Environment, Food and Rural Affairs Committee - Minutes of EvidenceHC 674

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Oral Evidence

Taken before the Environment, food and rural affairs Committee

on Tuesday 20 November 2012

Members present:

Miss Anne McIntosh (Chair)

Thomas Docherty

Barry Gardiner

Ms Margaret Ritchie

Sheryll Murray

Neil Parish


Examination of Witness

Witness: Neil Griffiths-Lambeth, Senior Vice President, Infrastructure Finance, Moody’s Investors Service, gave evidence.

Q139 Chair: Good afternoon and welcome. Thank you very much, Mr Griffiths-Lambeth, for joining us in our inquiry into the Draft Water Bill. I wonder if you could just introduce yourself and give your position, purely for the record.

Neil Griffiths-Lambeth: I am Neil Griffiths-Lambeth. I am the senior analyst at Moody’s covering the UK water sector.

Q140 Chair: We are aware of your work, and it is a wonderful opportunity for you to elaborate on that. Just before we turn to the Draft Water Bill, I wonder if you could just update the Committee: following the publication by Ofwat of proposals to modify water company licences in December, and again its revised proposals in this regard on 26 October, have you seen any movement in the credit ratings or the share price relating to water companies?

Neil Griffiths-Lambeth: In terms of credit ratings, no. We have not changed ratings over that period. In terms of share prices, I am not an equity analyst and do not religiously follow share price movements. Nevertheless, you may be aware that there has been a decline in the price of the three publicly listed companies. In the case of United Utilities, I believe that is of the order of around 10%, and for Severn Trent, I think it is around 8%; Pennon is a little larger, but there have been other factors at play there. As you will be aware, asset prices are a function of a variety of factors, so one cannot necessarily lay blame entirely at the feet of Ofwat.

Q141 Chair: Could we just ask you to consider whether the risk posed by changes to the licences can be separated from the risks potentially associated with the provisions of the Draft Bill? Could I possibly add a rider? Do you consider that Ofwat are assuming the powers that are to be granted under the Draft Water Bill before they have been passed through this place?

Neil Griffiths-Lambeth: It is very hard, going back to my previous answer, to distinguish between particular factors that may be driving share price movements. In addition, I wonder, to be honest, about the extent to which investors would differentiate between the Draft Water Bill and the other changes that are being suggested by Ofwat. To your second question, which I think is effectively about whether Ofwat are perhaps going ahead of policy, I do not have a view, to be frank. I think perhaps those on the other side of this table have a better feeling.

Q142 Chair: Like who, for example?

Neil Griffiths-Lambeth: My role in life is very simple. I am a credit analyst; I look at the credit impact of actual or potential changes. I look at the changes that government has set out and that Ofwat is talking about. I do not form a view as to whether Ofwat might be getting ahead of government.

Q143 Chair: You will have a view, though, as to the potential credit risk associated with the introduction of competition. Do you believe that there will inevitably be some sort of credit risk with the introduction of competition?

Neil Griffiths-Lambeth: If one looks at the UK water sector today, you have vertically integrated companies who are monopoly suppliers of an essential commodity. They operate within the context of a regulatory regime, which we hold in very high regard for its historic transparency, predictability and clear principles that have been consistently applied. That is a very different business model to one which is subject to competition. Therefore if you move towards competition the business risk profile will inevitably increase. It will increase from a very low base, and of course the extent of that increase will be related to the extent of the competition that is brought about.

Q144 Chair: But if you look at pension funds and other assets, would you not say that investment in the water industry has been deemed to be both transparent and, in an everchanging economic climate, ultrasafe, for the simple fact that within a fiveyear price review period there has been an element of certainty. Therefore the share prices have remained fairly stable, the level of investment has been fairly consistent, and the returns have been fairly reliable. Looking ahead, is that something that concerns you-that this now might be at risk, through both the introduction of competition, but also the behaviour of the regulator?

Neil Griffiths-Lambeth: You are absolutely right. The sector has been very highly regarded historically by investors, and its appeal has recently been heightened by the turbulence that we have seen elsewhere, in particular that associated with the continuing euroarea crisis. Companies have benefited from that to a meaningful extent over the last 12 to 18 months, a point we made in our industry outlook we published in October. On your point looking forward, our view is that the credit risk of the sector will deteriorate, or rather the credit risk will increase over the medium to long term. That is our view as credit analysts. Clearly our view is only a single factor that investors will take into account going forwards. People can legitimately disagree with our view. Nevertheless, people may perceive it as being less attractive in the future than they have done in the past. That may equally be the case as the situation improves elsewhere and other asset classes in other geographies perhaps become more attractive.

Q145 Chair: So how would you compare your assessment of the risk in relation to water companies with assessments of other utilities which have introduced competition at this time?

Neil Griffiths-Lambeth: It is very difficult to do a likeforlike comparison, and one cannot compare the UK water sector very easily with water businesses elsewhere in the world, because they tend to have a different model. As you will know, the sector tends to be in public ownership so much elsewhere. One cannot do a simple comparison and say, "The sector in this particular region used to look very much like the UK; now they have competition and as a result of that our rating has changed as follows." So it is very difficult for me to predict the future in terms of what the rating impact might be.

Q146 Chair: Can I just take you back to what you said about the drop in the share price? Did this surprise and concern you? Would you accept that within the price review period there should normally be an expectation of stability and certainty, and that that was shattered?

Neil Griffiths-Lambeth: That is a very interesting question. One sees quite a lot of volatility in share prices during regulatory periods. As I say, this is not my area of expertise, but share prices have been boosted quite significantly during the course of this year by potential M and A activity and the possibility that companies were going to be bid for. I think when the second licence amendment proposals came out there was an element of re-rating. Perhaps people decided that M and A activity was not imminent and perhaps there was greater focus on the perceived risks around the sector.

Q147 Chair: That is very helpful to hear that. Can I ask you to do something that you would not normally do? I think Moody’s would normally look to a threeyear time frame, which is quite a short time frame in terms of making a forecast.

Neil Griffiths-Lambeth: Our typical rating horizon is three to five years.

Q148 Chair: So if you were to look at the longer extreme of your forecasts, are you concerned at the impact of any regulatory movement, or any increase in competition, as to the impact on the share price, the impact therefore on the stock market and any potential credit movement-one hesitates to say downgrade-that there might be as a result of that?

Neil Griffiths-Lambeth: Let me focus, please, on credit. As I say, I am not an equity analyst, and that is beyond my area of expertise. In terms of credit, our view, as I have said, is that there will be deterioration in the credit standing of the sector over the medium to long term. Why do I say medium to long term? As you know, Ofwat has described a number of possible changes to the sector. However, it seems that many of those changes will not take effect particularly quickly. There seems to be a consensus that we will not have retail competition before 2017, and changes in terms of upstream may not occur until the latter part of this decade. So to the extent that negative credit pressure develops, we expect it to develop over that medium to long-term horizon. Having said that, as you will also be aware, we have said that the licence change proposals put forward by the regulator have introduced uncertainty, and that is also credit negative.

Q149 Chair: Let me put that question in a slightly different way. If there was a negative credit risk arising from the changes, specifically in regulation, would that risk possibly be more significant if the economy itself became stronger, yet water companies were to lose the benefit that they have hitherto enjoyed of being perceived as something of a safe haven in uncertain economic times?

Neil Griffiths-Lambeth: That is a possibility, yes. The demand for capital is only likely to grow over time as the UK, together with other economies, seeks to fund the infrastructure investments the Government want to make. So, yes, there is a risk that capital is going to be drawn in other directions.

Q150 Chair: Could you just repeat that? There is a risk-

Neil Griffiths-Lambeth: That capital may be drawn in other directions.

Q151 Chair: That would impact negatively potentially on the future investment in water companies?

Neil Griffiths-Lambeth: Yes, both in terms of companies’ ability to access capital and the cost of capital.

Q152 Chair: Have you considered what impact that might have on customer bills if that was the case?

Neil Griffiths-Lambeth: If there was an increase in cost of capital, it has been discussed in this forum that that would potentially impact customer bills. That is a consideration for us because, as you will be aware, we have a methodology that we follow in assigning ratings. That covers a number of factors. It particularly focuses on the regulatory framework and the financial metrics for the companies, but we also look at a broad range of factors including sustainability of the sector in the broadest sense. Affordability is clearly part of that.

Q153 Thomas Docherty: What percentage of the loss of share price firstly for UU do you attribute to the regulator’s recent remarks?

Neil Griffiths-Lambeth: I cannot say.

Q154 Thomas Docherty: We can happily get the quote read back to you if it helps, Mr Griffiths-Lambeth, but you were quite clear earlier on that you felt some of the blame should be laid at the feet of Ms Finn. I think that was the phrase you used. So you must have a figure in mind. You would not just be spit-balling.

