Environment, Food and Rural Affairs Committee - Minutes of EvidenceHC 374

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Oral Evidence

Taken before the Environment, Food and Rural Affairs Committee

on Wednesday 22 February 2012

Members present:

Miss Anne McIntosh (Chair)

Thomas Docherty

Richard Drax

George Eustice

Barry Gardiner

Mrs Mary Glindon

Neil Parish

Ms Margaret Ritchie


Examination of Witnesses

Witnesses: Alan Sutherland, Chief Executive, Water Industry Commission for Scotland, and Mark Powles, Chief Executive, Business Stream, gave evidence.

Q1 Chair: Gentlemen, good afternoon. Apologies for the delay. It was nothing sinister and nothing to do with this subject; we had other business to deal with. We are very grateful to you for your patience.

Thank you very much indeed for being with us this afternoon and contributing to the first formal evidence session of our inquiry into the Water White Paper. For the record, could I invite each of you in turn to introduce yourselves-who you are and who you represent? Alan, we have seen each other three times in three days. This is a treat.

Alan Sutherland: I know.

Chair: You are welcome. Could we start with you, Alan?

Alan Sutherland: My name is Alan Sutherland. I am Chief Executive of the Water Industry Commission for Scotland. I have held that post since 2005. Prior to that, I was the Water Industry Commissioner for Scotland, a ministerial appointee, since 1989.

Mark Powles: I am Mark Powles. I am the Chief Executive of Business Stream, the largest water and waste-water retailer in the competitive market in Scotland. I have been there for five years, and was brought in to set up Business Stream prior to the opening of the Scottish market.

Q2 Chair: Thank you very much indeed. Could we test the water, so to speak, relying on your expertise? Alan, if I can start with you, how long would you say the whole process took-I know it is in your written submission-to implement the framework from start to finish? That is both the legislation and the rolling out on the ground.

Alan Sutherland: I first included some thoughts on retail competition and separation of activities in 2001. There was Scottish Government interaction during 2002 and 2003. By the end of 2003 it was fairly clear that this was a policy that the Scottish Government was going to pursue. During 2004 we did our first work looking at the resources and time that it would take to do the work. In 2005, we set a deadline of April 2008 for opening the market. At the time we thought we had allowed ourselves more than enough time. We only just made it, and there were those who, even a month or two before, were saying, "Could we have a bit more time?" Start to finish, serious effort-four very, very hard years. I have just about recovered.

Q3 Chair: You are looking very well on it. Looking at the fact that it was a special market-a unique market-and looking at the context of the Water White Paper and the fact that most parties are calling for early legislation, what do you think would be a realistic timetable, both for the legislative process and also for market opening?

Alan Sutherland: I said to Defra officials and to Mr Benyon, before the White Paper, that were he to pursue a retail market, April 2017 would be the earliest sensible date for a market opening, unless some form of staged opening was what he wanted to achieve. That was the advice I gave him then. I do not see any particular reason to change that.

Clearly it would be helpful to have legislation sooner rather than later to achieve that end point, but there is much that can be done before the legislation is passed. Even if the legislation were to be a little delayed-it is better to be a little delayed and good legislation than rushed and not good legislation-I still think April 2017 could be achieved. It would be a reasonable date. Any earlier would be really pushing it.

Q4 Chair: Thank you very much indeed; that is very helpful. Mr Powles, is there anything you would add to that from your perspective?

Mark Powles: I look at it from a customer point of view. Customers are overwhelmingly telling us that they want to share the benefits they have started to receive in Scotland as soon as possible. As an operator Business Stream was created in November 2006. We had to physically separate from Scottish Water, and were ready on 1 April 2008 when the market opened. A lot of the effort in shaping the market is the role of regulators and market participants-to be able to contribute to how the model should look-but physically creating the company, preparing the strategy and being ready to compete took us just under 18 months.

Q5 Chair: That is helpful, thank you very much indeed. In view of the experience you have with the Scottish legislation and setting the Scottish framework, do you think, Alan, that while it would be helpful to have earlier legislation, it would be ambitious or possibly nigh-on irresponsible to introduce it in 2016?

Alan Sutherland: I can only comment on my own experience. I certainly do not want to tell others how to do their jobs, or you how to reach your conclusions, but I would not like to have to try to do it by April 2016 for a second time. I have done it once, and that was quite painful. I would not be keen to try to do it again by April 2016.

Q6 Chair: That is helpful, thank you very much indeed. Mr Powles?

Mark Powles: Potentially you would not be starting from scratch. Much of what Alan and his team and the participants had to do was to start from a blank piece of paper. If there is a commitment to try to create an Anglo-Scottish market, there are a lot of things in Scotland that might need adapting but are pretty much fit for purpose. We have had four years of testing them and adapting them to make the Scottish market work more effectively. Depending on how the regulators work together and how the market is shaped, there is a lot of good material that would need to be adapted, rather than starting from scratch. That may help.

The other factor is that separation was not within the scope of the White Paper. If I look at it from an operator point of view, one of the big efforts for us was to physically separate.

Chair: That is helpful, and leads naturally to Thomas Docherty.

Q7 Thomas Docherty: To clarify, for my own sanity, you are saying that the 2017 is based on a 2013–14 session Bill with Royal Assent. If, for argument’s sake, it was a fourth session-i.e. it was the last year of the Parliament when we got Royal Assent-effectively it would become 2018. If we got a Bill-he says laughingly-in the next session of Parliament, it would shift forward. Is the 2017 date based on the concept of three years to the following April?

Alan Sutherland: That would be part of the rationale, yes. I am cautious. I accept what Mark said; it is largely down to the companies to do the work and most of the work is with the companies, not with the regulator, but the one thing that is demonstrably new and very big is the setting of wholesale charges. To set wholesale charges one needs to have had a level of wholesale revenue set by the regulator. That almost certainly means you would need a determination of charges. We had one in 2005. We used that as the opportunity to set wholesale revenue for the first time, and then we were able to take that and convert it into a series of charges tariffs, and to use that as the price that the retailers would pay the wholesaler.

Q8 Chair: May I interject? Could they do that as part of the 2014 price review?

Alan Sutherland: Yes, they could. If I were looking at the process, that is the way I would do it. I would be looking to set either a revenue cap or a price cap for the wholesale activities, and some form of default retail cap to ensure that no business or organisation was worse off as a result of the changes. I would be doing the two things in parallel, but once you have done that you then have the effort to put together these new wholesale charges. It is the first time it will have been done, and it is quite challenging, simply because the things that determine wholesale charges are slightly different from those that determine retail.

You will no doubt get evidence that about 10% of the bill is retail and all that, but once you get into smaller businesses, as a percentage of their bill, it is much higher than the 10%. It is much lower when you get into the very large companies, but much higher when you get into the small companies. You have to get those sums right, because otherwise the incumbent gets left with all the customers that are more expensive to serve, with not enough revenue to do it. That leads to perverse outcomes in the market, which none of us should want to achieve.

Q9 Thomas Docherty: Turning to the issue of separation: first, on the issue of legal separation, Mr Powles, you mentioned that you are legally separated from Scottish Water. Mr Sutherland, how important has it been to have that legal separation? Mr Powles, what is your experience of that?

Alan Sutherland: There are two things I would say: first, the legal separation in Scotland came about because Scottish Water is a statutory corporation, and it was easier to require Scottish Water to separate its retail activities legally than it was to unpick the various statutes that underpinned Scottish Water the statutory corporation. That is why the legal separation decision was taken. It was not an ideological decision; it was not a governancebased decision-it was almost a practicalitiesbased decision.

In Scottish Water’s case, because at the time it was still relatively new to regulation and the overall regulation environment, it probably was quite useful in terms of getting the sorts of clarity of behaviour that are desirable between the retail and wholesale sides. Can you achieve the same thing in a different way? The answer would have to be yes, but it would require increased transparency and potentially it would require a more onerous governance code if there is less separation, but you can achieve it.

The critical thing is aiming for a level playing field, so that the new entrant can genuinely enter the market and not feel like someone will be dashing down the corridor saying, "Can you fix my customer’s leak?" rather than fixing a new entrant’s leak, for example. That is the sort of environment that is not going to be conducive to the development of a fair and equitable market with the consequences of innovation and value for money that we would all want to see.

Mark Powles: We have positioned our brand to sit on the side of the customer, and to do that we need to be independent. In a conflict situation, when there is a part of the network that customers may be suffering from, we want to be on the side of the customer and challenging the network operator to fix it, and fix it to the customer’s satisfaction. Separation helped in that regard, in that I consider Scottish Water as a supplier. They are my parent company as well, but in terms of the way we operate, it is as a supplier and a customer. That is one of the cornerstones of how we have positioned ourselves, and why we have been fairly successful; we have always been able to sit on the side of the customer and represent their interests.

Culturally it has meant that we have taken some people that were TUPE-transferred over from the core Scottish Water business and thrust them into the competitive retail world. We have had to equip them with a new set of skills. We have had to give them the confidence to give a far superior quality of service, because if we do not customers will switch elsewhere. That has been quite a galvanising force: to be separate and to stand on our own two feet.

