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The affluent and the effluent: cleaning up failures in water and sewage regulation Contents

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Chapter 3: Ofwat

Ofwat’s statutory duties

51.Ofwat was established under the Water Industry Act 1991, which stipulates its statutory duties .31 These are to:

• Further the consumer objective to protect the interests of consumers, wherever appropriate by promoting effective competition;
• Secure that water companies properly carry out their statutory functions;
• Secure that water companies can finance the proper carrying out of their statutory functions;
• Secure that water supply licensees and sewage licensees properly carry out their licensed activities and statutory functions;
• Further the resilience objective to secure the long-term resilience of water companies’ water supply and wastewater systems; and
• Secure that they take steps to enable water companies, in the long term, to meet the need for water supplies and wastewater services.32

Balancing objectives and making trade-offs

52.Ofwat told us that in regulating the sector, it sought to “to achieve a balance between these duties, and avoid regulatory action which advances one duty at the expense of another.” The regulator did not “perceive a need to manage trade-offs in respect of [its] objectives.”33

53.Witnesses such as Annabelle Ong, Director at Frontier Economics, did not agree. Ms Ong told us that Ofwat’s objectives “are to be traded off by design … there are multiple objectives that are at times difficult to balance.” She noted that sometimes there is a focus on storm overflows, but reducing leakage, reducing supply interruptions, reaching environmental targets, and meeting investment needs all matter. She said that “Going forward, it will be very difficult for Ofwat to balance its statutory objectives.”34

54.IFM Investors felt that Ofwat has historically protected consumers by keeping bills low at the expense of investment in infrastructure, and Waterwise asserted that in recent Price Reviews, “too much weight has been put on short-term bills and not enough on meeting [Ofwat’s] resilience duty”.35 Christine McGourty, Chief Executive of Water UK, noted that “by 2025, bills will have been flat or falling for 15 years [in real terms]”, and “Ofwat’s focus has been weighted somewhat too much to those short-term interests of current consumers.”36

55.Afonydd Cymru, Angling Trust, the Salmon and Trout Conservation, Guy Linley-Adams, a Solicitor at Salmon and Trout Conservation, and Mark Lloyd, Chief Executive of The Rivers Trust, all held the view that Ofwat has prioritised keeping customer bills low at the expense of environmental protections and investment.37 The Angling Trust said:

“Ofwat has duties to protect the interests of customers. Yet while it has often forced a reduction in investment plans put forward by water companies, under the guise of its potential impact on consumer bills, it has failed to fully protect consumers’ interests, by failing to recognise the value consumers place on a clean and healthy environment.”38

56.The Water Act 2014 amended Ofwat’s statutory duties as set out in the Water Industry Act 1991 to include a duty to “further the resilience objective”. This is defined as an objective to:

• “Secure the long-term resilience of water undertakers’ supply systems and sewerage undertakers’ sewerage systems as regards environmental pressures, population growth and changes in consumer behaviour; and
• Secure that undertakers take steps for the purpose of enabling them to meet, in the long term, the need for the supply of water and the provision of sewerage services to consumers”.39

57. Mr Linley-Adams outlined that when the Water Act 2014 was being passed, many NGOs “fought very hard to have a strong duty towards the environment and towards sustainable development placed upon Ofwat, but what we got was a very unhappy muddle”.40 The “muddle” is the resilience objective, which Mr Lloyd said “has been misinterpreted by many to mean financial resilience for companies rather than environmental resilience.”41

58.Professor Ian Barker, Managing Director of Water Policy International Ltd, said it “would be a brave company that proposed an investment programme that addressed … long-term issues because of the potential impact on bills.” He believed that in such a scenario, Ofwat would want to “focus on the here and now”. He suggested “companies in some ways have managed [the] trade-offs more than Ofwat has by virtue of what goes into their business plans”.42

59.Emma Clancy, Chief Executive of the Consumer Council for Water, acknowledged that Ofwat has a difficult task in balancing its objectives. She argued that this is not helped by the timeframes of the Price Review process, which requires that years in advance of any kind of execution, the regulator must try and predict the needs of customers and all other factors, including the environment and investment. She felt in the past “the pendulum had perhaps swung too far in favour of companies”, but applauded Ofwat for “swinging it back the other way for recent Price Reviews”.43

60.Professor Catherine Waddams, a member of the Centre for Competition Policy at the University of East Anglia, argued that balancing trade-offs between objectives should sit with the Government or Parliament rather than the regulator. For example, she said water companies will argue for better financing, but this would raise bills and could threaten the consumer welfare: “That is a trade-off that I do not think is proper for Ofwat itself to make; that would be better coming from Parliament.”44