Neil Griffiths-Lambeth: No, as I said, asset prices are driven by a variety of factors. One observed a decline in the share price from 26 October at a time when the FTSE was remaining more or less static, so it seemed that there were some water-specific factors at play. One cannot isolate the impact of any one of those factors. Going back to my earlier point, I am a credit analyst; I am not an equity professional. It is not my role.

Q155 Thomas Docherty: Just so there is no confusion, you are not actually suggesting that the comments from a couple of weeks ago from the regulator are the direct cause of a point-

Neil Griffiths-Lambeth: No, the two events were merely associated. I cannot say there was any causality.

Thomas Docherty: That is helpful.

Q156 Chair: Would you say that they were not?

Neil Griffiths-Lambeth: I could not say one way or the other.

Q157 Chair: So in fact what you are saying is completely neutral?

Neil Griffiths-Lambeth: Yes.

Q158 Thomas Docherty: So there is absolutely no evidence either way?

Neil Griffiths-Lambeth: I cannot provide you with any evidence.

Q159 Thomas Docherty: That is perfect, thank you; that is very clear. Would you regard water companies as now being a bad risk, or if there was retail competition would you then advise your clients that they are a bad risk?

Neil Griffiths-Lambeth: Water companies that we rate in the UK have very solid ratings, typically at Baa1 or A3. I know you may not be familiar with our scale, but those are strong investment-grade ratings. They are considered by us as still being very creditworthy. Our view looking forward is we expect the credit risk profile of the sector to deteriorate over the medium to long term, and it may therefore be that they are less highly rated in the future than they are today.

Q160 Thomas Docherty: But you would not say they have become a bad risk?

Neil Griffiths-Lambeth: No, they are not a bad risk today.

Q161 Thomas Docherty: If there is retail reform going forward, would you then see them as a bad risk?

Neil Griffiths-Lambeth: It depends on the extent of the reforms that are introduced and the way in which they are implemented. We published research in February of this year, which showed that in isolation, the effect of customers switching between companies could be very limited. We have said previously that retail competition could be implemented in a way that was credit neutral. So you could have retail competition in the future without, it seems, adversely affecting the credit standing of these companies.

Thomas Docherty: That is helpful.

Q162 Chair: Can I just ask: were your remarks about credit risk deteriorating in regard to the regulatory activities or potential competition? Could you clarify?

Neil Griffiths-Lambeth: We, as I say, assign ratings following a methodology. If competition is implemented it could adversely affect two of the factors within that methodology. The first of which is around our view of the regulatory regime, which we have historically regarded as being very strong. The second factor is around revenue risk. Inevitably if you have companies where a significant majority of their revenue is exposed to competition, there is likely to be greater volatility in that revenue, and all else being equal, deterioration in their credit profile.

Q163 Thomas Docherty: But deterioration from-

Neil Griffiths-Lambeth: A very high level.

Q164 Thomas Docherty: Yes. I think it might be helpful just to clarify the Chairman’s earlier question about comparing with other utilities. Certainly the frame I had in mind-I cannot speak for the Chairman-was within the United Kingdom, so, for example, energy companies or telecommunications.

Neil Griffiths-Lambeth: If you look elsewhere in the UK there are other utility companies that are highly rated. Centrica is one which springs to mind. I believe it is rated A3, so it is comparable with some of the more strongly rated water companies, but it does not have the same level of debt. As you will be aware, some of the water companies have debt equivalent to as much as 80%, or thereabouts, of their regulatory capital value. They are very highly geared, and they still have high ratings because that high gearing is offset by our view of the regulatory regime as being very strong, and by the monopolistic and noncompetitive nature of their businesses.

Q165 Thomas Docherty: So would you recommend to clients not to invest in energy companies?

Neil Griffiths-Lambeth: Just to be clear, we do not make recommendations to invest or not to invest. We simply publish credit ratings and opinions about the relative creditworthiness of particular companies. It is for investors to then take a view, based on those ratings and other information and their own views, as to whether they wish to invest or not.

Q166 Thomas Docherty: One final question: have you spent much time talking to, say, Mark Powles from Business Stream, because obviously we do have a market in Scotland.

Neil Griffiths-Lambeth: Yes.

Q167 Thomas Docherty: How many occasions have you met Business Stream representatives to look at how Scotland works? Have you met Alan Sutherland to discuss the Scottish perspective?

Neil Griffiths-Lambeth: I have met Alan Sutherland a number of times. One of his former staff members at WICS works for us at Moody’s, so we certainly have a degree of familiarity with what is happening north of the border, although to be clear, we do not rate Business Stream.

Q168 Thomas Docherty: No, of course, but am I right in thinking, therefore, it is because of Business Stream’s model that you are considering downgrading the English companies?

Neil Griffiths-Lambeth: No, we have not said that we are considering downgrading the English companies. As I said earlier, we believe that negative credit pressure will develop over the medium to long term. That may or may not translate into rating action; I cannot say over what timescale that may occur.

Q169 Barry Gardiner: Are you a student of Shakespeare at all?

Neil Griffiths-Lambeth: No. Do you think I should be?

Q170 Barry Gardiner: No, I just wondered if you remembered the impersonation that Tom Snout did in Act V, Scene 1, of A Midsummer Night’s Dream.

Neil Griffiths-Lambeth: You may have to help me, sir.

Q171 Barry Gardiner: He did an expert impersonation of a stone wall, and it strikes me that that is what you have done to perfection before this Committee this afternoon. Look, you have told us about the methodology, and that there are a number of factors. What you have not given us is any information, which is what you know we are seeking. So can I just ask you: your job presumably is not just to apply the methodology; it is to disaggregate the various factors. We are asking you to disaggregate the factors between those elements of the Draft Bill, perhaps upstream competition, and such things as the change to the licence condition, as to what are the negative credit pressures on this industry? Can you please do that?

Neil Griffiths-Lambeth: I will do my best. If we look at the medium to long term, as I have said, over that period we anticipate negative credit pressure developing; that anticipation is driven by the changes proposed by Ofwat, and I believe supported by the Draft Bill. If one looks at the nearer term and now, there is a degree of uncertainty associated with those planned changes and also with the licence amendments, which Ofwat, as you know very well, published at the end of October.

Going back to what I was saying earlier, and trying to differentiate between Ofwat’s proposals and the Draft Bill, investors do not make that distinction. We do not particularly make that distinction. What they are doing is looking at the broad direction of travel.

Q172 Barry Gardiner: Yes, but you weight those different elements; otherwise you could not claim to be providing a systematic assessment of the credit worthiness of this organisation going forward. It is not as if you do not have a weighting somewhere in the annals of Moody’s; you do. It may just be that for commercial reasons you are not prepared to impart what it is to this Committee, but it is there, is it not?

Neil Griffiths-Lambeth: We do not assign weights between, if you like, the regulatory regime and the legal framework in which it operates. We look at those things as one.

Q173 Barry Gardiner: You are simply telling us it is a case of "suck it and see". You are undermining the value of your own job and your own profession because you are saying, "We look at it and come up with a result". Nonsense. You actually try and quantify this quite clearly as to the effect it is going to have on the market. Now you may not be prepared to tell us what you actually have done in this instance, but at least have the decency to say that that is what goes on.

Neil Griffiths-Lambeth: If I may, we look at the regime as a whole, and in terms of the particular factors we look at in rating a water company, as I have said, there are four set out in the methodology, and the regulatory framework is one of those. Clearly we form a view on that, and associated with that is our view on the broader legal regime in which the regulator is operating. So there is no attempt on my part to be disingenuous and to not reveal the weightings we might give to regulatory changes as opposed to legal changes. As I say, we look at these things together.

Q174 Chair: In the specific planned changes on the horizon, how would you weight two separate issues: the regulatory regime in Ofwat’s proposed modifications to company licences on the one hand-this is the lawyer speaking-and on the other hand, the introduction of competition, particularly the upstream competition that we do not see in Business Stream, but which we do see in the English model in the Draft Bill? How would you differentiate or quantify those in your methodology and financial metrics?

Neil Griffiths-Lambeth: If we look at the methodology factors within the first one, the regulatory environment and asset ownership model, we have a factor for revenue risk. As I have said, in the future if you have meaningful competition it seems there is potentially going to be greater volatility in companies’ revenues, and perhaps therefore we would mark that score down. In terms of financial metrics, which accounts for as much weight within the methodology as the regulatory environment and asset ownership model, to the extent there is deterioration in those metrics, obviously that will result in downward credit rating pressure.

It comes back to the point that really the devil is in the detail, and it is a question of how these changes are to be implemented and what impact they then are going to have on companies’ standing. I was saying earlier that one could envisage perhaps retail competition being introduced without adversely affecting companies. Perhaps the same is true of upstream, but as of today we do not really have the detail to be able to say. So one can say if you are moving towards a world in which there is meaningful competition, then the credit standing of companies is probably going to be lower than it is today, but I cannot say how different it is going to be without that additional information of exactly how these changes might be implemented.