Q10 Thomas Docherty: What kind of practical things have you done to reinforce the separation? It was not just that you got legal separation; what are the other practical things that you have done?

Mark Powles: The regulator set us three tests: to be financially independent, to be independent in terms of decision making, and from a governance point of view to be transparent in the way we worked with Scottish Water as a supplier. We are in a physically different location. We have separated all of our IT systems. We own all our own data and all our own processes. We have cut the umbilical cord with Scottish Water in terms of the way we operate. We have our own board and our own management team, so we are free to make the decisions that serve our business in terms of creating our own business plan and direction for the business.

The regulator has put constraints on the relationship we have with Scottish Water; we cannot jointly contract with anything. If we want to do anything, we have to get the regulator’s approval to do so. It is fairly robust separation. Alan talked about the level playing field. It is important to new entrants to know that the incumbent’s behaviour has been moderated, and they do not get an unfair advantage in terms of the way they serve customers. I look at it as an incumbent in Scotland, and as a potential new entrant and a challenger in England. I want to be sure that there is a level playing field of competition.

Q11 Thomas Docherty: Mr Powles, do you have any concerns about competing over the border with companies that are not going to be legally separated?

Mark Powles: It goes back to what Alan said. If you do not separate you need to put a compliance regime around it so that incumbents do not have an unfair advantage. Without separation, regulators need to consider how robust that is. If new entrants do not believe they are getting a fair crack of the whip, they will challenge that.

Thomas Docherty: Thank you.

Q12 Chair: I am not sure that I quite understand. You are legally separate, but you are still part of a monopoly? Effectively there are two legal persons within one company. Is that correct, Alan?

Alan Sutherland: Public corporations are creatures of statute, and as creatures of statute they tend to be entities that do not have a holding company structure built into them, so the actual operating company is the company. Because of that, when separating Business Stream we had to take a number of steps to ensure that in creating a subsidiary, the operating company was demonstrably governed differently from the retail subsidiary. That is the different board and the rules that Mark talked about.

Although Business Stream is technically a subsidiary of Scottish Water-indirectly-it is entirely separate in terms of how it operates and is accountable. They are able to do what is in the interests of the customer. What this has always been about is trying to empower customers, and trying to get to a position where customers are able to influence the service they get, and it is not, as I like to say, the school dinner service-take it or leave it-which is what has characterised the industry a bit too much.

Mark Powles: I do not think I can add any more to that.

Q13 George Eustice: There was concern among some of the English water companies when there was a suggestion that there should be this legal separation. From what you say, you do not seem to think there has been a problem with that. Why do you think they were so concerned about it and lobbied the Government so hard to back away from it?

Mark Powles: I am not sure, to be honest. In my experience of being hired into a business with an obligation to separate, I have used it to my advantage. I have been able to create the right systems and supply base appropriate for the size of our business, and not for a big integrated water company with 5,000 people. We have managed to reduce our cost base as a result of separation. There were some set-up costs to go with it, but we have been able to create a business that is right for the customers we serve and the market opportunity that we have. It is all the things I have said before: culturally it worked for us, in terms of speed to market, and being able to serve customers in a more flexible and tailored way. Separation has worked for us. As a new entrant going into England, I want a level playing field, whether that is through separation or with a governance code. I want to be clear that I am on a level playing field with an incumbent operator.

Q14 George Eustice: They specifically said that it would shake investor confidence: that was the problem. Is there a difference in that because Scottish Water is set up differently you do not have the same problem? You are not reliant on shareholders.

Alan Sutherland: We are not reliant on private capital; that is obviously true.

Q15 Chair: Could I just interject? Where is the level playing field if you are not reliant on private capital, but the English companies that you are going to be competing with are?

Mark Powles: I feel the pressure of controlling my own balance sheet and making sure I have enough cash to pay the bills. Be under no illusions; we run this business as a commercial venture in the same way as any other private sector business would. When we lose a customer, we hurt. We hurt from a reputational point of view, but we hurt due to the impact on our profit and loss account and on our balance sheet. I come from 25 years of private sector organisations, and I run this business in no different way.

Alan Sutherland: If Business Stream does not earn the return that is set out in its governance code, it is in breach of its licence. That return was set having taken advice from half a dozen leading investment houses. It may be public capital, but it is public capital that is working very hard to earn good private sector returns.

Mark Powles: As well as the physical separation, the regulator also set us certain other licence conditions that are unique to us as the incumbent: the need to publish our tariffs and the need to make sure that any deal we do with a customer is cost reflective, and to make sure that we do not cherry pick customers. If we offer a discount to one customer in one class, we have to offer it to all the customers in that class. We have certain obligations that new entrants do not, and that was a way of creating that level playing field.

Q16 Mrs Glindon: Mr Sutherland, I address this question to you: how have you ensured that wholesale prices are fair to Scottish Water retailers and customers?

Alan Sutherland: In the 2005 determination we set a level of wholesale revenue that reflected-as the current determination would do in England-the level of revenue that the wholesale part of Scottish Water was going to need. A lot of this work has to be closely collaborative. We worked very hard with Scottish Water, new entrants and retailers to ensure that we had a set of wholesale tariffs that were fair, and were going to allow enough difference between retail tariffs and wholesale tariffs for all the costs the retailers were going to have in serving that particular class of customer.

The wholesale tariff bit is still regulated. The retail bit is regulated as a safety net, but there is flexibility for customers to pay more if they want better services, customers to pay less and get better services, or customers to do nothing and pay the regulated price. It is for the customer to decide, but we have put safety nets in place to ensure no customer can be worse off.

Q17 Mrs Glindon: Has the requirement for new entrants to pay the wholesaler in advance, or provide other financial guarantees, hampered competition in Scotland?

Alan Sutherland: I am often asked about this. I will be honest: when we set out doing this, I never envisaged asking retailers to pay in advance of wholesalers. It is not what you would immediately expect to have happen; you would expect suppliers to buy something on credit and that sort of thing. But on examining the economics of it all-trying to make sure that the market was sustainable and was going to work well-you ended up with a question: how am I going to assess the creditworthiness of the people coming into the market? How am I going to make sure that they are going to fulfil their obligations? The more we thought about that, the more we said, "It would be better if the entrants prepaid."

In terms of Scottish Water and separating the wholesale and retail bits, that was essentially moving some money around in the accounts; it was not a difficult job. When we started talking with new entrants, at the rate they acquire customers, finding the capital to acquire those customers is not terribly difficult. If you look at the actual returns on the capital employed, the margins are very low, but the returns on the capital employed are very high. In that sense, there is no particular reason not to put the limited amount of capital in by prepaying.

We have had one very large English water company participating in the market-clearly working capital is not really an issue for them; but we have had two very small entities. One was quite literally a few men in a start-up entity, who have probably been either the most or the second most successful of the new entrants. They have not been hampered by the prepayment in any way. We can be a lot less bureaucratic in how we regulate the market, because we do not have to worry about the creditworthiness of each of the retailers all of the time. If we had been going through the financial crisis with small entities, and with payment in arrears, who knows whether they would have been able to meet their obligations, and whether that might have had a detrimental impact on Scottish Water, and then potentially on customers as a whole.

It is very important to set up a world where we can be absolutely sure that the household customer is protected and we can be absolutely sure that the wholesale business receives a fair return for the activities that it does. If we do that, then hopefully we can have a successful market in England, just as we have in Scotland.

Mark Powles: That is from the market structure point of view. From a retailer point of view, it forces you to do creative things in the way you do tariffs. We have a tariff that gives a pretty good discount to customers if they pay us in advance, so we take away the impact of having to pay the wholesaler in advance, because we have encouraged our customer to give us the money up front in return for a discount. It just needs the retailer to be more innovative and creative in the way they transact with their customers.

Q18 Neil Parish: Water for Life envisaged an AngloScottish market for water in which Ofwat and WICS would mutually recognise licences granted by either regulator, share information, and produce market codes. What do you expect to be the key challenges in establishing this new AngloScottish market?

Alan Sutherland: The first thing to say is that we are a very small office. We like to think we punch a bit above our weight maybe-even my weight-but we try hard to do the right thing. We will certainly work with anyone, anytime, anywhere, as it were, to try to get to a market that is better for customers. As the Committee may know, we have advocated and tried to explain what we have been doing in Scotland to regulators, Government, companies, customers-to anyone that will listen. We do that for purely selfish Scottish reasons: we think customers in Scotland are better off with more choice, and we hear from many multi-site customers in Scotland that they would like one bill across the whole of Britain.

That is why we have pursued what we have pursued: it is very much customerdriven. We are aware that there has been an exchange of ministerial correspondence between London and Edinburgh that suggests a quadripartite forum involving ourselves, Ofwat, the Scottish Government and the Westminster Government. We think that is a good idea. We would be happy to contribute our experience-contributing our mistakes may be even more important than the things we have got right-and work from that.

