. So we would say that the review has certainly
delivered a significant amount of benefits and the whole regime
has. At the same time we think that we do have to look to the
challenges of the future because those challenges are different;
we are facing issues such as climate change, things like floods—which
I know are of particular interest to this Committee—but
also potentially drought; so changes in how our water is managed
are important. Population growth, particularly in areas where
water is becoming scarcer, like the southeast and demographic
changes like more single households that use more water. In the
face of those challenges we need to build on the successes of
the past but we do need to look to new ways of doing things and
we are doing that both in PR09 and in the longer term context
in the Flood and Water Management Bill.
Q190 Chairman: In some of the evidence
we have had from water companies there is a paradox in that United
Utilities told us that they were very supportive of the Strategic
Direction Statements, which, if you like, put in context over
a 25-year period the current Price Review and, given that many
of the investments are of a very long term nature, one can see
the value of that approach. But Severn Trent, on the other hand,
commented that they felt that you had considered elements of their
business plan in isolation without sufficient attention being
given to as what they would have described as the "bigger
strategic picture". I just wondered whether you felt that
in all cases you have taken a holistic view of the company, particularly
taking into account the SDS?
Ms Finn: One of the innovations
in PR09 that Ofwat introduced was the SDS. This is the first time
that the companies were asked to set out a strategic 25-year statement;
they have never done this before. We felt that was important because
this really is a long term business; it is not a short term five-year
business. So we required that. I think there was universal agreement
among the companies that that was a very helpful process for them
in the first instance. We then asked each of them to set their
business plan within that context of that SDS, so instead of it
being a five-year snapshot we asked them to make a longer term
case about what they are doing and how they are delivering for
their customers and the environment in their area. Clearly having
asked them to do that we then needed to look at those business
plans within the context of the SDS; I think that Ofwat is very,
very committed to doing that. At the heart of what we are doing
in PR09 and in carrying out our functions generally is the desire
to ensure that we have a sustainable water and sewerage sector
now and in the long term and that means sustainable from an environmental
point of view and it means sustainable—
Q191 Chairman: With respect, that
is a very nice declaratory statement but it does not actually
answer the question which I posed. The question I posed to you
was a criticism put to us by Severn Trent that you may not have
been able, from their standpoint, to have been able to look at
the "big picture"; in other words you were only looking
at bits and pieces. Equally, we have had people who have come
back to us who have said that there were delays in Ofwat making
available certain parts of critical information which again inhibited
the companies to fully justify the proposals that they went through.
I want you to be candid with the Committee and tell us whether
you felt that there were any parts of the approach, in looking
at individual business plans, where, if you like, with the benefit
of hindsight and more resources you could have done better?
Ms Finn: I will be candid and
say that I disagree with Severn Trent on that. In fact Ofwat has
taken a very holistic view of these business plans and where they
do not align with the Strategic Direction Statement we have challenged
companies hard. So this was our initiative and our proposal and
we have certainly followed up with full commitment looking at
these business plans in a holistic way. Having said that, we are
not at the end of the process and we will be publishing our draft
determination as you know, Chairman, in July. I would add to that
and say that as part of our commitment to the long term and to
transparency and openness we have introduced yet greater clarity
into the process than ever before, including publishing earlier
than ever our indicative views on the capital programme of the
companies—that is another innovation—and throughout
the process we have worked hard to ensure transparency. I would
not agree with companies who say that we have not done that. There
is always, always in every process the opportunity to continue
to learn and improve and we would always be open to that, but
in this case I think that that is not warranted.
Mr Mason: Since the Strategic
Direction Statements have come in we have had the four rounds
of meetings with each of the companies. It may be that one of
the companies that you have quoted, that in one of those particular
rounds they were at the beginning or at the end and it did not
quite suit their own planning process. But when you are dealing
with 20-odd companies somebody has to be at the beginning and
somebody has to be at the end, and these meetings take place over
a relatively short but a noticeable period of time. So it could
just be that that is where it has come from, and I would agree
with Regina that we have given every company every opportunity
to put in a very good business plan.