Q175 Chair: If I was to ask a question I asked earlier in a slightly different way, you just said your rating would depend on how the changes were to be implemented. Would it make more sense for the regulatory changes to be implemented as part of the Draft Water Bill, rather than separate licensing changes year on year?

Neil Griffiths-Lambeth: Certainly if one had clarity today on the full extent of the changes then we would be able to form a view as to what the full impact was going to be on companies. If you have a more gradual step-by-step process, we cannot say today where those companies are going to end up, and hence what our view of their credit standing might be at that time.

Q176 Chair: Before we move on to de-averaging of prices, can I just ask: in the water sector, is there an average, aboveaverage or belowaverage level of inward investment from foreign investment, such as Australia?

Neil Griffiths-Lambeth: As you are perhaps aware, we have seen significant investment into the sector from overseas over recent years. We have seen the acquisition of Northumbrian Water by foreign investors, and Chinese investors take a stake in Thames Water. This sector has undoubtedly been seen as very attractive to both equity and debt investors.

Q177 Chair: And might that be jeopardised?

Neil Griffiths-Lambeth: It may be that it will be seen as less attractive in the future for the reasons we have discussed. Firstly, because of the introduction of competition, and perhaps also because of other asset classes becoming more attractive than they are today.

Q178 Thomas Docherty: Very quickly, Mr Griffiths-Lambeth, would it be helpful, from your perspective, if we moved at two speeds? So we did the retail competition first and then did the upstream changes to competition at a later date? Would that be something you would support?

Neil Griffiths-Lambeth: It is perhaps important to say that we would not view any changes as being either good or bad. We do not view any particular pace of change as being either good or bad. Our role is simply that of commentator, to offer a view on what it is that we see.

Q179 Chair: Can we look at it in a slightly different way? How will it impact on your rating if we were to proceed with retail first and upstream later?

Neil Griffiths-Lambeth: There are two parts to that answer.

Chair: Excellent.

Neil Griffiths-Lambeth: The first is about transparency and predictability of the regime. A slower pace of change tends to be associated with a higher degree of predictability. It also depends on exactly what it is that you do. So if you move slowly but nevertheless make very major changes, then perhaps there will still be a substantial impact on the credit standing of the sector. If you move very slowly and do almost nothing then there will probably be almost no impact.

Q180 Barry Gardiner: Mr Griffiths-Lambeth, the Government has estimated that the introduction of competition is likely to increase the cost of capital to companies by between 1% and 2.5%. I am determined to get a figure out of you.

Neil Griffiths-Lambeth: Out of me?

Q181 Barry Gardiner: Yes. Do you agree with the Government assessment? If not, what figure would you put on it?

Neil Griffiths-Lambeth: I think those numbers actually originally appeared in the Cave Review, and I believe the range there was 1% to 4%. I believe, in the impact assessment published by Government, the higher end of that range was ruled out, leaving a range of 1% to 2.5%. It is actually very difficult to estimate these things. There could be scenarios in the future where the cost of capital changes by those amounts, but I cannot say today because I do not know what the changes are going to be. I cannot tell you the impact of something when I do not know what that something is. I know the broad direction of travel, but I do not know what that is going to involve. Ultimately, as I was saying, our role is to publish credit ratings. That is one of the factors that investors will take into account in pricing risk, but it is not Moody’s that prices risk.

Q182 Barry Gardiner: I started off being cross. I am moving to admiration for your capacity to maintain this wall. We live in a world of imperfect knowledge, right? But Moody’s operates in that world, and it makes judgments and assessments within that world. It will have a figure in mind about what the likely increased cost of capital is from upstream competition, and it will be operating on that basis when it makes this suck-it-and-see assessment that you have advised us of. What I am asking you is whether Moody’s assessment of the increased cost of capital roughly equates to the Government’s estimate, or do you have a vastly different estimate?

Neil Griffiths-Lambeth: But if I may, we do not assess cost of capital; we assess credit risk. If we do not know what changes are going to be introduced over what timescale, how could we assess the potential impact on the cost of capital? The range of numbers that have been cited by Government is perhaps sensible. I cannot say, "It will be less than that for the following reasons", and I cannot say, "It is going to be more than that for the following reasons", because I do not know what change ultimately will be introduced, or over what timescale, or the degree of investor confidence that might be associated with those changes.

To be very dull and to go back to my key point, ultimately we are assessing credit risk. We are not assessing cost of capital, or offering views on actual or appropriate costs of capital.

Q183 Barry Gardiner: But the one, as you have just pointed out, is influenced by the other.

Neil Griffiths-Lambeth: That is right, but when we are assigning ratings today we are observing companies’ ability to access capital in the market, and the cost of that capital. I cannot make predictions as to what that cost of capital might be in the future. I cannot predict how the water sector is going to evolve. Clearly I can try and form a view, but also I cannot particularly predict how investors are going to react to that. I can offer the view that I see credit risk increasing over time, but exactly how that credit risk will be priced, I do not know.

Q184 Chair: Is it going to invite more investment, or will it risk that investment? What is it actually going to do to investor confidence?

Neil Griffiths-Lambeth: The UK’s water sector, as I said, is currently regarded very much as a gold standard. It has attracted, as you know very well, very significant investment at very low cost. In a sense one might say it has only got one way to go, which is down. Nevertheless, government is very keen to maintain investor confidence, as was the regulator, and that may be the case.

Q185 Barry Gardiner: Which particular elements of upstream competition do you consider pose the greatest threat to investor confidence?

Neil Griffiths-Lambeth: I do not think one can disaggregate them. If you are moving towards a model in which you have competition, that has a very different business risk profile to the current vertically integrated monopolistic companies. Perhaps it does not really matter which aspect you might change. If you do things that mean that in future there is going to be significant volatility around companies’ revenues, that is likely to adversely affect their credit standing, and hence their cost of capital. It really does depend on what you do. Going back to what I was saying earlier, the analysis we published in late February showed that actually the impact of retail competition could be very modest, could have little impact on companies’ revenues and hence could have little impact on their credit standing. The same may be true in terms of upstream competition, depending on what is done.

Q186 Barry Gardiner: Yes, but you have disaggregated there to a certain extent, haven’t you? You said it does depend on what is done. We know some of the elements of what is being proposed, and one of the fears put out there is that there will be cherrypicking in the upstream sector, which may lead to de-averaging of prices. So my question, rephrased to you, is: is this a particular aspect of upstream competition that might reasonably, in your view, give rise to lower investor confidence?

Neil Griffiths-Lambeth: It could do.

Q187 Barry Gardiner: I will be grateful for small mercies. Thank you very much.

Q188 Thomas Docherty: Is the reason why it has such a high confidence, to paraphrase what you said before, because it is easy money, because there is no competition, customers are getting screwed over by the water companies regularly and it is basically a licence to print money? Is that the reason why any opening up of competition will make it less attractive?

Neil Griffiths-Lambeth: You may view it as easy money, but we have had more than 20-plus years of economic regulation of the sector of continual downward pressure on their operating costs. The allowed returns for these companies are, in my view, commensurate with the risks that they assume, and I believe that is the view of the regulator. That is the basis on which they set prices.

Q189 Thomas Docherty: Yes, we all know that water companies are such a martyr case at the moment. But turning to the Draft Water Bill, it delegates responsibility to Ofwat to determine the market codes and the new access pricing regime. To what extent is it uncertainty created by leaving Ofwat to determine these and other measures, rather than the retail competition, or upstream competition, to be fair, which is the cause of increased credit risk concerns?

Neil Griffiths-Lambeth: The Bill does potentially give Ofwat very significant discretion, and of course in the licence change amendments that were put forward, the regulator is also seeking quite significant additional discretion. The uncertainty arises because of a lack of clarity as to how that discretion is going to be exercised. As we know, Ofwat will be publishing its draft methodology towards the end of this year. That will provide greater clarity, as will the final methodology next year. It may be that those things reduce uncertainty by creating greater knowledge about the direction in which the regulator is heading, but there is a general sense that there is a desire to introduce greater competition into the sector. From our perspective, competition is naturally a credit negative.

Q190 Thomas Docherty: So from your point of view competition is a bad thing?

Neil Griffiths-Lambeth: I am not saying that competition is bad.

Q191 Thomas Docherty: Okay; it is not as good as no competition?

Neil Griffiths-Lambeth: It is credit negative rather than credit positive for a sector that to date has experienced very little competition.

Q192 Thomas Docherty: I think we are getting somewhere. I do not know if that is a good thing or a bad thing. Am I right, therefore, in thinking that it is the uncertainty over the direction, rather than the direction itself, that carries a high proportion of risk?

Neil Griffiths-Lambeth: I think it is both things. Uncertainty is credit negative, because if you have certainty, that is always a more positive thing. But moving towards a world in which you have more meaningful competition is also credit negative, simply because, all else being equal, activities that are contestable, and environments that are competitive, where there are winners and losers, tend to have a weaker business risk profile than the current monopolistic water sector.