Q19 Neil Parish: Who do you expect to be granting licences where? Do you expect Scottish Water or WICS to be granting licences in England, and do you expect Ofwat to be granting licences in Scotland? Will this cause a great deal of confusion if you are not careful?

Alan Sutherland: I suppose there could be confusion. My understanding of the legislation is that if you are licensed in Scotland, then Ofwat would recognise that licence in England, perhaps with an amendment-I do not know. Similarly, if you were licensed by Ofwat, the idea would be that we would recognise that as fit for purpose in Scotland. If that is what we are talking about, it is fairly clear. I would be hopeful that companies that are active in England would think it worthwhile to come and experiment a bit in Scotland and see what it is like to try to win customers in a competitive market before the reform is fully operational in England.

Chair: Can we come back to this, because we are coming on to that in just a moment? Could we turn to market codes, if we may, and then come back to the regulatory model?

Q20 George Eustice: You have touched on the structure and how you all might get around the table and discuss how to make this thing work, but what would a successful market code look like, particularly a joint market code? Mr Powles, you hinted at concerns that it might not be a level playing field. What would it look like? What are the key headlines you would like to see to protect your position?

Mark Powles: I would probably go back to what was just talked about. I do not mind who licenses me, as long as I know what obligations I am taking on as part of a licence to operate both across border and across territory, in different regions within England. If you take a multi-site retailer operating in Scotland and England with branches across the different water regions, I want to be able to present them with one bill that they can understand and that has very clear service standards. I do not want to put in 30 pages of contractual small print that says in this region we will respond to a query within 10 days, but in that region it will be in 15 days. I need some sort of harmonisation of service standards in terms of the obligations that the wholesaler has to us and to the customer.

Those are the critical things to us. We recognise that pricing might be slightly different by region, but as a retailer I am happy to take on that complexity and to be able to present a bill to a customer that they understand. I want to be clear what obligations I am taking on as a licensee, and how I can service that customer and deliver what I promised. That is what customers want as well.

Q21 George Eustice: Do you envisage this setting out response times to a broken water pipe-that type of thing?

Mark Powles: The principle in Scotland is that there is a regulated wholesale price that is the same price for every participant in the market, but a set of service standards comes with that, and there is a capped retail price. Any customer at the very worst is going to be able to get the default retail price in return for a set level of service standards and obligations that are placed on the retailer that serves them. It is transparent, it is easy to understand, it protects the customer and it means that you can deal with wholesalers in a transparent and easy way and do not have to negotiate different things all the time. That has been one of the successes in Scotland: the simplicity and transparency of regulated access. Those are the sorts of things I would like to see in an AngloScottish market.

Q22 George Eustice: Is there anything missing from the Scottish code that you think should be in there, or do you think we should just dust off the Scottish one and say that it now applies across the UK?

Mark Powles: We need to recognise that England is a bigger beast: there are 21 regions and a lot more customers. I cannot think of anything particularly that I would say, "That has definitely got to change." But there does need to be a meeting of minds in terms of creating something that is going to work in a much more enlarged market. That is where the regulators need to sit down and find that common ground.

Q23 George Eustice: Where do you think the sticking points will be? If you were to say, "Let’s apply the Scottish code to the UK," what would be the objections south of the border?

Mark Powles: There needs to be a harmonisation of service standards, because different companies work in slightly different ways. On the issue about paying in advance or paying in arrears, as a retailer if one does it one way and one does it the other, that is not a problem for me, so that might be a slight difference between the two. In the main it is ensuring that there is a regulated price that is transparent and easy to contract with. The whole basis of contracting with a wholesaler to be able to serve a customer, and to be able to switch a customer easily, is very important. The glue that sticks all this together is the registration and switching system-the market dataset and how the mechanics work. That is the area that needs a lot of care and attention to ensure customers’ transactions can move freely between the parties, and customers can switch easily.

Chair: Thank you. Could we now turn to the regulatory model?

Q24 Thomas Docherty: If I understand correctly, Defra and the Scottish Government are proposing a mutual recognition of each other’s licences and, as far as practicably possible, harmonisation of market codes. What are the arguments for and against having one of the two regulators effectively acting as a regulator for the joint market, rather than duplicating with two regulators?

Mark Powles: That is a matter for Government. As a retailer, I do not really mind, to be honest with you. As long as I know what my obligations are, as long as I can contract easily with wholesale businesses, and have clear, visible, transparent, simple service standards and pricing, I can operate. I go back to what I said about central registration and the market system: in Scotland that is run by the participants. The regulator keeps a close eye on it and can still influence it, but the participants run the market, and that might be the glue that sticks together two regulators cross-border; there might be a role for that market administrator in terms of managing those sorts of issues.

Alan Sutherland: Mark is right: that is a political call. We have our experience, we lay it out; we will talk with anyone and explain the mistakes we made, the things that we think we got right by luck and the things we might have got right by a bit of planning. We would work with whoever is charged with doing it to ensure that we get to a decent outcome. We have to recognise that we are a small organisation-we have 16 people-and this was implemented by about five of us. It was a huge amount of work; we were fortunate to be that small, because it meant we communicated very well with each other and, hopefully, with the others that were involved in helping us. It was a big collective effort of all the parties.

There is clearly a political decision about who runs it, but the key message has to be that customers, potential entrants, incumbent wholesalers, water and sewage companies, or water-only companies have to be involved in the process. They have to be bought into this, because everyone needs to work together to pull this off. You cannot go away and do this in an ivory tower somewhere; it is a big collective effort. We will play our part if that is what is wanted from us. We will try.

Q25 Thomas Docherty: Out of those 16 members of staff, how many are doing retail in the non-domestic market?

Alan Sutherland: About two and a half full-time equivalents.

Thomas Docherty: That is fine.

Alan Sutherland: That includes my time on it.

Q26 Thomas Docherty: Mr Sutherland, the way Defra envisaged it, and I am assuming the Scottish Government are the same, is that with the two regulators there is the potential for some disputes. For example, Tesco have a contract in Carlisle and Annan, and Thames Water have that contract; Tesco are unhappy with Thames Water, and, as Defra set out, they would complain to you, Mr Sutherland, about their Annan store, and to Ofwat about their Carlisle store. If one regulator revokes the licence and one does not, how would you envisage that kind of dispute? It is the worst case, but how would you try to resolve disputes between two regulators?

Alan Sutherland: I hope, Mr Docherty, that situation does not arise.

Thomas Docherty: We all do.

Alan Sutherland: My answer to you would be this: we should not have got ourselves into that situation in the first place. The reason for having commonality around settlement and registration, which Mark has already talked about, is that you have clarity on what the rules of the game are. If that clarity exists, there should be clarity for the customer that whether they technically have to come with a licence issue that is Scottish directed or English directed, they are going to get the same answer, because the rules are there-they are transparent, they are written down, and everyone understands the way in which those decisions are going to be taken. This should not be something where there are huge degrees of discretion. To the maximum extent possible, it is really important that we get a commonality of view and some clear rules written down so that customers know where they stand. If we do not have customers knowing where they stand, we are not going to have them as engaged as we want them to be.

Q27 Neil Parish: You have both made reference to the importance of data quality in your written evidence. What impact did data quality issues have on the Scottish market?

Alan Sutherland: I am going to do a complete mea culpa here. People told me I should worry more about data quality. I said, "It can’t be that bad; we’ll get through it." To be fair, we have got through it. Things in general work pretty well, but that does not mean that the data is anything like as good as it should be. There are reasons for that. You need much better data when you have two entities using the same sort of data and they have to interact and talk to each other-knowing where the meter is, knowing whether the billing address is the same as the premises that is being supplied, knowing what the shorthand that someone might have written in the billing system 20 years ago might actually mean.

All sorts of things like that need clearing up, and it is more difficult in the water sector than it is in electricity or gas, because when someone is disconnected in water, if you are really disconnected you are talking about cutting the pipes. It is a real physical act, not just the flicking of a switch. The practice is that you do not tend to physically disconnect; you turn the stop valve off.

Q28 Neil Parish: Knowing where the meters are is sometimes a headache.

Alan Sutherland: Knowing whether there are six dials or five dials in the meter can be a headache. Which way does the meter count? I know it sounds ridiculous, but these are the sorts of things we have had. What has tended to happen is there has been a bit more angst than there should have been when customers have switched, as a consequence of relatively poor data in some instances. It is not huge numbers; we are talking a very small percentage, but that does not mean that we have addressed the problem as well as we should have done. I recently wrote to Mark and the other licence providers and Scottish Water on the subject of a collective initiative to up our game on this. Hopefully, by the end of this calendar year we will have got the data to the point where it is as good as it can reasonably be, which will not be perfect. I would imagine that each company in England will have more or less the same issues.

Q29 Neil Parish: Yes. I was going to ask what English water companies can gain from the Scottish experience.

Alan Sutherland: I think to address the matter earlier than we did.

