environment magazine

Price Setting Consultation

By Keith Mason, Director of Finance, Ofwat

We have come a long way since the water and sewerage sectors were privatised 22 years ago.

In 1989 polluted beaches and rivers, and a neglected infrastructure, meant we were seen as the ‘dirty man of Europe’. In 1990, less than 80% of England and Wales' bathing waters met the required standards. Yet taxpayers had little appetite for spending more. Water companies were seen as inefficient, and the system meant there was little incentive for them to improve standards of service. Privatisation of the sector sought to tackle these challenges head on.

And we have come a long way since then. The sector has delivered huge improvements in service for customers and in environmental standards. We now have salmon in the Mersey, more than 100 Blue Flag beaches, and our drinking water is recognised as up there with the best in Europe.

Leakage is also down by a third since its mid-90s peak. That's more than enough water saved to serve the daily needs of London, Birmingham and Manchester. And the proportion of properties at the highest risk of sewer flooding has been reduced by more than 75% in the last decade.

In achieving this, the water and sewerage companies will have invested almost £100 billion (at today’s prices) between 1989 and 2010. This is double the rate of investment when compared to pre-privatisation levels. Yet we have been able to keep bill increases down by driving out inefficiencies. Bills are 30% lower than they would have been without our regulation. A litre of tap water delivered and taken away costs less than a penny.

New challenges
At first sight then, it is hard to see the case for change in water and sewerage regulation. But look into the future and the picture is more worrying. The social and environmental challenges that the companies are facing are different in scale and complexity to those of the past. They help make the future much less certain. In particular, the effects of climate change, a growing population and changes in lifestyle mean we cannot necessarily rely on doing things in the same way as before.

In many areas water resources are becoming more stretched. Collectively, the water and sewerage sectors need to consider the way services are planned, managed and delivered so that they are secure over the long term. We need to become smarter in how we value, manage and use our water.

And while this is a long-term industry, we cannot afford to wait – already, some water sources in England and Wales are running dry because too much is being taken from the environment.

Tackling these challenges
The good news is that steps are being taken to address these challenges. Most recently, with the government publishing its Water White paper in December. The White Paper sets out the Government’s overarching policies for a sustainable water and sewerage sector in England through to 2030.

The proposals in the White Paper follow three key themes:
• A focus on the delivery of a sustainable sector over the long term. This includes the importance of ensuring that the sector continues to be attractive to investors over the long term and that the cost of capital remains affordable.
• A focus on improving how we manage water resources so that we are resilient to a changing climate and future increases in demand - and in a sustainable manner so that we do not damage the natural environment.
• A need to create a more customer focussed industry - including giving business customers choice over their supplier and helping customers with affordability problems through company designed social tariffs.
We welcome the White Paper putting customers at its heart, while recognising the challenges facing the sectors such as the effects of climate change and population growth and the compelling case for reform. It provides the foundation to deliver a long-term, sustainable water and sewerage sector.

Our work in this area
There is much in the White Paper that is complemented by our own work, particularly our publication in November of a consultation on a framework for future price limits. In that document we set out for consultation our proposals for the framework within which we will set price limits in the long term.

In summary our proposed approach would:
• encourage companies to set high level outcomes in consultation with their customers and stakeholders, and give the responsibility and accountability for delivering those outcomes to companies.
• include proportionate, targeted and tailored incentives to encourage delivery of those outcomes efficiently and effectively.
• be supported by strengthened customer engagement.
• encourage companies to meet different customer needs by setting separate retail and wholesale price limits.
• ensure the sector can continue to raise the finance needed to invest in ongoing improvements at a reasonable cost.
• be flexible enough to adapt to emerging challenges and new information.

Ensuring environmental sustainability
Our proposals aim to make sure that the right incentives are in place so that companies do not focus on investment-heavy engineering solutions where better value, more environmentally sustainable alternatives may exist. This includes encouraging more efficient water trading. Water trading between companies has the potential to reduce the costs of supplying services to customers, while also protecting the environment by encouraging more sustainable choices about how water is used.