Q193 Thomas Docherty: I promise that, hopefully, this is my final question. Would you prefer, therefore, to see more detail placed on the face of the Bill, so to speak, rather than left to regulators to go away and come up with?

Neil Griffiths-Lambeth: If there was more detail, then perhaps we would be able to form a firmer view than we have today. Ultimately it is a matter for government and for the regulator as to how they wish to prescribe this industry, if I might put it that way.

Q194 Thomas Docherty: You tempt me to a supplementary. Which do you think should do it? Should it be the government or the regulator?

Neil Griffiths-Lambeth: I think that is a question of policy, is it not? It is for the government to decide.

Q195 Thomas Docherty: Forgive me, sir, but you are sitting in front the Select Committee, having volunteered to give written evidence and then oral evidence, so I do not think it is unreasonable to ask your opinion. In your professional capacity, which would provide less credit risk damage-if I have not just made up a new phrase-and which would be preferable from your point of view: the government, on the face of the Bill, or left to the regulators?

Neil Griffiths-Lambeth: More information is always positive and it allows us to advance our views, but I have no preference as to whether that information comes from the government or from the regulator.

Thomas Docherty: Okay. Thank you, I think.

Q196 Ms Ritchie: Moving on to the area of other regulatory and legal frameworks, how likely is it that changes in the regulatory framework will lead to a greater divergence in the credit ratings of companies, rather than a reduction in the industry’s credit ratings overall?

Neil Griffiths-Lambeth: We could see both things; we could see a migration downwards in the overall rating for the sector associated with the introduction of competition, but we could also see divergence between the ratings for companies within the sector. As I was saying earlier, if you have competition you have winners and losers. You have companies that do better and companies that do not do so well. Perhaps in the future we will see a greater divergence in the ratings of the top and bottom of that band.

Q197 Ms Ritchie: Do you agree with Ofwat that it is those companies which are unable to adapt to a changing environment that will be most threatened by competition?

Neil Griffiths-Lambeth: I think that is probably right, is it not?

Q198 Ms Ritchie: You have described the degree of flexibility that Ofwat is seeking to change the level of services and activities covered by the wholesale price controls as "surprising". Do you think that licence changes would be more acceptable if Ofwat reduces the level that it can change the activities covered by defined priced controls, for example, from 40% to 20%?

Neil Griffiths-Lambeth: I think that would certainly reduce the uncertainty. It may not entirely eliminate it, but yes, it is a small number.

Q199 Ms Ritchie: And can you put an estimate around that number?

Neil Griffiths-Lambeth: Sorry, an estimate in terms of whether it should be 20% or 25% or 15%?

Ms Ritchie: Yes.

Neil Griffiths-Lambeth: No, I cannot. As I was saying earlier, our view is simply to comment on what we see, so I cannot say that the numbers should be X or that the number should be Y.

Q200 Ms Ritchie: You are not prepared at this stage to say?

Neil Griffiths-Lambeth: It is not a question of being not prepared. Our job is not to structure companies, to structure sectors, or to advise people. It is simply a question of looking at what we see and offering a credit perspective.

Q201 Ms Ritchie: Could it be argued that water companies are contributing to levels of uncertainty in their business and their negative credit ratings by choosing not to accept Ofwat’s proposed changes to the licence, leaving the Competition Commission to decide the matter?

Neil Griffiths-Lambeth: It is clear that Ofwat and the companies have failed to agree on this matter, or most of them have failed to agree. We were not party to that process. I cannot allocate blame either to the regulator or to the companies for that failure to agree. Cleary had the companies accepted, then there might have been a perception of less risk, because externally investors would say, "Okay, companies and the regulator have managed to agree. The companies are clearly comfortable that this does not expose them to risks that they cannot manage, and on that basis I am comfortable." However, we have a situation where the regulator and the companies cannot agree, and perhaps that elevates the level of perceived risk.

Q202 Chair: Is the water sector unique in that regard?

Neil Griffiths-Lambeth: I do not recall a similar situation in the history of regulated utilities within the UK, but I cannot rule it out. I certainly do not recall one.

Q203 Chair: Does that have an impact on the way that you view the credit rating, going forward?

Neil Griffiths-Lambeth: We hold the regulatory regimes in the UK in very high regard. We regard the Competition Commission as being part of the overall framework, so a failure on the part of a company and the regulator to agree is not credit negative, and ordinarily a referral to the Competition Commission is not credit negative. It is just part and parcel of the normal mechanism. We have said, however, that it sustains this uncertainty associated with the licence changes, and were it to happen it would draw additional attention to the matter, and perhaps that is not helpful for the sector in terms of continuing to raise capital.

Q204 Chair: Just taking you back to 29 October and Moody’s announcement, in which it said that continued uncertainty around licence conditions was credit negative for the sector, what do you believe the impact of that statement has been for the market, potential investors and the consumer in terms of potential future water bills?

Neil Griffiths-Lambeth: It is very hard to point to evidence, and we have talked earlier about share prices, which have clearly moved. There has been, as far as one can see, no reaction in the bond market. Bond prices have not fallen. Nevertheless, as we say, it has created additional uncertainty. That uncertainty may persist. It is something that investors may remember, and it may play a part in their decisions in the future as to whether to invest in this sector. Certainly amongst investors there are some very strong feelings at the moment on the UK water sector and its continued attractiveness. Others, no doubt, perhaps think this is rather a storm in a teacup and are happy to continue to lend their money.

Q205 Chair: Just to take you back to what you said earlier, if there was a resistance to future investment, there would be implications for future water customer bills?

Neil Griffiths-Lambeth: Yes, if the cost of capital for the sector goes up, then customers have to pay more, and/or returns to shareholders will suffer, which will impair companies’ abilities to attract additional equity to support future investment.

Q206 Chair: Being a simple soul, what concerns me is that water companies are going to be left in a certain no-man’s land, potentially, where there might be a resistance to invest and where there might be a need to pick up the lack of investment through increased customer bills, but the regulator will prevent that from happening.

Neil Griffiths-Lambeth: Yes, certainly water companies could, in the future, find themselves squeezed, as you say, between the regulator, on one hand, and investors, on the other.

Q207 Thomas Docherty: But you cannot point to evidence that that is what is going to happen?

Neil Griffiths-Lambeth: No, I cannot. As I said earlier, all I can do is offer my view. I cannot provide you with evidence that that is going to happen. It may not happen. That is my view; others may legitimately disagree with that view.

Q208 Chair: Mr Griffiths-Lambert, thank you for being so generous with your time. We have had quite an education in the role of Moody’s, but we are very grateful to you for being with us this afternoon. It has been enormously helpful.

Neil Griffiths-Lambeth: Thank you very much indeed.

Examination of Witnesses

Witnesses: Mark Powles, Chief Executive, Business Stream, and Nathan Sanders, Managing Director, Utility Solutions, SSE and Director of SSE Water, gave evidence.

Q209 Chair: Gentlemen, good afternoon. Can I welcome you and thank you very much indeed for participating in our inquiry on the Draft Water Bill? For the record, could just give your positions?

Nathan Sanders: My name is Nathan Sanders, MD of SSE Utility Solutions, and I have responsibility for SSE Water, of which I am a Director.

Mark Powles: I am Mark Powles. I am the Chief Executive of Business Stream. We are the largest incumbent water retailer in the Scottish competitive retail market.

Q210 Chair: Just to set the scene, what impact has the introduction of competition in Scotland had on introducing new entrants to the sector?

Mark Powles: The characteristics of the Scottish market were very much that, as an incumbent, the regulator made sure that there was a level playing field for competition in terms of moderating our behaviour, physical separation, the way we were funded and the way we interacted with Scottish Water. We could get no unfair advantage over a new entrant. I think that gave confidence to new entrants. Allied to that was the creation of a central market data set, so the data that new entrants could use to potentially price and switch customers was exactly the same data that I or the central market had. So visibility, transparency and protection for new entrants against incumbent behaviour played a fundamental part in the creation of the Scottish market.

Chair: Mr Sanders?

Nathan Sanders: We really stick to the English market, not the Scottish market. We are looking at putting assets in the ground, so it was not a market that we went towards.

Q211 Chair: Could I ask you, Mr Powles, bearing in mind what we just heard from the first witness, whether you believe that the regulator is equally setting a level playing field at this stage?

Mark Powles: I think the Draft Bill has many other-

Chair: No, that was not my question.

Mark Powles: If you do not mind, I was just going to move on to that. I think it creates most of the component parts that are needed to create a retail market, but it does give a lot of latitude and freedom to how Ofwat interpret things. The Bill would benefit from more clarity around regulated access versus negotiated access. In England, the access pricing regime has played a major part in stopping a retail market functioning. The Draft Bill talks a lot about bilateral agreements, and I would like to see more clarity on regulated access, i.e. creating wholesale prices that all entrants can enter into.