61.Mr Cox told us he would “reject very strongly any suggestion that Ofwat, under my tenure, had an objective for bills that overrode other objectives. It categorically did not.” Similarly, David Black, Chief Executive of Ofwat, said he did “not think that it is right to characterise Ofwat’s focus as being on low bills”. He pointed to the 2019 Price Review where no schemes were rejected on the grounds of affordability. Mr Black acknowledged that bills have fallen in recent Price Reviews (PRs), but explained this has been due to a fall in allowed returns, and not at the expense of investment.45 He said that going forward: “Substantial new investment is required, which may well impact on bills, depending on the other elements of the package.”46 Iain Coucher, Chair of Ofwat, emphasised “it is not the case that [Ofwat] have held back investment”.47

62.The Secretary of State said she felt Ofwat’s statutory objectives were clear and appropriate, and that the Government “had the opportunity in the Environment Act [2021]” to consider the issue. She argued that there had been changes to the original duties given to Ofwat in the Water Industry Act 1991, such as opening up competition for non-household suppliers. She outlined that using directive Government statements such as the Water Industry National Environment Programme and the Strategic Policy Statement, which sets the Government’s priorities for Ofwat, “is a reasonable way to keep going with [updating Ofwat’s objectives], as opposed to constantly having to wait to change primary legislation all the time”.48

63.It is the view of many in the water sector that Ofwat’s objectives require it to make trade-offs between prioritising consumer bills, investment, and the environment. It is the impression of some stakeholders that Ofwat has historically given more focus to a short-term desire to keep water bills low at the expense of long-term environmental and security of supply considerations.

64.Ofwat faces the challenge of balancing the financial needs of customers during a cost-of-living crisis with the urgent need for infrastructure and environmental investment. Given the distributional and intergenerational consequences of many of these decisions, it is crucial that Ofwat is given strong, clear guidance by the Government on how these trade-offs should be made.

The Government’s Strategic Policy Statement

65.The Government has the opportunity to provide clear guidance on how Ofwat should prioritise its objectives. The Water Industry Act 1991 provides that “The Secretary of State may from time to time publish a statement setting out strategic priorities and objectives for [Ofwat]”, and Ofwat must carry out its functions in accordance with such a statement.49 This is known as the Government’s Strategic Policy Statement (SPS).

66.In its January 2022 report on water quality in rivers, the House of Commons Environmental Audit Committee stated that witnesses had suggested to them that DEFRA’s 2017 SPS had “ducked the hard choices” by describing processes rather than specific outcomes. In its response to DEFRA’s then-draft updated SPS, the Environmental Audit Committee welcomed the protecting and enhancing the environment strategic objective, but expressed concern that the SPS was imprecise in its expectations, with no indication of the specific outcomes expected.50

67.In February 2022, DEFRA published its latest SPS. It identified four priorities for the water sector:

• Protect and enhance the environment;
• Deliver a resilient water sector;
• Serve and protect customers;
• Use markets to deliver for customers.

68.Mr Lloyd said that The Rivers Trust welcomed aspects of the 2022 SPS, but there was “a bit too much language about Ofwat enabling and encouraging things to happen rather than requiring them to happen, so it looked a bit gentle.” He said stronger language would be helpful to hold Ofwat to account, as it is far easier to assess if they have required companies to do something as opposed to merely encouraging them to.51

69.Mr Linley-Adams agreed that the language in the SPS is too weak:

“We need the Secretary of State to make it absolutely clear to Ofwat that it is not just about encouraging or cajoling the water companies to do what they are required to do by law; it is about actually requiring them to do it—directing Ofwat to use its enforcement powers.”

70.He said that Salmon and Trout Conservation, together with the Angling Trust, had released a shadow SPS with stronger language.52 When asked if stronger language would compromise Ofwat’s independence, Mr Linley-Adams responded that outcomes—a better water environment—are what matters, and “If Ofwat needs to be told firmly what to do and that compromises its independence a little bit, then so be it.”53 Mr Lloyd agreed.54

71.Ms Bentley, Annabelle Ong, Director at Frontier Economics, Prof Barker, Water UK, Blueprint for Water, Waterwise, and Affinity Water, all told us that the SPS missed the opportunity for the Government to advise Ofwat as to which objectives it should prioritise.55 For example, Affinity Water said:

“The priorities as laid out [in the SPS] are not organised in any hierarchy and do not provide any indication or guidance in terms of relative importance. The implicit assumption is that all are equal, none are contradictory and all are achievable at the same time … We consider that there is scope for more specific direction to be given on how Ofwat should prioritise these objectives and how the trade-offs should be considered … Without clear direction on relative priority, there is a risk that the balance that is struck does not aligned with Government objectives.”56