We also propose to use an environmental incentive to discourage water being taken from where resources are already overstretched to avoid damage to the environment – we call this the Abstraction Incentive Mechanism (AIM).

Currently the scarcity and environmental costs of water abstraction vary substantially between areas. Yet at the moment water abstractors have few incentives to optimise the efficiency of their water use and investment, and to reduce the damage over-abstraction has on the environment.

By valuing our resources in the right way we send clear messages not only to companies about how they should plan and use resources more efficiently, but also to consumers about the care they should take in using those services.

Our approach in this area is in keeping with the government’s approach. Environmental sustainability is at the heart of thinking in both the Water White Paper and our framework paper. This sector must be environmentally sustainable if it is to have legitimacy in the eyes of crucial stakeholders including customers and government.

The Government’s proposals for the long term reform of the water abstraction regime are intended to facilitate better use of resources, and reduce barriers to both water trading and trading of abstraction licences. The clear aim of this is to improve incentives to better manage the water that we have.

In the short to medium term, there are proposals to deliver a more transparent and planned way of achieving sustainability reductions which should provide greater clarity to companies, who may be able to realise value in unused water abstraction licences. Government has also proposed more emphasis on interconnection and bulk trading as part of companies’ statutory Water Resource Management Plans.

Financial sustainability Of course the sector not only needs to ensure environmental sustainability. It needs to be financially sustainable.
Investors value the stability, transparency and consistency of the regulatory framework for the water and sewerage sectors. The preservation of investor confidence in this long term sector is important so that efficient companies can continue to finance their investment programmes. Our future price limits proposals will continue to provide predictable returns to the investor that reflect the low underlying risk of the sectors. We will continue to use similar mechanisms to do so. For example, we will use a regulatory capital value approach, particularly in the capital intensive wholesale part of the business.
We are considering moving to a total expenditure (“totex”) approach that considers operating and capital expenditure together. This could help address any perception of a bias towards capital expenditure in the choice of solutions to achieve outputs and outcomes.

We also recognise that the price setting process has become increasingly complex and burdensome. As complexity has grown, the risk of unintended consequences has increased. We aim to make the price review process simpler. We want to reduce the regulatory burden on companies while ensuring that we focus our attention on the things that are important for customers.
Involving customers more in how companies set their spending plans will improve the legitimacy of bills in customers’ eyes, and this in turn will give investors additional comfort that customers are prepared to pay their bills.

Social sustainability
Customers being prepared to pay their bills is fundamental to the social sustainability of the sector. They need to know that bills are fair and legitimate. They must also receive water and sewerage services that meet their needs. If they do not, they may not pay for them, potentially causing hardship to other customers or putting at risk the delivery of the safe and reliable services we all rely upon. So it is essential that water customers are involved in decisions about the future services – and bills – they will receive.

Our proposals will give customers a much stronger say in how companies put together their plans. We expect companies to use these processes to discuss and agree the outcomes they will deliver. Companies will be accountable to us for delivering outcomes, not the means of delivery. This will make sure companies will increasingly focus their energies on what customers want, not what regulators say.

The process forward
The proposals we have made in 2011 look to build on the solid platform we already have, and tackle the challenges we face head-on. The key decisions will be made in 2012. Following our consultation, we will publish a decision statement in the spring, setting out the principles we will use to set price limits. This will be followed in the autumn by a more detailed consultation on the methodology used for the next price review in 2014.

Ofwat, of course, is just one player among many in the sector. We won’t be successful if we don’t work with others to shape our plans. A draft Water Bill for pre-legislative scrutiny is expected soon. And we look forward to further details on how the Government will deliver on its policies, and will work with Defra to ensure that we regulate to deliver the best results for customers.

The signs from 2011 are good. I am confident that we all – regulators, companies, government, consumer and environmental representatives – can build on this in 2012, so we can continue to deliver for customers. That means delivering a sustainable sector - one where bills are kept down, which can continue to attract further investment, and will deliver safe, reliable supplies for decades to come.