The levelplayingfield argument is one that we would like more clarity on. I am an incumbent in Scotland but will be a new entrant in England; in the absence of separation, how can I be assured that I will get the same treatment from a wholesaler as their incumbent retailer?

Q212 Chair: Would the regulator in Scotland be able to act in such a way as Ofwat has, by modifying company licences?

Mark Powles: It is not my area of expertise, if I am honest with you, Madam Chair, so I would be wrong to comment on that.

Q213 Chair: Are you both confident that the Draft Bill will be successful in encouraging new entrants to this sector? Does it go far enough? Are there any amendments that you would like to see to promote further competition?

Nathan Sanders: If you look at SSE Water, we entered this market because we wanted to install and look after assets, and we have been able to do that as a new entrant. It has allowed us to have touch points with the customers, and it has also given what the customer wants. A developer who was around in 2007 mentioned to us, "I wish you guys could do the same as you do in electrical and gas". That is one of the main reasons we have come in.

The market has not been difficult to break into when we came in, back in 2007. We do not think the Bill would make that any harder, but it has been very difficult to grow within that market because of the time it takes to get an inset appointment and the size of developments that we are able to go after, mainly due to the competitiveness of the wholesale prices. We do welcome the way the Bill is, but think it is long overdue.

With regard to amendments, it is really around the level playing field. We would like to be sure that it is a level playing field. For example, at the moment with connection charges, occupiers of properties can be charged differently from the way an inset appointee may be charged, and potentially it is the same with the water licences. We also have some concerns about how the current inset regime will work with the new regime. How will that transition work? Effectively, if we can introduce these market codes or understand what these market codes looked like earlier, we can get some comfort that this Draft Bill will provide a platform for new market entrants.

Chair: Mr Powles?

Mark Powles: We have got to start by thinking about how we can deliver better outcomes for customers. In Scotland what drives me is whether I can give customers better value, better service and more innovation. The model that we create in England should build on some of the component parts in Scotland. Where are my concerns? Again, I go back to this level playing field and some of the other things. Also harmonisation of price and service tariff structures will mean that if you are serving a multi-site customer you can provide one bill very easily, but you do not have to have 25 backing sheets with different service standards. So we should try and avoid the complexity that will be built in to having different structures in each region. I think harmonisation of those sorts of service standards is really important.

We also need to create a model that makes it easy for a customer that intends to go to a new entrant, so they do not have to go through four months of waiting for that process to take place. In Scotland, a customer, from making that decision, can switch within 20 days. It is instant and they can start to deliver the benefits of that. In terms of creating common codes, common structures and common contracts, enabling that to work in a cost-effective, efficient and timely way will mean that we give customers confidence and deliver maximum benefit to them. I would also say that we do need an efficient, wellfunded and stable set of wholesalers because ultimately a large chunk of what we do as a retailer depends on the network businesses performing those services. We do not want instability because that will, in the end, impact on customers.

Q214 Chair: This seems to be a new term that you are using, that was not raised in the evidence we took on the Water White Paper, about a level playing field. What is in the Draft Water Bill that is alarming you that was not in the White Paper?

Mark Powles: The lack of separation. In Scotland, Business Stream had to legally separate from its parent company to give new entrants confidence that we were not getting an unfair advantage. Clearly separation has not come through in that form, so it is incumbent on the regulator to put in place a governance regime that creates that level playing field. It may just be terminology, Madam Chairman, but again, I want confidence, and I think all new entrants will want confidence that they are getting the same treatment as a water company’s retail arm.

Q215 Chair: Could I just ask you, Mr Powles, why the Scottish model did not look at upstream competition?

Mark Powles: I think the regulator and the government are the best people to answer that question, but at the time there was a focus on delivering customer benefits and bringing market forces into play. It was felt that the retail end was the right place to start with that, to see where that took it. In previous evidence sessions, Alan Sutherland, the regulator, has talked about there being an initial definition of retail that focused on those customerfacing points. There has been iteration since then, where retailers are now being encouraged to go further into the value chain to try to give better value and deliver more efficiency. That incremental approach was the way that the Scottish market decided to go. The regulator also had a responsibility to do nothing that was to the detriment of the core business as a mandate, so that perhaps influenced it as well.

Q216 Chair: Has there been a problem with stranded assets in the way that the Scottish competition has been led?

Mark Powles: No, but there is a clause within the reform in Scotland, called 29E. The best way of describing it is that if I, as a retailer, can do something with a customer that would reduce Scottish Water, the wholesaler’s, cost base, then that can be shared between customer, wholesaler and retailer. For instance, if part of the network is capacityconstrained, and if I, with the customer, built a 72-hour storage tank that enabled them to reduce that pressure on the network that in turn meant Scottish Water did not have to upgrade and invest in that asset, then that money can be shared between all parties. That is the only way, and I do not believe there have been any issues on stranded assets to date.

Q217 Sheryll Murray: I want to specifically ask Mr Sanders a little bit more about the inset appointments regime at the moment. You currently use this. Could you tell me why you have chosen to use this route so far, rather than the existing water supply licensing regime?

Nathan Sanders: We listened to our customers back in 2007, and it was apparent that they were looking to bundle up utilities. They wanted to go to one provider who could provide them electrical, gas and water. So this is now using our expertise to add value to this marketplace, and that value is getting pipes and water pipes in the ground, which means owning the asset. We wanted to own the asset and look at the long-term revenue, so we are in this market for a long period of time. We could not do that under the water supply licence regime. However, looking at the Draft Bill, we have asked for such reforms as the national licence. We have asked for the market codes; whilst there is more development on the market codes, hopefully when we get some details around those, it will give us the opportunity to see where the best place to set our future growth lies.

Q218 Sheryll Murray: And do you think you will be likely to reconsider your approach if the draft Bill is enacted?

Nathan Sanders: I think we would. We would look at all options. It is around the transition-how we transit from one to the other.

Q219 Sheryll Murray: I just want to ask both of you about Ofwat, and whether the Draft Bill strikes the right balance between legislation, guidance and regulation. We have had different people with different views, and it would be interesting to know what you both think about that.

Nathan Sanders: Yes, fundamentally it does. The key, fundamentally, is flexibility in the market codes and how they develop; that is the real fundamental there-setting out market rules such as cost principles. Legislation is probably too inflexible. Ofwat, therefore, would be the best people to be the policemen, to oversee the rules and the governance of that. We have seen Ofwat use their powers in the past, and they have changed the way things are done. They worked with us to revise the inset process. Hopefully we will see some benefit of that going forward, but I suggest that with all reforms the devil will be in the detail, and when we see the detail we can act accordingly.

Sheryll Murray: And Mr Powles?

Mark Powles: In the main, yes. I am always nervous of having too much in legislation that can create unintended consequences in the future. I think perhaps the access pricing regime is an example of that. The Bill would benefit from some more guidance to give some clarity of the principles that we are trying to create, and also some principles from Ofwat of how it intends to interpret the relevant pieces of legislation. I know there are consultations coming out later, but things like the clear definition of what retail and what wholesale is; some clearer definition of how they intend to manage the governance of incumbent behaviours; and regulated access versus negotiated access. All of those things would give clarity to incumbents and new entrants as to how we want to access that market.

Q220 Neil Parish: Good afternoon. In Scotland, the company had to split the wholesale business from the retail business. The government here has decided against mandating the legal separation of incumbent companies’ retail operations. What impact do you expect this decision to have on competition? Mr Sanders, perhaps, to start with?

Nathan Sanders: I think we believe that this is really for the politicians and the regulators to decide. We find dealing with incumbents a fairly mixed bag; some are good and some are bad. Separation, therefore, is not very high on our agenda when we are looking as a competitor to this market. It is more important to us that the market codes are done very well and that they themselves introduce the competition.

Q221 Neil Parish: At the moment, then, do you buy water and supply just to businesses, or to households?

Nathan Sanders: To households as well, but ours is an asset business. We look to put the water pipe in the ground, take the water and deliver to the end consumer.

Q222 Neil Parish: I see. Because what I cannot quite understand is if a company owns both wholesale and retail, surely they can control their prices to make sure that you cannot price against them?

Mark Powles: That refers back to what I was saying earlier, about if it is regulated access. In Scotland there is a clear wholesale price. That is the same price that is paid by me as an incumbent, and it is also paid by new entrants, so there is complete transparency. There are also a default set of service standards, so if my customer wants Scottish Water to respond within five days to a particular fault find or whatever, that is exactly the same service as a new entrant will get from customers they are serving. A lot of that is picked up within the market and the operations codes. We would like to see that regulated rather than negotiated.

The other point on separation-you are preaching to the converted., because I have had to go through it, and we are now in a physically separate business. We have separated all our IT systems. My people cannot speak to Scottish Water in the same way as they did when they were colleagues; we have to go through defined channels. The regulator audits me on that. To new entrants that means they have certainty that we are not getting an unfair advantage. The Bill is silent on how that will be applied in detail, but my worry is that if we do not get that right at the start we will end up with multiple claims in the competition courts or to the regulator that are lengthy, costly and burdensome, and customers will not get benefits.