72.Ms Bentley and Blueprint for Water told us that a lack of clear priority-setting in the SPS differs to similar documents issued to other regulators.57 Ms Bentley highlighted:

“Other regulators, such as Ofcom, [get] set very clear direction when it comes to the trade-offs and the balance of investment versus the bill profile … Ofcom’s version of the SPS makes it very clear that the Government state that ‘promoting investment should be prioritised over interventions to further reduce retail prices in the near term’ … That sets quite a clear steer in the Ofcom example, which I think Ofwat would benefit from. “58

73.Ms Ong said an implication of a lack of prioritisation in the SPS is that it is difficult to measure if Ofwat is meeting the priorities set: “It will be very hard to say that [Ofwat] did not meet the SPS, given that the SPS does not prioritise.”59

74.Several witnesses told us that there needed to be further scrutiny of Ofwat’s work to meet the objectives set in the SPS. Affinity Water noted “there is no mechanism to check or measure [Ofwat’s] delivery of [the SPS’] expectations.”60 The Independent Water Networks Ltd. felt there was more scope “to regularly monitor the performance of the regulator in facilitating [the SPS’ objectives]”61. Lawrence Slade, Chief Executive of the Global Infrastructure Investor Association, commented that “there does not appear … to be a really solid, formal way of understanding the regulator’s performance against [the SPS]”. He suggested such scrutiny could be conducted by a parliamentary committee62. This suggestion was also made by IFM investors and Water UK.63 In its January 2022 report on Water quality in rivers, the House of Commons Environmental Audit Committee announced its intention to invite Ofwat to appear “routinely” to discuss its progress against the objectives of the new SPS.64

75.Mr Cox said that Ofwat has the most directive government intervention of any of the economic regulators through the SPS, arguing that it provides very strong guidance. While the SPS does not explicitly state how to make trade-offs, it gives guidance. He felt it would “be wholly inappropriate to go any further” than the Government does in the SPS, due to the benefits of the independent regulation model, which attracts investors. Mr Cox believed it was the role of those heading the regulator to make decisions about trade-offs.65 The Consumer Council for Water similarly argued “a more detailed SPS would run the risk of undermining regulatory independence.”66

76.Mr Black said there is an argument about balance regarding the SPS. Ofwat is looking for the Government to set the outcomes it wants to see from the sector, which it is starting to do in the form of its 25 Year Environment Plan, which sets environmental goals, and Storm Overflows Discharge Reduction Plan, which sets targets on storm overflow use. The key is having clarity on the outcomes that are expected from companies and then having greater flexibility in the system to get the best value means of delivery. He felt that:

“The role of the Government in the process is more intrusive than it looks from the outside, if you look just at the SPS and Ofwat’s role. Every environmental investment scheme that was put forward at PR19 was designed and developed by companies and the Environment Agency … The sign-off process is a matter for the Environment Agency, but there is the ability for the Government to sign that off, if they choose.”67

77.Mr Coucher said that in the future, there will be significantly more investment in the environment, and “That may well cause the Government to get involved in decision-making or balancing between investment and bill payers.”68

78.The Secretary of State said that the SPS allows the Government to show Ofwat “what we want to see”. She felt the 2022 SPS “is very good” and noted it had “a much stronger emphasis on the environment”.69 On managing the trade-off between customer bills and investment, the Secretary of State said “Ofwat cannot stop the investment into things that the Government has directed. That is our influence in having involvement in the bill-setting process”.70

79.Ofwat needs clear guidance from the Government on how it should balance and prioritise its objectives. The Government should do this through its Strategic Policy Statement (SPS). However, the 2022 SPS failed to give a sense of prioritisation, particularly in relation to the balance between the affordability of bills and infrastructure and environmental investment. We recognise the concern that more directive Statements could impact Ofwat’s independence, but it is critical that elected politicians take controversial decisions which will have financial and environmental consequences for many generations, rather than passing that responsibility to regulators. The Government has not yet shown the necessary political will to make these decisions on the most important issues facing the sector.

80.Like the House of Commons Environmental Audit Committee, we welcome the greater emphasis the 2022 SPS placed on protecting and enhancing the environment. However, some of the outcomes are vague and the language tends to call for Ofwat to “enable” and “encourage” actions from water companies and the water industry rather than require these actions.

81.Ofwat’s performance against meeting the objectives of the SPS should also be subject to greater Parliamentary scrutiny. We welcome the Environmental Audit Committee’s intention to carry out this scrutiny routinely.

82.The Government should update the SPS to strengthen the language contained within it to ensure that Ofwat requires companies to meet SPS priorities. It should also provide a clear steer to Ofwat on how to balance its priorities, particularly in relation to the need to ensure higher levels of infrastructure investment, and these lessons should be taken on board in future Statements.

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