Mark Powles: I wish we had done more pre-market opening than post-market opening. Alan alludes to it: the data quality that you would need within an integrated water company, those informal rules and flows, are very different from what you need in a market. The market dataset is what new entrants will use to quote on a customer, to identify a customer, and to switch a customer. We have had to build a lot of new processes and expertise into our business to ensure we get data right from a market obligation point of view, but also ensuring that we are serving customers well by billing them properly, with the right services, with the right tariffs, and all those sorts of things. It is probably the most important thing, but be under no illusions: data in utilities is always going to be a challenge. You will never get to the end of the journey; it will always be an ongoing refreshing job.

Q30 George Eustice: This is really for Mr Sutherland. You have your next strategic review of charges in 2014. What impact will these proposals have on that, and to what extent will you factor what is proposed into that review?

Alan Sutherland: It will have no effect on our determination, I think, simply because we already set a wholesale charge. The default retail tariffs will be what they will be. We are in the process of learning a lot of lessons about what a more responsive Scottish Water can deliver to its customers, so we learnt lots of lessons in that form, but in terms of the mechanics there will be no extra expenses for customers. Prices will be a bit lower than they would otherwise have been, because Scottish Water has saved money. Things like that will be positive. Fortunately we have been through the exercise that the English companies and their regulator are going to have to go through in their next price review, which I suspect will be altogether more painful.

Q31 George Eustice: Is there a point at which, if you get sufficient competition at the retail end, it does start to affect the prices you would set at the wholesale end, or do you always see a very hard separation? That was the concern of the water companies in England, which is why they objected.

Alan Sutherland: There are two things. In terms of the end customer, already over 60% of customers in Scotland are paying less than the default tariff. Without switching, they are better off: they are getting a better service and they are getting a better price. That is the impact of competition working through the system. Hopefully that scores a tick with everyone; we all want our economies to be going in the right direction. In terms of the wholesale level, clearly we all want a sustainable wholesale water business that can do the right things for the environment, for public health, and serving households and all of that, so that will be in essence regulated price.

We have built into the framework an element I regard as very important, which is that should someone come along with an innovative idea that reduces the costs of the wholesaler, the benefits that are achieved by that are shared out. They are shared out between the customer, the retailer, and the wholesaler, so that everyone pulls in the same direction in order to achieve the innovation or the improvement-the reduction in cost. It is done in a way that it is a win-win win, if you like.

What can that be? It can be giving extra water efficiency advice in an area where the supply-demand balance is such that if less water were not being used, some new asset would have to be commissioned. It could be about taking waste water out of the waste-water system and partially treating it or recycling it for use in loo flushing, or car washing, or other activities like that. That is already happening. Different sorts of initiatives are possible, but we want to see as much innovation come through as possible.

If innovation is going to stick, it is going to be customer-led: it will be things that customers want to pay for, or want as part of their service. We are keen to get as many incentives into the process as possible to reward customers for doing things that are good for the environment or good for other customers, because if we can do that, the whole system starts to become more efficient.

Q32 Chair: If competition is believed to drive innovation, why is upstream competition not allowed in Scotland?

Alan Sutherland: There are a couple of horrible myths that seem to get quoted about Scotland all the time. One is that we have a messianic ambition to take things over or something.

Q33 Chair: Some might say the cream always rises.

Alan Sutherland: All I can tell you is what we think. All we are trying to do is get to a better outcome for the customer. It is just that.

Q34 Chair: I am possibly missing the point. Why have you limited competition to wholesale and not extended it to upstream?

Alan Sutherland: The law in Scotland says that common carriage-the issue four, five, six, seven years ago probably-is not allowed in Scotland unless Scottish Water agree to it, or the Scottish Government agree to it if Scottish Water have not agreed to it. In that sense it is not a ban on competition upstream. Government has reserved itself the right, on public health grounds-because the Scottish Parliament could not legislate on anything to do with competition-to say, "We do not want that to happen." People who say there is a ban, and I know in the political process people will often say there is a ban, are not actually correct in saying that. There is not a ban; there is just a sort of deferred reference process.

Q35 Chair: May I ask it in a slightly different way? Why would it be deemed to work in England if it is not deemed to work in Scotland?

Alan Sutherland: Maybe I do not understand what is being proposed in England well enough, but my sense is that if there were opportunities for Scottish Water to buy water from Northumbrian Water, or from United Utilities (UU) across the border, there would be no particular issue in doing that if it were a mutually beneficial transaction to both Northumbrian or UU and Scottish Water. I do not think there would be an issue about that.

Clearly the number of times that water and sewerage companies touch each other in England and Wales leads to potentially more opportunities for cross-border transfers of water. I would not for a second want to suggest to you that there could not be more transfers of water between regions, but it ought to come about as a result of a process of collaboration, rather than some sort of situation where someone might sell water that they then run short of, and that person has got a problem because they have sold it, and the person who has got the water is quite pleased because they have got it when they would have been short. The process needs to be a more collaborative and co-operative one than that, otherwise I do not think that you are going to see the sort of benefits that are potentially achievable.

Q36 Chair: It is possibly another area where there will be no level playing field, because Scottish Water or Business Stream can buy into UU or Northumbrian Water, but they cannot buy into-

Alan Sutherland: I do not think there would be any issue with Scotland supplying water to England. I suspect politically that would probably work quite well.

Q37 Chair: We will possibly ask you to clarify it in writing; we will put the questions in a more specific way, if we may, because it would be very helpful. Mark, regarding something you said about making it easier to transfer customers, the example that we have seen is the energy market; I know they are talking about household customers, but it has not always been easy or successful for customers to transfer. Why do you think the experience in the water market might be better?

Mark Powles: It has worked pretty well in Scotland since it opened; a customer can switch in a maximum of 20 days, from deciding they want to go to a new entrant to registering that transfer with the registration system. As the incumbent we get five days to review it, to see if there is any reason why that customer should not be able to switch. After that the process works, and in 20 days from start to finish the customer switches. That gives the customer confidence, because if the customer wants to switch but it is going to take three or four months to happen, they lose confidence. The system has worked pretty well.

Q38 Thomas Docherty: Very briefly, we have talked a lot about price, but water is also a resource. How has competition helped to shape that debate? What examples can you give of how competition has dealt with water as a resource?

Mark Powles: We try to get into the head of our customer and what drives their world. Different customers have different things that are important to them. Some want to save money, some want to save time, some want to improve their environmental credentials, others want to reduce risk, and others want to be more in control. The suite of services that we have had to put together to make sure that customers want to stay with us, rather than go to a new entrant, has responded to that. From a water efficiency point of view, we have proactively done everything from water audits, to benchmarking tools, to sending people in to do process improvements, to putting smart meters on to supply points. That has driven around £20 million of pure consumption savings for customers since the market opened.

We work with customers that want to save time; we have embraced the internet. Approaching 50% of our customers now trade with us electronically. Multi-site customers that were getting 200 bills a quarter are now getting one electronic file on a monthly basis from us. That has saved them money, but also reduces our costs. That saves money. It saves time, and makes the whole understanding of what, when, and why you are using water far more visible to customers.

You used the word innovation. We have had to innovate in a lot of different ways. We have gone from a range of six services when we launched to having almost 60 different propositions that we give to customers today, and that is the reason why I think we have been successful.

Chair: Thank you. Can I thank you both very much indeed on behalf of the Committee for being so generous with your time and contributing so fully to our inquiry? Thank you very much indeed.

Examination of Witnesses

Witnesses: Regina Finn, Chief Executive, and Keith Mason, Senior Director of Finance and Networks, Ofwat, gave evidence.

Q39 Chair: Good afternoon and welcome. Thank you both very much for agreeing to participate in the first evidence session of our inquiry into the Water White Paper. For the record, could you introduce yourselves?

Regina Finn: My name is Regina Finn. I am Chief Executive of Ofwat.

Keith Mason: I am Keith Mason. I am Director of Finance and Networks at Ofwat.

Q40 Chair: Thank you very much indeed. Our first set of witnesses shared with us the experience in Scotland, and we had the opportunity to ask them about the legislative time frame and the time it took to take the proposals to market. They are on record as saying that in their view 2017 would be the earliest opportunity, without being over-ambitious, both of bringing the legislation forward and bringing the proposals into market operation. Would you share that time frame?

Regina Finn: The important thing about the time frame for implementing the proposals in the Water White Paper is that there is an issue of elapsed time from the implementation of legislation. It is a somewhat moving timetable in that a quite considerable time ago we at Ofwat were asked for indicative timetables, which we provided based on assumptions around legislation. We do not know precisely when legislation will be put in place to implement those proposals, so that will be the first determinant of the time it takes to implement the proposals.

The fact that we now have the White Paper means that we can develop the work plan to implement the proposals, and that is what we are working to do now. Our indicative work in Ofwat, which we did in response to people’s requests for information about timetables, shows that a timetable of approximately three years from the implementation of regulation could be achievable for market opening. Clearly that is subject to quite a bit of work, because we have only had the proposals since just before Christmas, and we are now in a position to work with the various stakeholders to figure out what can be done.