I would really like to see some clarity on how they would apply a governance regime in the absence of separation.

Q223 Neil Parish: How do you see competition working where you have got two different wholesale water companies, because you only have one in Scotland? For example, Wessex Water and South West Water have significantly different charges, partly because of sewerage disposal and cleaning of beaches. How would that work?

Mark Powles: In terms of the price per litre, if that is what we are talking about, we accept that there are going to be different prices in different regions because of the cost profiles and the investment that has happened over the years. We accept that, and it would be our job, if we were serving a customer with sites in different regions, to aggregate that and put a deal to the customer that made sense and was fair. However, we would like to see more harmonisation of price structures, because that is where complexity can get out of control-if you cannot demonstrate to a customer the value they are getting from contracting with you. If that is broken down 21 times, it starts to get difficult.

Q224 Neil Parish: What I cannot get to the bottom of is why Wessex Water or South West Water would sell their water to another company for a cheaper price than that for which the customer could buy it from them?

Mark Powles: They should not be able to.

Q225 Neil Parish: Right, okay. It does not create much in the way of competition, as far as I can see. I will move on to the next question. What particular forms of potential discrimination must be addressed if a well-functioning market is to be established? I am not convinced it is a well-functioning market yet.

Nathan Sanders: There are two that we would probably see. One is around the inset process as a whole. Currently the process takes a considerable amount of time, and that time is too long for the developers and it deters them. The process currently allows incumbents to slow down the mechanism for the transfer of information, such as the reporter’s report, which is to prove that any site is not served, and also agreeing the bulk service terms. We would like to see that discrimination taken away and for the market code to really define that, or even go further around those terms within the Bill.

The second one is calculating the cost of connections, which we talked about earlier. There is a requirement to be applied under the Act to take into account discounts on future revenues. Some of the incumbents apply that to us, as a new entrant; some do not. Some use the Act itself, because there is a technicality in the Act that says that that discount should only apply for occupiers of the premises, rather than the people that go under the inset regime. Those issues can be addressed in the market codes, but we would like to see a stronger steer in the Bill for the charges for connections to make sure that they are for any person on a nondiscriminatory basis, and therefore that they will apply consistently across the industry.

Q226 Neil Parish: Who will police all this? Would it be Ofwat?

Nathan Sanders: I would see it being Ofwat.

Q227 Ms Ritchie: This is a question for both of you. Are you confident that Ofwat will be able to effectively police non-discrimination through regulatory means?

Mark Powles: It is certainly easier in a physically separated market. The regulator audits me, as the incumbent in Scotland, and we have signed up to certain licence conditions that mean we need to behave in a certain way. As I say, it is easier in a legally separated context. It is difficult to answer your question until we see the substance of the regime that Ofwat intend to put in place. The principle should be that, as a new entrant, I should be able to access exactly the same terms, pricing and service levels as their incumbent company.

In terms of communication, the way people interact within that integrated water company needs to be considered. They cannot be able to access back doors and other channels that I, as a new entrant, do not have. There needs to be a thought about transfer pricing: how do they price elements of service contracts between their wholesale and retail business? We need to see more detail before we can comment on it. For a market to function effectively and fairly, there needs to be a very robust system in place that is open to scrutiny.

Chair: Mr Sanders, did you want to comment?

Nathan Sanders: I just think time will tell. They have the powers. They just need to use them better than they may have been using them in the past.

Q228 Barry Gardiner: One of the other things that you said in your written evidence about a well-functioning, fair market was that it should provide for less efficient incumbents to exit that market. You were backed up in that by Ofwat, and you backed Ofwat up in that. What do you think of the government’s decision, then, to not allow that, and what impact will that have?

Mark Powles: Retailing is an economies-of-scale business. If we do not allow an exit, we could have anything between 20 and 30 retailers all vying for 1 million customers. I do not think that is the way of maximising both the value and the efficiency to the customer. Whether you are a small company or a large company, if the competencies that you have are more network-based, you could be a bad retailer, and ultimately bad retailers give bad service to customers. The only way a customer will benefit is to switch, and I just think it would be healthy to create a scenario where those that do not have and do not want the competencies can get out.

Q229 Barry Gardiner: Do you actually foresee a possibility of a high level of competition with a very poor level of service, and a very high charge as a result of this?

Mark Powles: No, I think the charges will be regulated, I hope, so you are assured of no problems there. If a bad retailer has to stay in the market, and it withers on the vine, because they are not very good at it, that is potentially going to damage their wholesale business in terms of things like the revenue streams.

Q230 Barry Gardiner: Will that not put prices up?

Mark Powles: Potentially in the longer term. I just think it would be healthy to have a mature conversation. Regarding Scottish Water and the discussions they had before the market opened, they had to bring in a whole new set of skills to run the retail business. I was one of them, but I have also brought other people in. It is a very different skill-set from running a customer service department at a billing service in an integrated water company. Just to pick up on Mr Parish’s point, competition is not just about price benefits. It is about service benefits and beyond-the-meter solutions to reduce consumption for customers. That is a very different skill-set to what was there when it started, and we should be mature about that, because not everybody will want to play in that game.

Q231 Barry Gardiner: What do you think could persuade the government to change its mind on this one?

Mark Powles: I am not sure I have an answer.

Q232 Barry Gardiner: Apart from experience.

Mark Powles: Looking at that, you have to recognise that retail is an economiesofscale business. To do it you do need to have volume. There are niche players in every business, and maybe it is just looking at some more impact assessments of what 30 retailers fighting for a million customers might actually look like.

Q233 Chair: Mr Powles and Mr Sanders, thank you both very much indeed for contributing to our inquiry and being so generous with your time. We really are very grateful.

Mark Powles: Thank you.

Nathan Sanders: Thank you.

Examination of Witnesses

Witnesses: Rob Cunningham and Nicci Russell, Blueprint for Water, gave evidence.

Q234 Chair: I welcome you both very warmly, and thank you for being here to contribute to our inquiry into the Draft Water Bill. If you could just introduce yourselves for the record, and give your position, that would be great.

Nicci Russell: I am Nicci Russell, Policy Director at Waterwise, and I am here as part of the Blueprint for Water NGO coalition.

Rob Cunningham: I am Rob Cunningham, I head up the water policy team at the RSPB, and I am also here as part of the Blueprint for Water coalition.

Q235 Chair: If you agree with each other and do not need to add anything, then that is fine. If you do wish to supplement what the other has said, that is equally fine. Can I just ask, in your view, are there any obvious omissions or gaps in the Draft Water Bill, either in and of itself or having looked at the White Paper that preceded it?

Rob Cunningham: I think probably the most glaring gap is any action on abstraction or significant action on water resources reform. I cannot help but conclude that if we had not had the wettest summer on record we would have probably had a very different Bill in front of us. The Blueprint for Water coalition is very clear that there should be some action on abstraction reform. There are a few other things that could be wrapped up in the Bill, such as removing legislation that restricts compulsory metering to areas of water stress, to try to encourage that to move forward in places where it is cost-effective and supported by customers; another issue is about removing statutory limits on fines. We do not get a Water Bill very often, so we would like to see a much broader base of reforms brought forward in a Bill.

Q236 Chair: We are going to come on to abstraction in a moment. On water efficiency and resilience, would you have expected to see something perhaps more in the Draft Bill?

Nicci Russell: Yes, we would have liked to see something on water efficiency in homes. We are grateful that when Ministers launched the Draft Bill they stated clearly that they hoped that the competition proposals would lead to greater water efficiency for nondomestic customers, but we would have liked to have seen something for domestic customers. We think something along the lines of an enabling duty, subject to a future ministerial target on water efficiency, would have reflected the ambitions set out in the Water White Paper, and given a clear steer that the government wants to see a shift in the balance between supply and demand-side measures towards more demand management.

Q237 Chair: And of the 10 steps that you have set out towards sustainable water in your Blueprint, how many of those steps relies on legislative change-either primary change or secondary legislation?

Rob Cunningham: There is surprisingly little on primary legislation, perhaps, and I have touched on a few of those. There is a backlog of things that require secondary legislation. That is one of the reasons we are so concerned about this being a missed opportunity, because the government already has powers under the 2003 Act, for example, to take action on damage. Abstraction is causing significant damage, and we have had a consultation on that. It is lumbering towards a conclusion, but we are not entirely sure what that will be, so there is that kind of thing.

Under the 2010 Act we were very keen to see widespread use of sustainable urban drainage, but that is being held up by a lack of secondary legislation and statutory guidance. There is a backlog of work, so promising future reforms in a future Bill, when we have still got so much unfinished business, feels a bit-

Q238 Chair: You have certainly pressed the right button with me by referring to SUDS. Have you assessed the government’s progress towards achieving environmental measures, which were set out in the White Paper, that fall outside the remit of the Draft Water Bill?

