Environment, Food and Rural Affairs CommitteeSupplementary written evidence submitted by Ofwat

Thank you for sending further questions following our formal evidence session. We have responded to them in turn below.

Would Ofwat support a staged market opening with the introduction of competition in the upstream (as described in paras 5.46—5.50 of the White Paper) delayed until the retail market charges have been implemented?

We are committed to working with customers, the sector and other stakeholders to develop an overall timetable to deliver choice to business customers as well as greater efficiency in the way that companies (and others) manage water resources. As the Government has set out in its White Paper, these reforms are likely to take place over a number of years and it is therefore not the case that all aspects of upstream and retail market changes will be implemented simultaneously.

Defra published three impact assessments alongside the Water White Paper. These showed that the net benefits of retail market reforms were £190 million, of upstream market reforms were £1,952 million and of abstraction reform were £65.7 million. The benefits of upstream market reforms are considerable and suggest that it would not be sensible to delay obtaining those benefits beyond what is necessary to allow successful implementation. The current drought situation also underlines the importance of upstream market reforms which will help address the significant resilience/supply constraints we currently face.

We will be issuing a statement of principles shortly on the changes that we propose to introduce for the next price review. These changes are proposed to cover aspects of both upstream and retail development. The statement will be followed by consultations on various aspects of our proposed changes such as water trading, sustainable abstraction incentives and our approach to regulating retail. We will listen carefully to the responses to these consultations before taking any overall decision on the scale and pace of change in our methodology paper in autumn 2012.

Since Ofwat gave evidence, the rating agency Moody’s has issued a special comment, warning that the combination of changes to the Price Review process and the White Paper’s proposals on market reform have the potential to increase credit risk in the UK water sector. What is Ofwat’s reaction to this analysis?

It is crucial that the sector is financially sustainable and able to attract the right amount of inward investment at the right financing cost. Our proposals are an “evolution” of our approach rather than “revolution”, not least as a reassurance to investors that the stability and transparency of the regulatory process remain high priorities for us. The elements of our regulatory regime that have helped deliver £98 billion of investment since privatisation will remain. Examples include the regulatory capital value approach, including indexation by RPI, and many of our risk mitigants, such as reopeners in the case of new obligations being put on the companies. We also continue to adhere to our primary duty of making sure companies can finance their functions. Our proposals alongside the Government policy direction will not impact on this.

The Moody’s analysis shows that there may be greater differentiation in performance between companies and this may impact the credit quality of poorer performers. However, this is what might be expected from properly designed incentives.

We aim to keep and build on the parts of the approach we expect to continue to work well, and to adapt other areas by taking appropriate steps. We will continue to maintain an open and constructive relationship with the major credit rating agencies and the investment community more widely and welcome their input.

The White Paper proposes that Restoring Sustainable Abstraction programmes should be included within a company’s water resource management plans so that they can be funded through the price review. What steps is Ofwat taking to prepare for this and are you confident that these changes could be implemented in time for the next Price Review in 2014?

We have established a process under which we would be able to make allowance for restoring sustainable abstractions schemes as part of the water resource management planning and price review processes. We are working with Defra, the Environment Agency and others to make sure that customers continue to be protected under any new system. We are confident that we will be able to implement the changes for the 2014 price review provided that those conditions are satisfied.

In oral evidence, Regina Finn suggested that any differences between the English and Scottish regulator with regard to the issuing or revocation of licences in a joint Anglo-Scottish market would be dealt with according to a protocol which should be agreed before such a situation could arise. Please could you clarify whether you believe that such a protocol should be agreed before the opening of the Anglo-Scottish market; and are you able to provide further details of how such a protocol might work?

We are committed to working with WICS to establish an overall framework for regulation that can support the development of choice for business customers across England and Scotland. As part of these arrangements we would envisage putting a protocol or a memorandum of understanding in place to explain how the regulators would work together on all relevant matters including the revocation of licences. The precise details of these arrangements are still being developed and we would expect to consult with all interested parties before putting the arrangements in place. We will aim to get the protocol or memorandum of understanding in place well before the opening of the Anglo-Scottish market.

May 2012