We have quite a lot of experience in terms of market opening. I have been involved in market opening for three other sectors, and we have the experience of market opening north of the border, in Scotland for water, so there is a lot we can learn. There are differences and there are similarities, and we are on the path of being able to develop that timetable to firm it up. For now, we are still on the page where our indicative timetable would say three years from the date of legislation, but that is dependent on legislation, and it needs more work.

Q41 Chair: If you look at the Scottish example, it took approximately three to four years from the date that there was a commitment in the legislation to bring it to market. Obviously the English market is much bigger. Do you think you were being over-optimistic in the White Paper?

Regina Finn: There are similarities and there are differences. There are 21 companies south of the border whereas there is one in Scotland, so that might make it more complicated. On the other hand, we already have a water supply licensing regime, which puts in place quite a number of the elements already here south of the border, so that would help. We already have accounting separation implemented for a number of years with the companies, so that will help. We also have the benefit of learning from the published and implemented market codes north of the border, which will help.

Some elements would go towards making things more complicated, and some elements in our case are perhaps simpler. Government has made it very clear that it is not going to require legal separation of companies, so we do not have to implement that element. It is swings and roundabouts, and this is where we need to work through the detail to come up with a firmer timetable with all the stakeholders.

Q42 Chair: We will come to legal separation in a moment; Gray argued forcibly for it, but we will park that to one side for the moment. Your bottom line, though, is that the Government should bring forward legislation as soon as possible.

Regina Finn: We think the publication of the White Paper has been an excellent step forward; it sets out the long-term direction of travel and it allows us to get on with some of this work. Publication of legislation as swiftly as possible would help with that, because it will provide ever more clarity on what the Government wants to achieve. So, yes, we think the opportunity is there for Government to publish as soon as possible so all parties know what they are trying to achieve.

Q43 Chair: I am familiar with what Ofwat are saying the savings are going to be, but have you done an assessment at Ofwat of what the upfront costs to the water companies are going to be?

Regina Finn: The decision to proceed with the policy of market opening was a Government decision, so the impact assessment for the Water White Paper, which includes both costs and benefits, includes our input on the costs to the sector of what needs to be done. We have provided the information to Government to do its own impact assessment to make its policy decision. Clearly the impact assessment came out overwhelmingly positive for the package of reforms that is in the Water White Paper. Now that is set out, the next step will be to start turning those original estimates into more detailed work.

Q44 Chair: What is your initial assessment of investors’ response to the market reform proposals? What do you think are their key concerns?

Regina Finn: Investors’ response to the Water White Paper has been generally to welcome it. We have seen published analysts report. I have met with a lot of investors myself, and Keith, in his role in Ofwat, has met with all of the rating agencies. Their general view is that it is sensible and cautious, and both the Government and Ofwat’s parallel publications underpin Ofwat’s commitment to ensuring the low-cost finance to the sector remains protected, and that means ensuring that it remains attractive to investors. I think the general response has been positive, and the package of measures is broadly welcomed.

Keith Mason: It would be difficult to distinguish the Water White Paper reaction from our Framework Paper reaction, so they probably took the two together. What they felt was helpful was that the two seemed complementary: the things proposed in our Framework Paper chimed well with what was proposed in the Water White Paper. As Regina said, you can look differently at equity investors and debt investors, but broadly both of them were reasonably positive. Equity investors were probably slightly more positive, because they could see greater differentiation and greater opportunities for higher returns. Debt investors are more interested in ensuring their interest payments are received and protecting their capital. But overall it was positive, and share prices on the day of the Water White Paper announcement did not move very much at all.

Q45 Chair: Who do you think will end up paying for the costs under the White Paper? Will they be passed on to the customer?

Regina Finn: Taking the package of measures in the Water White Paper and the package of reforms, they incur both costs and benefits. Clearly they are only worth proceeding with because the benefits to customers outweigh the costs that customers will incur. There will be cost to customers, but the clear view of Government and the impact assessment demonstrates that those costs will be outweighed by benefits, which means that overall bills to customers will be lower than they would otherwise have been.

Q46 Chair: Do you recognise the figure that a small increase in the cost of finance would be enough to wipe out the benefits? Your calculations show that the radical changes that you propose to make in the price review at the high end would yield savings of £2.5 billion over a 30-year period, but your calculations also showed that an increase in the cost of capital of just 0.2% would more than wipe out these benefits?

Regina Finn: The challenge is to take a balanced, stepped, evolutionary approach to change that ensures we capture benefits, not just for today’s customers but for future customers, and do so in a way that retains the investor confidence and the low cost of finance that we have managed to achieve in this sector over this period. We are incredibly conscious of the need to strike that balance throughout all our work, and I would echo what Keith said about alignment between our work on price limits and the work of the Government on the White Paper. It also recognises the need to strike that balance.

The important thing is that we do proceed, and in the way it is set out in the White Paper and in the way our price limit reforms are set out, they are evolutionary changes designed to ensure that this sector is not in a position where we do not capture the ability to rise to the challenges that are definitely coming down the road. We have seen drought declared over great swathes of the country recently, and we must put in place the reforms necessary to enable this sector to prepare for those sorts of challenges better in the long term, while at the same time protecting that efficient cost of financing. We are very conscious of that balance.

Q47 Chair: Are you able to assure the Committee this afternoon that the impact on customers’ bills will be proportionate and affordable?

Regina Finn: Our core twin duties are to protect the interests of consumers and to ensure that efficient companies can finance their functions. I can assure the Committee that we will discharge those duties with the same zeal as we always have, and that is at the centre of our focus.

Chair: I am sure we will return to these points at a future date. Thank you.

Q48 Barry Gardiner: The water companies must be jumping up and down for joy, mustn’t they, with Defra saying that they are not going to require legal separation?

Regina Finn: The Government decided not to require legal separation on precisely the basis of wanting to avoid causing investors any concern. They wanted to avoid that. That has been described by commentators as "cautious". That was the Government’s choice. Having said that, the package of reforms and the introduction of choice for customers can be implemented without legal separation.

Q49 Barry Gardiner: Of course it can, but the point is that Professor Cave’s independent review said that it should be compulsory. The written evidence from Business Stream in Scotland states that legal separation was fundamental to their success, enabling them to create their own "identity, brand, and culture" and to challenge their wholesaler to provide a consistently high level of service. In England we are going to lose all that, aren’t we?

Regina Finn: The first point is that we also agreed with Martin Cave that legal separation would be a preferred route.

Q50 Barry Gardiner: Are you still shouting about that to Defra?

Regina Finn: It would be a cleaner route. Government policy choice has been not to do that, and it is perfectly possible to introduce market competition without legal separation. It has been done in many sectors in the past.

Q51 Barry Gardiner: But to the detriment of new entrants into that marketplace: that is the point. The Government has talked about you being so smart. I think you are a very smart woman; I have no doubt about that, but it talks about Ofwat using "smart ways" of getting round that. What are these "smart ways"? I have not got very much confidence that, no matter how smart you are, it would not be a damn sight better if there was legal separation.

Regina Finn: I would agree that legal separation would be cleaner. The tools that we have to police nondiscrimination are both ex post and ex ante. I apologise for using jargon. We have a number of tools to police discrimination, some of which I mentioned earlier. We have accounting separation, whereby we require the companies to account separately for the businesses. We have a requirement for no undue discrimination, which we can police, and if we find discrimination we can take enforcement action, and we do. We have a system called transfer pricing, whereby we reveal the transactions between the two parts of the business. We can place a range of licence conditions on companies to ensure that they do not abuse that scene; we can require maximum transparency. There is a wide range of tools. If there are transgressions, there are tools we have to take enforcement action, and we have a track record of taking enforcement action where companies do not comply with the rules. That is a big deterrent.

Q52 Barry Gardiner: Thank you for that, and I hope you apply every one of those different elements. But look at the track record in other sectors. I look across to the electricity sector, where you had wholesalers and retailers, but even where you have a split, there is common ownership. You know the difficulty is getting real transparency and real liquidity into that market, and that has been the problem for new entrants. How are you going to get round that in the water industry?

Regina Finn: I would say it is not just the electricity market. I have overseen the liberalisation of telecommunications markets, gas markets, and electricity markets, and I have every sympathy with new entrants and the need for them to have confidence in the regulatory regime and that it will protect their interests. The thing that is really helpful to us in the White Paper is that it proposes to give us tools to require ex ante regulatory terms and conditions on which new entrants can access the networks of incumbents. That is incredibly important, and a very important step forward from where we are now, where those new entrants must come in and must negotiate individually, without any transparent terms and conditions or common codes or contracts.

The White Paper suggests a number of new tools, particularly market codes, upfront common contracts and new transparent access pricing, which we will certainly police. It is giving those to the new entrants and providing that transparency that will encourage them and give them the transparency they need.

Q53 Barry Gardiner: Will you be separately reporting on the accessibility of the market to new entrants in your reports each year?

Regina Finn: We will be working to ensure the architecture is everything that new entrants need to get into the market. The point I was making to the Chair a moment ago was that now that we have the White Paper and the sooner we have a draft Bill, we can engage with those entrants and with the incumbents about exactly what the rules need to be to ensure that new entrants can get fair, non-discriminatory access to this market.