Nicci Russell: Yes, we have. Earlier this month we published a scorecard on the 10 steps, which we set out a couple of years ago for the government. The Minister asked us to come back and test him on them. Overall we gave the government a D. We gave fewer Bs and fewer Es than we did in 2008, but overall we gave a rating of "Must try harder". Perhaps I can pick out a couple of quick examples.

On water efficiency, we welcome the scale of ambition set out in the White Paper, and the narrative, but we are lacking a lot of the policy action to deliver that. We welcome the link with energy efficiency and Green Deal, but there was nothing on retro-fitting the vast bulk of homes for water efficiency, and nothing on new homes. We are in danger of losing the existing water efficiency measures that we have in building regulations, so we gave overall a C on water efficiency.

On metering we gave a D, largely because the government explicitly ruled out anything that looked like universal metering coming as a steer from the government in favour of local solutions led by the companies.

The only E we gave was on the step relating to stopping pollutants contaminating water, where there has not been enough progress, if any, on pesticides, and we gave a D on keeping sewage out of homes, rivers and beaches. So overall "Must try harder" was our assessment, but we very much believe that the Government is on the same side as us in terms of the narrative. It is about the delivery now.

Q239 Sheryll Murray: If I could turn to abstraction, the water companies and Ofwat were not convinced by your suggestion that the Draft Bill should include enabling legislation for abstraction reform. Given that the details of the reforms will not be settled for some time, why do you think it is so important?

Rob Cunningham: The fundamental point here is that Water Bills do not come around very often and we should grasp this opportunity while we can. It is indicative of the overall problem we have, that memories are very short. We were facing a really significant drought in the early part of this spring. We were saved by unseasonably wet weather.

Q240 Sheryll Murray: If I could just come in there. I have heard you say twice now that Water Bills do not come around very often. Do you have any specific evidence to back that up?

Rob Cunningham: In terms of specific evidence, the 2003 Act was probably the last time that abstraction reform was looked at in a really significant way. Two of the key parts to that were, first, the serious damage test, regarding which we are waiting for the secondary legislation so we can revoke licences causing serious damage, and the other is removing exempt abstractions for navigation and other large abstractions, which are locally very significant. The action on that has been delayed again. I think we were promised something late next year.

So there are missed opportunities. The Water White Paper set out a very compelling narrative about the problems with the current system, and we really look to this Bill to establish commitment to act. We are not asking for secondary legislation powers that are not going to be subject to scrutiny and public consultation and all the rest of it. We just think that if the Government is really serious about this it should signal its intention in this Draft Bill or in the Bill that comes forward.

There are also a couple of other issues around abstraction. One is the consequence of upstream competition. In the discussion of unbundling water supply licences, the narrative talks about farmers or others being able to utilise abstraction licences that they are not using and put them into water supply networks for onward sale. Anyone who is working on the water resource reforms knows that a significant number of catchments are over-licensed. Something like a third of our catchments are over-licensed or over-abstracted. This Bill, as it stands, could actually reactivate a number of dormant licences causing damage, so if the Government is going to go forward with these upstream competition proposals there is a very clear need to tackle that.

There is also the issue that, even if we were to follow the glacially slow reform process for abstraction reform, that is all predicated on dealing with today’s damaging abstractions under something called the Restoring Sustainable Abstraction regime. Everyone recognises that that is moving very, very slowly. The Government, in its White Paper and its statements, has said that it would like to see, for the water industry, those Restoring Sustainable Abstraction schemes funded under the periodic review process. We think this Bill could be a way of forcing that issue, because at the moment the only people we can see opposing that is Ofwat. We really think it is time to break that impasse, so we think that there are reforms that could be made in the Bill to actually force that issue, to get those Restoring Sustainable Abstraction schemes put through the periodic review process, and actually get that system moving. If we miss this next periodic review process it will not be 2025 on the Government’s timetable; it will be 2030 or beyond. Therefore, it is really critical that we break that.

Q241 Sheryll Murray: Did you want to add anything?

Nicci Russell: The only other I would add is that we have identified that the move to environmental permitting in the Bill would be a good opportunity to do this. It would not be a brand new clause; it would be a linking in with a new measure that was already being brought in.

Q242 Barry Gardiner: Can I turn to the issue of Ofwat declaring that it is a secondary duty to have sustainability, rather than a primary duty? Your written evidence to us on that suggests that it should be a primary duty. There have been concerns raised that if it were a primary duty it could have an adverse impact on investment in the industry and actually drive out investment from the industry and have a negative effect in that way. Firstly, can you respond to that criticism, and then we will go from there.

Rob Cunningham: Regarding that criticism specifically, on investor confidence, I have heard that before. It was interesting that we heard from Moody’s earlier that actually taking a long-term view and having long-term certainty in terms of investment is really critical. That is the kind of thing that sustainable development duty would drive you more towards, because you are taking the long-term view, thinking about inter-generational issues and not putting off difficult decisions in the short term because of the long term sustainability issues. I do not particularly buy it. I do not see it as a significant issue given the scale of uncertainty that Ofwat itself is willing to introduce into the regulatory system, as we heard earlier.

Q243 Barry Gardiner: Can you give us any examples in which the fact that it is currently a secondary duty, rather than a primary duty, has had an adverse effect?

Nicci Russell: We have had a chat about this and came up with lots of examples. One is that water companies currently spend 0.08% of their capex spend on water efficiency measures. Given the narrative-and everybody agrees that we will need to shift towards more demand management, which is set out clearly in the water resource management plan guidance-that is not sustainable. We would not be there if, when the industry was privatised 20-odd years ago, a sustainability duty had been in place. I think the discussion about water efficiency and leakage would be different. It is possible that we would not have needed a desalination plant on the Thames.

There are also some more specific issues. It is only quite recently that water companies have been allowed to look beyond the five years for their investment plans. Clearly, if you are putting in place a demand management measure to offset the need for future supply 20 years down the line, it is really important that the regulatory framework can reflect that. The other I would add is that I also heard the evidence from Moody’s, and he said that the industry is considered a gold standard industry. I am no economist, and I am not an investor, but it strikes me that the industry is not particularly resilient to climate change, and it is at the forefront of climate change. We have had two dry winters, we are in danger of having a third-although we have had the recharge this summer-and I think the investment community should be looking at that resilience to climate change and not just uncertainty in regulation itself.

Q244 Barry Gardiner: Yes, I suspect Moody’s are more proficient at looking at the capital base rather than the natural capital base.

Nicci Russell: Yes.

Q245 Barry Gardiner: Finally, you cited Ofgem as a regulator that does have a primary duty for sustainability. It is almost the flipside of the last question: can you give an example of where it being a primary duty has substantially made a difference to the regulation of the energy industry in a positive way?

Rob Cunningham: We did a bit of thinking about this before we submitted our evidence. The first thing we would acknowledge is that a sustainability duty in itself is not a silver bullet. You do not give somebody a sustainability duty and expect things to change overnight. But what we have seen in Ofgem is that they have restructured themselves, so it has put sustainability higher on their agenda. Talking to NGO colleagues who have been working in the energy sector, they feel that it resulted in a much more open dialogue about the sustainability challenges that are facing Ofgem. The way it was phrased to me was that there is a definite sense of willingness to engage and discuss, but four years on since they were given that duty, there is still a strong cultural issue around the skillsets of the staff and the way in which the organisation operates, but it is the beginning of a process. That is how I would see where we would go with Ofwat as well.

Q246 Neil Parish: I think Harold Wilson said, "A week is a long time in politics". I think six months in water supply is a very long time. We were talking six months ago about being in a drought situation and now we have had the wettest summer on record. As you have been saying, that does not really alter the fact that we might well need to bring in more metering. Are you aware of any specific instances where water company customers would support compulsory metering but the company is prevented from carrying it out because it is not in an area of serious water stress, because that is very much in the Government proposals.

Nicci Russell: The barrier in terms of only being able to compulsorily meter in waterstressed areas is not just regulatory barrier or a hard barrier, but it is also a barrier in terms of customer perception. I do not have a specific example of a water company whose customers were desperate for metering but were unable to do so because it was not defined as waterstressed. It is a bit more three-dimensional than that, although I know that is not what you were suggesting.

Thames Water, who are in an area of high water stress, were not awarded their metering programme at the last price review, despite being in an area of water stress. We feel that it complicates the issue, and, in line with the Government’s red tape review, it would be worth, as we propose, just getting rid of that distinction entirely, and just allowing companies, where their customers are happy for that to happen, to meter compulsorily wherever, as necessary. The Environment Agency’s new definition of water stress will actually put a lot more companies into the high water stress category.

Q247 Neil Parish: So give the companies the freedom to go ahead with metering if their customers wanted it; is that what you are saying?

Nicci Russell: Yes. It strikes us as a regulatory barrier that does not need to be there.