Q192 Chairman: In your submission
you said—and I quote—"We may have to rely on
the established mechanisms for dealing with new requirements arising
between price reviews."[1]
Was that a shot across the bows to say that in spite of the rigour
of the processes that you have just outlined that there might
be events over the next five years that would require interim
determinations? If that is the case, what might those factors
be?
Ms Finn: Yes, there are a number
of things that can happen within a period. Our objective is to
deliver as much certainty as possible upfront, both for customers
and for companies and for investors. However, things can change.
In particular, there may be changes in legislation that might
change the obligations on companies and that will have to be considered.
Another area that we specifically noted is that we are all—companies
and ourselves—awaiting the UK Climate Change Scenarios,
which were supposed to be published in 2008 and are now due this
year. If that information is not available in time for companies
to consider it within their business plans we may have to consider
it within the period. So there are a number of items like that
which could come up within the period and we need to strike a
balance between certainty upfront and being able to deal with
those flexibly.
Q193 Mr Williams: A year or so ago
Welsh Water were facing criticism in the press—I am not
quite sure if it was from the regulator as well—that because
of their not for profit system of operating that they were able
to borrow even more cheaply than was anticipated, and yet that
extra profit was not returned to the customers but was accrued
to the company. Is that a view with which you would agree, or
did you make any representations to Welsh Water along those lines,
do you remember?
Ms Finn: I do not think that is
attributable to us. I will ask Keith to comment on the company
structures.
Mr Mason: You are right to say
that the Welsh have a different company structure—not at
the operating level but their parent company is a different structure
to others in that it is a company that is owned by members as
opposed to owned by shareholders. We treat it quite similarly
to all the other companies and so it gets an allowed return on
capital which it can use within its own business. Welsh Water
has to borrow in the markets as do other companies and I would
be surprised if it got better rates than any other company available,
but it has done very well in terms of when it was initially set
up in 2001; and it has improved its credit rating since that date.
But I do not think it gets better rates simply because of its
structure than any other company.
Q194 Mr Williams: I am sure it did
receive that criticism of having been able to borrow more cheaply.
What would you say about the credit rating of other companies
and do you see any difficulties arising during this review of
some companies having more difficulty in getting competitive borrowing
rates?
Mr Mason: Clearly the financial
climate is not great for all companies but water companies have
to have investment grade credit rating, so that is the top quality
of credit ratings, and it is a licence requirement that all water
companies must have those. So they are all rated A minus or triple
B plus, and although companies generally are finding it difficult
to get access to financial markets water companies have seemed
in the past four or five months to be able to be a set of companies
that can go to the markets. So at the moment—and you can
never guarantee it—they seem to be in a reasonably good
position to be able to access the markets.
Q195 Mr Williams: It has been suggested
that some acquisitions have been at a price that was too dear
for the operation and that that could lead to problems. Do you
take any account of that during this process? You must look at
the capitalisation and the debt structure that is associated with
these companies?
Mr Mason: Our remit looks only
at the water and sewerage company, or the water only company,
but you are right to say that we cannot just look at that purely
in isolation. What we do have is that the water companies are
ring-fenced so that all the money that comes in is used, by and
large, simply for the water and sewerage business. So we are not
that concerned with how companies have financed themselves above
the operating company except to where there is a ripple effect.
So if someone goes bust there can be ripple effects across the
markets and is that read across to other water companies where
it should not be read across? So we would be clear in those circumstances
that we did not think that it was anything to do with the operations
of the water and sewerage businesses. But we have not seen anything
like that very recently either and some of the recently acquired
companies have put in more equity; so I quote Southern Water,
Anglian Water, Southeast Water are all what you might class as
more highly geared structures but their owners have put in more
equity recently.
Ms Finn: I would just add to that
that I think that is probably one of the strengths of the regulatory
regime that we do operate in that it has delivered a very substantial
investment in the interests of consumers and at a cost that has
been reasonable over that period and what it has also done is
ensured that the sector remains stable and secure, as Keith says,
even when times are difficult.
Q196 David Lepper: When you were
looking at the proposed capital programmes of water companies
over a period of time what sort of information do you expect from
them about how realistic some of those capital programmes are,
not in terms of securing the financial investment but the planning
process? I am thinking in particular of Southern Water and its
aspirations for a sewage plant in the East Sussex area, which
seems to have dragged on for years and I imagine over at least
two Price Review periods. So what kind of assessment of the planning
process would you be looking for when you are looking at those
programmes?