Q54 Thomas Docherty: On the issue of separation, if Defra say, "We do not even need them to leave the building, and we do not need them to separate their staff; they can share staff and offices," do you think that will help or hinder confidence that they are playing by the rules?

Regina Finn: I read the White Paper to say that there is a decision not to require legal separation, but there is a clear signal in the White Paper that Ofwat should be empowered and should use all the tools available to police nondiscrimination. We need to develop the suite of what those tools are and how we apply them, but my reading of that is that it is very clear that it is to be properly policed, so that Government policy, which is to open up the market, can happen effectively. I would read that to mean that we can put in place the appropriate level of rules. I would not read it as constraining us in putting in place those rules, but these are the details we will need to work out.

Q55 Thomas Docherty: Would you be surprised if Defra were to suggest to you that they did not think that they even needed to leave the building-that they could sit literally side by side? Would you be comfortable if Thames Water said, "We are not going to move them out of the building-they will sit in the same corporate offices, sharing functions, sharing staff, and sharing the IT"? Would your instinct be that you would be comfortable with that, or would you want to put in place some physical or cultural distance?

Regina Finn: We will want to assess the degree of separation of the functions that would be appropriate. The famous words are "Chinese walls"-you use Chinese walls, which are codes of conduct, internal memoranda and agreements. There is a wide scale that you can go to on that. Ofwat were clear that we felt the full legal separation would be preferable, so clearly rowing back from that-the further we would row back from that-the less preferable it would be. We would like to have as clear a degree of separation as we could get.

Q56 Thomas Docherty: I am sorry to have to press you, but if Defra say, "We do not want them to separate; we are quite relaxed; they can sit literally side by side in the same office suite," that would be less than favourable?

Regina Finn: If that were hardwired into legislation I would be incredibly surprised, because that is not the sort of thing that should be put into legislation. It is something that should be for the market design between the regulator and the participants. The first point is that I would be very surprised, because it does not sound like a policy; it sounds like operation. If that level of detail were to be prescribed, it would be unhelpful.

Q57 George Eustice: On the same issue but from the industry’s point of view, are their concerns irrational, effectively, and it is just short-term market sentiment-the share price flickered, because there were worries, they had a panic attack and have not thought it through? If you have a regulated wholesale price, that should underpin the investment that you need to invest in the infrastructure, which is what they claim they are worried about. Is it just an irrational fear that they have got, or is it the case that their model requires them to rip off their customer?

Regina Finn: As Keith said, we did not see a reaction in the share price when the White Paper and our Framework Paper were published.

Q58 George Eustice: No, but in the run-up to it my water company was coming to me and saying, "You have already trashed our share price by even thinking about this idea."

Regina Finn: The fact is the evidence does not support that, because the share prices have not been affected at all, so the first point is that perhaps that is a little bit misleading. The share prices were not affected by what we said. That leads me to believe that investors are perhaps a little bit more rational than was being represented to you. I think investors understand exactly the point you have made, which is we have made a commitment to protection of the monopoly wholesale business, and the investment in that, including the regulatory capital value (RCV) and the return for efficient companies. Investors, by and large, understand that.

Certain investors do not like any change of any kind, because it involves trying to figure out what it means, but in this case we have had an extensive round of communication. They understand that the change is evolutionary, and that they have that protection. The evidence of that is that the share price has not been trashed, and it has stayed steady, that these companies are continuing to raise finance at good rates and where there have been takeovers of these companies recently, they have been bought at significant premiums. That to me smacks of a sector that still attracts investors quite strongly.

Q59 George Eustice: They would argue that is because you took out the bit they objected to: the idea of separating the retail from the wholesale.

Regina Finn: I would argue that probably is not the case. If Government decided for conservatism reasons and for their concerns that it would rattle investor confidence, then we are here to implement Government policy and we will work with that. It is perfectly possible to achieve market opening without legal separation, even though it would be cleaner to have legal separation.

Q60 George Eustice: You think the reaction of the water companies was kneejerk conservatism rather than a rational view?

Regina Finn: If the water companies were representing to people that their investors were going to take flight from the sector, the water companies were not correct, because their investors did not, and I do not think would have.

Keith Mason: Northumbrian was taken over by CKI, prior to us issuing our Framework Document, prior to the Water White Paper, and that still attracted a premium of around 20%-25% on the share price. Obviously, CKI felt that they were buying into a sector that had value for them, even given the fact they were not completely sure what framework they might be following post White Paper, and post our Framework Paper.

Regina Finn: At that stage they may well have been assessing that there was a possibility that legal separation would be put in place, but they still paid that premium because they still valued the company.

Q61 Mrs Glindon: How will you ensure that abolition of the cost principle does not result in household customers subsidising big business?

Regina Finn: We can certainly do that very easily, because cost principle or not, whatever the access pricing is we already have in place a "no unfair discrimination" clause in licences, so we already ensure that household customers do not crosssubsidise big businesses. That is part of our regulatory framework as it is, and we do that through understanding the costs and the revenues for both parts of the businesses, and by ensuring what we call transfer pricing rules, whereby there is transparency between each set of customers paying for their own costs and not subsidising the other. Those tools are already in place.

The cost principle acts as a significant barrier to the introduction of choice for business customers. The removal of the cost principle means that we will want to replace it with a fairer set of access pricing rules, and there are many precedents for that: it is very possible to do. Whatever set of access pricing rules comes into play, the existing protections to ensure no cross-subsidisation of the kind you mention are already in place. We are very well tried and tested with them, and I can assure you we will continue with them and police them.

Chair: I think we covered time scales earlier, so I will turn to upstream competition.

Q62 Mrs Glindon: Would you support a step-by-step approach to reform with upstream reforms delayed until the retail market reforms have been implemented?

Regina Finn: Our view is that the Water White Paper has a lot of strength, because it is a package of reforms that together deliver benefits, and that includes retail competition and upstream reforms. If you look at the impact assessment for the Water White Paper, the upstream reforms-although it says they will certainly take longer, so they are staged, or already stepped-will overwhelmingly deliver a huge chunk of those benefits. We believe it is important to take it forward as a holistic package. That is particularly important when you think about the big pressures on this sector. The pressure is about availability of water in the face of rising population, climate change, volatile weather, and the drought declaration we have just seen across huge swathes of the country.

I was at an event recently where a number of commentators talked about this. We know those challenges are there. We must reform the upstream part of the sector to enable the water companies to meet those challenges of the future. We have known that these problems are here for a long time now. Now is the opportunity to tackle them. Our view is that it is very important to set out the legislation and the enabling steps to facilitate that upstream reform, albeit the Water White Paper already says it is staged and it will take longer, but if we do not take it forward as a package, if we ignore the upstream issues, we will be ignoring the sustainability of this incredibly precious resource for future generations.

Q63 Thomas Docherty: You were far too polite to say to George that the water companies were lying through their teeth, but I will certainly do that. On the issue of joint working, what do you think will be the key challenges in establishing the AngloScottish joint market?

Regina Finn: My experience in setting up markets across different jurisdictions-I have done this personally, setting up a single electricity market in the South and North of Ireland-is that there are challenges, because there are differences. There are differences in duties and there are differences in the remits of the regulators, but the opportunity is that a joint market will deliver economic benefits for both jurisdictions. Therefore, it is an administrative or economic issue that regulators can handle and can put in place mechanisms and systems to deal with. Now that we have the White Paper, we can start to sit down and identify the maximum degree of joint working and harmonisation that we can put in place.

We need to do that so that the customer sees a seamless experience on both sides of the border, and the new entrants see, as far as possible, a seamless experience, which means aligning market codes, which is very doable; Scotland has a great precedent for us to learn from. Then we need to recognise that there are some issues where we will have to manage the differences. WICS in Scotland has a duty to do no harm to Scottish Water and we in Ofwat have a duty to ensure financeability of efficient companies. They are slightly different duties, but we need to manage ways of ensuring that those differences can be handled. My experience is they can be handled.

The challenge is to sit down and set up a set of governance structures-how we meet and manage the decision making that affects both markets. I have experience of one set-up that did it. I am not saying that is the answer here; we need to work with our colleagues to find the best solution for England and Scotland. But in the example I gave you, we set up a joint committee of regulators to make decisions where they were affecting both sides of the market, and it worked very well. The reason it worked well is that there were benefits for all, and both regulators had an objective to maximise those economic benefits.

Q64 Thomas Docherty: I do not know if you heard the question we asked Mr Sutherland earlier on. It sounds as if there is going to be a great deal of duplication and overlap between the two regulators. What are the pros and cons of having a single regulator, rather than both regulators, who would regulate the retail sector?

Regina Finn: The challenge to us and WICS is not to have that duplication, and essentially that means we work together to share out the work that needs to be done, and we share resources. That is very doable. You can do that whether you are one organisation or two organisations: it is an administrative issue, and my personal experience is you can manage that. The idea of setting up another regulator-

Q65 Thomas Docherty: I did not say that. I said one or the other regulator regulating the retail sector. I would be grateful if you could also clarify why you do not think there is duplication, given that you are both going to have to recognise licences?