Q248 Neil Parish: And does Mr Cunningham want to add anything?

Rob Cunningham: The problem is that it is difficult to come up with examples; why would a water company go through the pain of putting it in its water resource management plan and trying to win the argument when it knows that the legislation is against it? We think the water companies should be given greater latitude in coming up with a sustainable solution, and, if it is supported by the customers, that going forward.

Q249 Neil Parish: My next question is very much linked really, because I want to talk about how we designate water as stressed. Various parts of the country will change where the water stress is over a period of time. Perhaps the eastern side is usually drier and the western wetter, but it does not always work that way. The Environment Agency is currently consulting on changes to its methodology for designation of water stress. Do you expect the new methodology to have a positive impact on levels of metering?

Nicci Russell: Yes, we do. We are very supportive of that process. It will move more companies, including companies in the centre of England, into a classification of serious water stress. We think that will make a difference. However, although I am not quite sure how regularly it would be made, that classification certainly would not be made every six months. Your six-months analogy is relevant, because everything can change in six months. Even under the new classification, a company that is not classified as highly water-stressed or seriously water-stressed might still need to be taking urgent measures. .

Q250 Neil Parish: I see from my notes here that Bristol Water, Severn Trent Water, South Staffordshire Water and Wessex Water could well having serious shortages of water.

Nicci Russell: Yes.

Q251 Neil Parish: So you would support the idea that they then could bring in more metering?

Nicci Russell: Yes, and that reflects more our view of the world. The previous classification did not include climate change impacts, for example, or catchment management approaches and the CAMS process, for example. So we are very supportive of that, but it is a halfway house for us. We would like to see the regulation gone entirely.

Q252 Chair: Just before we leave metering, in the South West Water area, they have probably metered to the maximum that they are going to, and it seems to have a perverse consequence that those that are not metered because they are on particularly low incomes are actually being disadvantaged. Do you share that view?

Nicci Russell: This one of the reasons why we were keen for the Government to take a strategic role in the move to full metering. We feel very strongly that there is a tipping point, which might be different for each company, where you do start to get those cross-subsidies and inequalities that people are concerned about with the move to full metering actually starting to happen during the transition. That is an issue. It comes at a certain stage as you move to full metering, but you can manage that through tariffs and water efficiency measures as a package with metering, not metering alone. .

Q253 Neil Parish: The trouble is lowincome families who use a lot of water do not want to go onto the meter. Would it actually be better that all people were metered, and then help was given to those families that are having difficulty paying the bill? I do think it is ultimately fairer that all people are metered, not only from an environmental point of view, but on the fact of the resource that they are using.

Nicci Russell: Yes, we absolutely share that view, and it enables you to address the affordability aspect far more strategically. It is fairer in the long run, and I certainly agree with you that it is fairer for everybody if they pay according to how much they use, with those safeguards in place.

Rob Cunningham: Waterwise, RSPB and a range of other organisations are members of a coalition called Fairness on Tap, which explore these issues, and we would be happy to send you a copy of our coalition document that sets out the case for metering. But the point you make is perfectly valid.

Chair: That would be very helpful.

Q254 Sheryll Murray: I have just a couple of very quick supplementary questions. Firstly, some water companies, such as South West Water, have a scheme where you can try a water meter for 12 months and revert back to the normal billing if it does not prove to suit your needs. Do you think that is publicised enough? Secondly, how would you deal with multi-occupancy properties if you had compulsory billing for every household?

Nicci Russell: On the first issue, I certainly think it is a good idea to meter in a consensual way and to give customers information to help them drive a change in their behaviour, otherwise putting the meter in has less of an impact. Southern Water are metering all of their homes and doing the same-giving both bills for a year so you can see the difference and try and drive your use down-so I very much agree with that.

In terms of publicising it, that is obviously a really important part of the package. I think working with other partners helps in that measure. We are always happy, as NGOs, to work with water companies as they go out to customers and say, "We would like to meter you, and this is why", and that might help with the trust issue.

Sorry, what was the other question?

Q255 Sheryll Murray: It was on multi-occupancy homes. There are some properties that physically cannot have a meter. How would you deal with those?

Nicci Russell: I agree with you that some homes cannot be metered. Universal metering gets up to about 80% or 85%, and they would probably still have to be billed on the basis of rateable value, but that could be updated because it is currently 25 years old.

Q256 Sheryll Murray: How much do you think that would cost if you were going out to rerate properties? Have you got any assessment on that?

Nicci Russell: No, we have not. I think at the last election there was a big political debate about this, and a decision was taken that it was far too politically sensitive. That rerating of properties was beyond water.

Q257 Ms Ritchie: I have another question around Ofwat. Do you accept that if Ofwat had a primary sustainability duty this would be likely to lead to increases in customers’ bills?

Nicci Russell: I do not accept that. Affordability is an issue in the water sector that will always be there, and we need a far better system to deal with it. The issue of sustainability leading to higher bills is not a fair representation of the situation because Ofwat are committed to protecting the interests of current and future customers. Sometimes it feels as if there is a skew towards current customers, but if we are investing on the basis of sustainability, then that might mean that future customers do not need to invest or pay bills for another desalination plant, for example. Therefore, I do not think there is necessarily a tension; it is just a question of spending the money differently. It does not necessarily mean that bills would need to go up.

Q258 Ms Ritchie: How would you envisage the equal duties to promote sustainability and financeability could be balanced by the regulator when there is a conflict between them? I suppose it is a question of balance.

Rob Cunningham: One of the issues here is the definition of sustainability, which is mercurial and has been debated by academics for years. Defra and the Government have a very clear view about what sustainability is. We are not here talking about sustainability being purely the environment. Sustainability, as defined by the Government, includes aspects of social and economic consideration, so I do not think it is something that necessarily we should view as being intention. It is just broadening the assessment criteria of how you make your decisions. It was described, by the Sustainable Development Commission, as the difference between making a cheap system more sustainable or making a sustainable system most cheaply. I think that is essentially what we have to be aiming for.

Q259 Chair: Looking at the implications for water customers, I know you are very keen to see the Water Framework Directive implemented, and probably also the Urban Waste Water Directive implemented. Are you in a position to cost what the implications for future and present water customers’ bills will be?

Rob Cunningham: That is something that has been keeping people occupied for a while. No, but I think the interesting thing about the Water Framework Directive is that as its core it has the disproportionate costs test, and that is that marks it out as being unusual, unlike the Urban Waste Water Treatment Directive. So the Environment Agency, Defra and Ofwat will come to a view, or government will come to a view, as to what is disproportionately costly.

There are a couple of wrinkles in this that are relevant to the current water policy debate. The first is, of course, we have heard from various people that upstream competition could increase the cost of capital, and that could have a knock-on in terms of the cost to water customers. So the Water Framework Directive is a bit of a moveable feast. From our point of view, in terms of the disproportionate costs test, we need schemes delivered at the least possible cost. There is a really big question as to whether opening the water industry to upstream competition is going to do that, so you could see a tension between competition, driving up water customers’ bills and driving down environmental ambition. That is a very real risk we are concerned about.

The other thing that is exercising a lot of people is the fact that we have in the Bill this realignment of drought planning, which is an industry in itself, but compared to the overall periodic review and the Water Framework Directive, it is a small component. However, in the current planning cycle we are facing Ofwat coming to a final determination on water company investment two or three months before the Government officially announces the outcome of the river basin management planning process. That timing mismatch is going to cause an awful lot of headaches and a lot of uncertainty for customers, in terms of the decisions about whether the water companies will suddenly be facing another set of investment priorities that were not accounted for in the price review, and how they are going to deal with that. That is something that the Bill could deal with, or government policy could deal with, because it is going to be an issue of one or two months this time round; it will be 13 months the next time round, and I think that is a big problem.

Q260 Chair: That is very helpful. On climate change, Ms Russell, you said that it should be a core function of water companies. In North Yorkshire, we saw temperatures of minus 19 and minus 17 for four days in a row. That obviously was over and above any leakage policy that they had. You mentioned earlier that if the leakage work had been done, perhaps we would not have needed the desalination plant. It would be very helpful if you could perhaps share, in writing, with the Committee the background that you actually reached that calculation on. And going forward, perhaps in writing you could share with the Committee what role you would expect water companies to play. Clearly any extreme weather conditions like burst pipes because of cold weather is over and above what any water company is expected to do, so if you had anything like that you could share with us, that would be most helpful.

Nicci Russell: Yes. I am not sure we have a huge amount on that, but certainly what we have we would be happy to share with you. One of the things that we are pushing for as the Blueprint for Water coalition in the price review is a water supply target, so that would cover water efficiency, leakage and metering, and would take up a bigger slice of the pie, and would potentially be a more strategic approach to leakage.

Chair: Thank you both, Ms Russell and Mr Cunningham, for being with us and being so generous with your time, and participating in our inquiry. We are very grateful to you, and we stand adjourned.

Prepared 31st January 2013