Ms Finn: The first thing to say
is that through our regulatory regime we concentrate on what gets
delivered for customers; that the outputs are what we try to aim
to tie the company too. Then the method of delivering those outputs,
which might be in particular a capital programme, is a matter
for the company to propose. We do challenge that at every Price
Review quite hard. We have a significant engagement with the company
and it is one that has increased this time around; so one of the
changes or the innovations that we have delivered is an early
review of the capital programmes of the companies with a view
to publishing what we call a Capital Incentive Scheme, which is
an early sight of what might be approved. We have reporters in
the company who scrutinise the capital programmes—they are
engineering companies usually with particular expertise—and
they advise us as well as the company. We challenge it for coherence
with the rest of the plan; and we challenge it for deliverability
so that both the scope and the costs get challenged quite hard,
in order to ensure that they can deliver the output, which is
what they will be tied to.
Mr Mason: I think your particular
question about the treatment works at Brighton, what we cannot
say is—
Q197 David Lepper: It would be rather
contentious for you to say it was at Brighton.
Mr Mason: You are absolutely right.
If companies put forward and say that they are likely to get planning
permission but then they are refused planning permission they
have put all reasonable best endeavours into gaining it; if they
cannot and they have to go back to the drawing board, which was
in the case of Southern, we just have to make sure that they have
not financially benefited from that and let them start again with
the next project. You are right, that is one that has dragged
on—this is probably the third review with which we are dealing.
Q198 Chairman: The fact that this
is not a zero-based budget process, that does not undermine the
robustness and the strength of the way that you are able to look
into companies because I suppose any finance director in trying
to protect his company, to ensure that it can deliver for its
shareholders, may have the odd back pocket somewhere, and it just
concerns me that we are always building on what happened in the
last review as opposed to re-setting the clock. Do you think that
is a weakness of your process?
Ms Finn: No, I would not say it
is because we use a wide range of tools and the goal of the tools
that we use is to delivery what the medium-term incentive based
regulation delivers, which is an incentive for companies to continually
gain efficiencies such that the benefit of those efficiencies
are then captured at the next review and passed on to customers.
So there is a constant challenge particularly in terms of operating
expenditure. On capital expenditure, as we have discussed, there
is a more output based and in some cases scheme-based challenge
which is significantly around what the companies have to deliver.
So I do not think that that is a weakness in the process; I think
in fact that one of the strengths of the process is this medium-term
incentive mechanism that is built into it.
Q199 Mr Drew: One of the issues that
was picked up with me by a major company in the water industry
production of various fixtures and fittings is the undesirable
nature of the five-year timetable and at the moment they are just
not selling anything because everybody is waiting for the new
Act to lock in. You, Regina, have been quite critical of the five-year
period, saying it is not long enough. Have you done any research
on the impact on those who supply the industry on the undesirable
nature—that it is literally feast and famine in terms of
money being spent and investment streams being organised? And
would you say that this can be quite undesirable in terms of the
way in which this has a backwash effect on what is happening?
Ms Finn: I would say in the first
instance that we think the five-year period for setting prices
for customers is appropriate. If we were to set prices longer
than that we would be concerned that customers would not be adequately
protected—we do need to come back to prices. What we have
said is that that five-year price setting process must be in a
longer term context and that is where we have introduced a number
of innovations in the process, including the Strategic Direction
Statement and the 25-year look, a thing called an Overlap Programme;
the early sight of the capital programme so that companies could
plan their capex earlier. And we are actually seeing the benefit
of that with a number of companies having gone through their procurement
exercises earlier than in previous periods and having awarded
contracts for some of the supply chain earlier in the process,
so that they can start construction and projects earlier and avoid
that rollercoaster effect of investment peaking and dropping off.
We believe that we have put in place the certainty and the tools
to enable the companies to manage their procurement cycle effectively.
We do see some benefits of that happening already and we expect
them to continue with that throughout this process and future
processes because there is a long-term Strategic Direction Statement,
a long-term direction of travel and more certainty about what
is happening.
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