Regina Finn: To take the duplication issue first, we are going to have to have licences for all players. We already have licences here in England and there are licences in Scotland, so we know we have licence texts. The piece of work we would need to do jointly, which goes back to my experience in other sectors, is to ensure those licences can be aligned and harmonised as much as possible, and that they can be recognised. I do not think that is duplication of work; it is a necessary element that you would need to put in place anyway, because the licences in England are going to be issued under a different piece of legislation from the licences in Scotland. The only way you could change that would be to set up a new piece of legislation that enabled you to issue licences for all of Scotland and England. That means you get back into the need to set up new legislation, if that is what you want to do.

Q66 Thomas Docherty: I am not sure I follow that. Using the example of railways, the Scottish Government, through Transport Scotland, issues the franchise for the railway. In England it is DfT, yet ORR is the regulator for both parts.

Regina Finn: Frankly, you can establish a single regulator for England and Scotland. You can do that.

Q67 Thomas Docherty: I am not saying that we necessarily should, but what are the arguments for and against?

Regina Finn: In my experience, to set up one single regulator, or to give one regulator the functions for the entire market, will require legislation and a revision of duties, and allocation of duties to one or other organisation. You will have to go back to the primary legislation and make changes there. That raises issues of jurisdiction, devolution and responsibility, which is perfectly fine. That is something that politicians here will probably know more about than I do, and that is something that would need to be tackled. I am not sure how long that would take or what would be involved.

The argument for co-operation to create a market and make it work is that you do not need to create new legislation and revise duties of the two regulators. You would certainly need to revise duties of one or more of the regulators if you wanted to give one or other of them jurisdiction over England and Scotland. You do not have to do that to achieve the outcomes. From a pragmatic regulator’s point of view, I believe you can achieve the benefits without that necessary overhead and without the necessary delay that would cause to things. That does not mean you cannot do it. You can use any institution you want to achieve the outcome you want, but the existing institutions are quite well placed to do it.

Q68 Thomas Docherty: That is helpful. Looking at an example of potential disagreement-this is the worst-case scenario-Tesco have a contract, for argument’s sake, with Thames Water for both Annan and Carlisle. Defra’s view would be that WICS would have the regulatory responsibility for Annan and that you would have the responsibility for Carlisle. Tesco are unhappy with Thames Water and they complain to both regulators, which is the model that Defra are proposing-with the Scottish Government, to be fair. Let us say you and WICS take a different decision on revocation of the licence. How do you resolve those kinds of issues?

Regina Finn: The challenge is to deal with that up front. There is work to be done on this with WICS, the Scottish Government, and Defra. If I was designing that now, I would ensure that, before you got to that situation, there was a protocol of agreement as to how you would handle that sort of issue. The decision making might well be done jointly between WICS and Ofwat. We would set up an arrangement whereby we would jointly decide how to deal with that and how to handle the outcome, so that you would not get to the stage where two regulators had investigated something, ended up with different conclusions, and then you have a conflict.

Q69 Chair: Could we pursue this in writing? Could we ask some further questions in writing?

Regina Finn: I would be very happy to follow it up if you would like.

Q70 George Eustice: In your written evidence to us you talked about this idea of two licences for the incumbent operators, one for retail and one for wholesale, so that you could encourage them to exit and have consolidation. Could you explain what the advantages of that would be-why that would help the customer?

Regina Finn: If you look at the objective of the proposed policy, the policy in the Water White Paper is to ensure that business customers have choice, and that means that they can choose the supplier that gives them what they want-the best supplier. Essentially, we are talking about an effective market for that part of the business. In those circumstances some companies are going to be more efficient at delivering that retail service, and therefore able to give customers what they want, so customers will go to those more efficient operators.

In any wellfunctioning market, a company that perhaps is not very good at providing retail services-and it costs it quite a lot-would say, "We’re not doing well here. We’d like to sell this business, get out of the business, and focus on something else." Therefore, they exit. New entrants come in, some people exit-that is how you get the dynamic market.

We understand the Government’s decision not to require legal separation. However, we are concerned that-perhaps inadvertently, perhaps not-the requirement to keep the vertically integrated licence prevents the incumbents from saying, "I’m doing a retail business, but I’m not doing very well at it; I’ve decided I want to get out of the market." That incumbent will not be able to get out of the market, because they will have a single vertically integrated licence that requires them to deliver a service to retail customers. So they will not be able to do that. We are not saying anybody should be required to enter or exit the market, but we think it is better not to constrain the market from delivering the best outcome.

Q71 George Eustice: Did you flag this proposal up with Defra before they published the White Paper?

Regina Finn: We have had discussions at working level, but until a clear policy decision was made about what the degree of separation would be or would not be, which was a matter for Ministers in the run-up to the final decisions about the White Paper, it was not possible to tease through all of the options. We have certainly made Defra aware of our concerns around this.

Q72 George Eustice: What has their reaction been? Have you had a reaction to that idea?

Regina Finn: We have not had a direct reaction. We have explained our concern, and it has been acknowledged. Officials understand it. I have not yet been able to talk in any detail with Ministers about that. It comes back to the point about seeing draft legislation: that is an opportunity to widen the debate to see whether our concerns might be shared by other people, and whether they think it would be a good idea perhaps to adjust that part of the proposals. We look forward to that debate, and we are open to the debate.

Q73 George Eustice: Do you think that should be a provision very early on in the system, or is it something that might evolve down the line? I was struck, in terms of what has happened in Scotland, that Business Stream still seems to dominate the market, with 97% of the market. It is pretty limited in terms of the number of people coming in. Are you in danger of snuffing out competition if you start removing players and consolidating it before you even have plurality?

Regina Finn: All we are suggesting is that the licences are separate; that does not require any change at all. It helps with transparency-the point that was being made earlier-because we could then align the incumbent’s retail licence with the new entrant’s retail licence, and everybody could have quite similar conditions. That would help with transparency and confidence in the market. It has a number of benefits, not just enabling exit. The Water White Paper is setting out a long-term direction of travel, but the legislation has an opportunity to put in place the enabling tools for that to happen: not force the pace, not require any specific outcome, but enable the best outcomes to emerge over time. Clarity up front, and understanding, is what tends to aid in that; it is the transparency point that we were discussing earlier.

Q74 Chair: Can I return to one of your replies to Mary Glindon for clarification? Was your answer relating to the proposals for upstream competition and changes to the water supply licensing regime? When you mentioned upstream reforms, do you mean changes to the abstraction licences, water trading, or changes to the water supply licensing regime?

Regina Finn: I mean the package. I was referring to the total package in the White Paper, which includes abstraction reform. As we know, the Water White Paper talks about abstraction reform over a very long time scale. It includes measures to improve water trading and interconnection, which we echo in our Framework Paper, and certainly the upstream licences. All those things are evolutionary; it is important to take them all in a stepped way, but it is important to set out now the enablers and the glide path. It goes right back to the point that if there is transparency on where we are going, it will really build confidence in the system.

Q75 Chair: Could I turn to the price review? How do you think the 2014 price review will be affected by the introduction of the White Paper’s market reform proposals, particularly if it becomes apparent that the reforms will not be finalised until after the next price review?

Regina Finn: The White Paper itself acknowledges that Ofwat’s proposals on future price limits, which we published just before the White Paper, are very well aligned with the policies in the Water White Paper. We have sought to future-proof our regulations, so future-proof the next price review. We are consulting, as you know, on a separate wholesale and retail price cap, which clearly aligns with the idea of a wholesaler and a separate retailer, and market entry. We have built those tools into our future price limits framework. Therefore, we will set price limits for 1 April 2015, because they need to be set for then; that will go ahead, and that is not a timetable that will change. We believe we can do that in a way that will facilitate the implementation of the market-opening proposals in the White Paper after that, at whatever stage that happens.

Q76 Chair: In terms of the Water Framework Directive and other EU directives coming through, are they already factored into the prices?

Regina Finn: The Water Framework Directive, as you probably know, is implemented over three set periods. The costs associated with the first period have been factored into customers’ bills in the current price period up until April 2015. When companies come to us with their business plans in 2014, those business plans will include the factoring in of costs that will apply in the forthcoming period-the five years we are currently proposing. Those costs will be factored in at each price review.

Q77 Chair: Returning to the earlier point, do you believe it will not negatively impact either on the ability of water companies to raise the money in the market or on customer bills?

Regina Finn: Sorry, is that the White Paper?

Chair: The totality-the collection of the reforms in the White Paper, in the proposed Bill we will eventually have, and also in the next stage of the EU directives?

Regina Finn: To be clear about my answer to this, I believe the totality of the reforms in the White Paper, added to the reforms of our regulatory regime, will deliver net benefits to customers. They will have an impact on bills, because I believe that bills will be lower overall than they would otherwise have been without this. Customers will get a more resilient and sustainable service than they would have gotten without these reforms. That is the impact that we will see coming out of this.

The challenge, and I absolutely take this challenge on, is to manage the process over a period in a way that retains stability and ensures that the sector can continue to attract the investment it needs. The evidence we have seen-the evidence of share prices, the evidence of premiums paid for these companies-is that it remains, with these reforms proposed in place, a very attractive sector for investments, and it continues to be able to raise that finance.

Q78 Chair: Do you think there should have been specific proposals on social tariffs in the White Paper, or do you believe there is scope for them in the Bill?

Regina Finn: We are conscious that Defra has consulted recently on social tariff guidance, which follows from the provisions of the Flood and Water Management Act, which enabled that to happen, so the Government has taken a step towards affordability in that arena. It has not built on that and revisited social tariffs in this White Paper, and I do not know whether it is intended to revisit it in a Bill. Our primary concern around affordability and social tariffs for vulnerable customers is that Government social policy is clear, because for private companies to implement social policy, it must be very clear to them what the parameters are. Who does Government consider are vulnerable? Who does it consider should get special support? Who does it consider should cross-subsidise that and pay for it, and by how much? Those things must be clear to the sector, and be it through guidance or through legislation-I am completely agnostic-that clarity is important.

Q79 Chair: On water efficiency, are you content with the references in the White Paper?

Regina Finn: I believe the White Paper provides a good approach to the need to balance overall our supply and demand, which includes water efficiency, as in how we all use it in our homes, but also water efficiency in that it is seeking to make the people who take the water out of the environment, treat it and deliver it to us, do that more efficiently as well. It is this holistic package: it has taken a good approach towards those two aspects.

We already have a lot of tools in place around water efficiency downstream for domestic customers, but in this White Paper we have the introduction of choice for business customers, which we have seen from evidence in Scotland actually drives those business customers to seek to be more water efficient and get their suppliers to be more water efficient. That could have strong gains potentially. The upstream proposals seek to get water companies to listen to the signals about the value of water, use the water more efficiently, and move it around where they need to, rather than build. The Paper has taken quite a holistic view of addressing efficiency in all of those areas, which is positive.

Q80 Chair: If you look at the Walker Review recommendations, some feel if there is going to be a green deal, water meters should link into that. Are you persuaded?

Regina Finn: From the point of view of the downstream issues, there are opportunities around smart metering, around Green Deal, around operational things like water efficiency targets, customer advice or labelling of white goods. All of those issues have value and merit. I believe that a lot of them are being taken forward already or at least have the enabling powers in place to be taken forward. It is not necessary to change the legislation to do those things. However, we need to do them, and that is a fair point.

Q81 Chair: How will Ofwat assess whether catchment management schemes to improve water quality provide value for money for customers?

Regina Finn: This is a really interesting area. It is quite a new area for us. In the last price review we approved over 100 catchment management schemes, many of which are trials. It is crucially important to get the evidence from those trials to find out what works and what does not work, because by their nature, if something is experimental, some things will not deliver value or will not help. We need to find out what works and what does not.

We are doing two things: first, we are working with the industry through UKWIR-the UK Water Industry Research organisation-to input into developing a methodology for assessing costs and benefits. Crucially, in the next price review we are changing to get companies to justify directly to their customers the costs and benefits of what is happening, so having much more customer engagement in their business plans. We would expect Customer Challenge Panels to have a view on this.

The twin track is ensuring that customers’ voices are heard on whether these schemes are delivering value for money for them as water customers, and the framework for assessing costs and benefits that we are working on with the industry. Those are the tools that we will use to ensure that we get the best value for customers.

Q82 Chair: Bulk trading and improving interconnections: what is your preferred route to promote those? Surely the cost of introducing bulk trading and improving interconnections is going to be colossal.

Regina Finn: I do not think we are talking about colossal costs. What we have identified in our work, and what Defra has identified in the White Paper work, is that at the moment we have a system where we build a lot of infrastructure, including reservoirs and treatment plants in order to supply customers, and that carries a cost with it. At times when we face what we are facing now-a drought over significant parts of the country-it does not matter how big your reservoir is; if it is empty, it is not going to be any use to you.

We want to incentivise and encourage companies to choose the more resilient and best option for their customers, which includes the lowest cost option. Based on the work we have done and our modelling, we believe that is likely to include more trading of water, and more interconnection. Our work has shown us that that would deliver a lower cost solution to meeting customers’ needs, and we projected it over a 30-year period.

It is not that it would have colossal costs; it is that it would avoid costs that would not be as effective and resilient and replace them with the costs of interconnection and bulk trading, which we believe would deliver a better result. We are consulting on a suite of possible tools that we could put in place to incentivise this, to make it of better interest to water companies, including revealing better information about the relative value of water, revealing information about scarcity to help with their planning and requiring them to consider bulk supplies.

All those measures increase transparency and give the companies better information and incentive to choose the best option. If the best option is interconnection and a bulk supply, that means it is better than the next option, and that means it is lower cost.

Keith Mason: Where sources are particularly overabstracted, one of the incentives we are putting in place is for companies to face the real cost of overabstraction. In looking at particular choices for their next source of water, we want to make sure that the proper full cost of overabstraction is faced, so they do not simply take what looks on paper the cheap option for an overabstracted source; the full cost needs to be taken into account. That may make interconnection and other potential options come more into play than they might have been if you are simply looking at, "This source only costs me 20 pence per cubic metre." If you took in overabstraction costs and it went up to 50p or 60p, it might go down the pecking order as a choice.

Q83 Chair: There is a great emphasis on competition in the White Paper. Are you concerned that moving towards competition might destroy the collaboration that is developing, particularly through interconnections and bulk trading, between the water companies at the moment?

Regina Finn: I do not see that contradiction at all. The White Paper presents quite a balanced view. On the one hand it is seeking to harness the benefits of market forces, because market forces reveal the information that allows you to make better decisions, as well as delivering more efficient outcomes directly to customers. That does not in any way prevent collaboration where it is necessary, or essential. For example, if we had a fully competitive upstream and downstream market, it would not stop Ministers calling water companies into a drought summit if that was necessary because there was a crisis. There would be nothing to stop that happening and nothing to stop collaboration.

I would go a step further and say that if what we want is better resilience and interconnection of networks, the revealing of the signals that make that worth the water companies’ while is going to improve collaboration. Whereas what we have seen so far is that despite the fact that we know we need more resilient and interconnected networks, it has not happened under the current regime, so we must improve those incentives.

Q84 George Eustice: I know it is slightly outside the scope of the Bill, but what would be the prospect in the near future of extending this to domestic customers? Which? magazine are running this thing with the energy companies, where they are getting whole communities to sign up and then to tender their collective electricity. Is that something you think there would be potential for?

Regina Finn: It comes back to the point about learning to walk before we can run. We do need to get this market working and make sure that we can reap the benefits of it. We think household customers will get some knock-on benefits. If retailers get more efficient, they will be more efficient for their existing household customers as well as their business customers. The question as to whether or not choice for household customers is another issue is something we should come back to when we consider the success of this, and can prove the benefits of it. That is a conversation I have had with Ministers and they certainly agree; it is not that you do not look at it, but that you make sure you can reap the benefits before you consider going any further, and I would support that.

Q85 Chair: In terms of Pitt especially, but also Cave, Walker and Gray, do you think that we are going to have unfinished business left over from particularly the Pitt recommendations that are not in the White Paper? Does that concern you?

Regina Finn: Listening to the Water Minister speak on this recently, it was interesting to hear that as well as the White Paper, we have a range of other things going. He mentioned Defra’s consultation on SuDS, for example, which is still open and coming to an end. It is true that the entire universe is not in this White Paper, but that is partly because some of the universe is elsewhere. It is important that we ensure that if those initiatives are not explicitly in this legislation-the ones kicked off by the Flood and Water Management Act, the ones around the SuDS, the ones you, Chair, have mentioned in the past around reservoir safety and the ones around automatic right to connection-they are picked up in other areas. The Minister name-checked quite a few other things that were going on. I cannot give you the entire universe of what is going on at the moment, but that would be the way we would want to deal with that.

Q86 Chair: If you look at it in terms of drought and the fact that building on flood plains is still going on, and that there is no end to the automatic right to connect, they do seem to be conflicting with trying to reduce water stress and eliminating drought.

Regina Finn: My point would be that there are a number of tools and vehicles that we need to make sure we harness. The White Paper sets out high level policy direction, which is exactly what a White Paper should do. One of the reasons for seeing legislation soon is that it will help us fill in the gaps and see what is going to be in there. That will help all participants in the pre-legislative scrutiny phase to answer your question, which is not one I can answer now, without sight of that detail.

Q87 Chair: That is enormously helpful. Thank you both very much indeed on behalf of the Committee for giving up your time and contributing so generously to our inquiry.

Regina Finn: Not at all. If there are any of these issues you want to follow up, either for the Committee or in bilaterals, we are very happy to do that.

Chair: Possibly one or two in writing, if we may; that would be helpful. Thank you very much indeed.

Prepared 4th July 2012