Select Committee on Environmental Audit Minutes of Evidence

Examination of Witnesses (Questions 60 -79)



  60. The second issue which puzzled us last time is the use of the Reporters. This is really linked in with the debate about asset maintenance. If you are so heavily dependent on the information provided by the Reporters, yet you are not fully in control of the appointment of the Reporters and the Reporters are on contract to the companies, you have said that you have influence over the appointments, but it just seemed to us to be a very peculiar if not a unique arrangement whereby you needed the information, but the companies actually appointed the Reporters. Could you tell us what your thinking is on that and whether there is any move to clarify the contractual position vis-a"-vis the Reporters?
  (Mr Fletcher) I do not think that this is altogether unprecedented. I would suggest that it is not very unlike the relationship between a company and an auditor and the others who depend on that auditor for true and fair opinion of the accounts of that company. Of course the auditor is himself liable to finish up in court if he in any way fails in his professional duty. Ofwat has actually had a review carried out by KPMG of the Reporter system, which established that there is a duty of care both to the company and to Ofwat and in KPMG's view this does work appropriately, that both the company and Ofwat can have confidence in the opinion of this professional officer whose professional reputation—they come of course from leading engineering consultancies usually—is very dear to him and not to be influenced or biased either by Ofwat or by the company. We took full account of the Committee's recommendation and actually made it something we talked about to our stakeholders who came to our workshop on our draft forward programme. We are still absorbing the lessons from that. We are looking to publish the final forward programme by the end of the coming month, before the new financial year begins. There was a very clear view emerging there from Reporters and broadly from companies, though they are not unanimous, and from other stakeholders that the present arrangement does work well and should be retained. They pay, so it is in their interests to ensure that their systems and their setup make a Reporter's life easy, just as an auditor. They can set it up so a Reporter can do his job, can reach his unbiased professional opinion, either with a great deal of work if they are making a mess of it, or not too much if they are doing it all properly. They will pay less if the work is being done properly, whereas the duty of care is still left to Ofwat. We find it very valuable that the Reporters go in, look from the inside at the company and give us this unbiased opinion.

  61. Given there is a duty of care to two institutions whose interests may be in conflict, are you saying categorically that there has never been a conflict of interests for any Reporter during the period of time this system has applied?
  (Mr Fletcher) We have not been aware of such a conflict.
  (Dr Emery) We are quite careful to make sure that these conflicts do not occur. Occasionally a Reporter's firm has started to become a main contractor type provider for the company. In those instances we have required the Reporter to be changed, required a new reporter to be employed and that has happened in a couple of companies where these things happen. We place a great deal of importance on the Reporter and his people not being involved in any strategic or significant contractual way with the company himself and establishing those Chinese walls. We are not aware that any Reporter has been captured or this type of thing, and they are very conscious of the need to establish with us that they are independent. What we are trying to do here with the reporting function is to get a kind of independent view on the accuracy of the information presented by the companies, to avoid the kind of model which existed possibly before 1989, where essentially you had assessors from both the regulator and the company and a doubling up of this kind of exercise. This model was an attempt to have this job done once. The companies would probably say that Ofwat actually decides who the Reporter is and we have been going through an approval process for the new Reporters at the moment. We require the companies to submit three names after a detailed process. We choose those, we interview them and we have in several instances not gone with the recommendation of the companies at all. In a sense we are making sure that the prime client for the Reporters is Ofwat. The Reporter is still there as part of a contractor of the company as well, introducing slightly easier access in and to the company than possibly if we just had an Ofwat auditor going in. We think that there are positive benefits and that is exactly what came out with the KPMG study where they looked at the process and they concluded that it was robust, they were not captured and the regulator could rely on the work which was done by the Reporters and the advice and opinion they were getting. It was reasonably successful.

  62. In respect of the relationship between the Reporters and employer and the company, particularly the extent to which they have contracts, are specific criteria or guidelines set down or is it entirely at your judgement or discretion?
  (Dr Emery) We have a comprehensive protocol which we have issued to the companies as to what the job is. We issue guidance to them in writing in our normal reporting guidelines. We issue supplementary guidance about particular issues in the company. We talk directly during the year at workshops and they come in to talk to our team leaders to focus on these things. Their reports are seen by the company, so I do not think there is any ...

  63. Given that it is not an enormous pool of people who do this job, it is certainly not an enormous pool of companies, there is bound to be overlap and relationships developing, as with any group of professionals operating in a fairly narrow sphere. Do the protocol and the guidelines not specify some minimum volume of work which a contractor may have with a water company above which they cannot use a Reporter from that contractor?
  (Dr Emery) They do not specify a minimum. If an exposure is significant we clearly say that if it goes into any form of advice about strategy, advice about carrying out work to inform an asset inventory submission, that would be ruled out of court. The main reporting firms, that is W S Atkins, Halcrows and Binnies, have tended to set up separate business units completely isolated from their main consultancy outfits. We have been out there and one of my team leaders goes out and looks at what is actually happening in these companies to see whether Chinese walls do exist. As far as we can see, we have a process which is probably the best of both worlds in a sense of keeping costs down but being fully effective and it works. You are right to say that it is a relatively small body of people. This particular reporting round we have managed to get one new Reporter so far so it is slightly expanding and we have been pushing that as we would do as a competition type regulator.

Mr Thomas

  64. When we were doing the report last year an interesting proposal came forward from Kelda with respect to Yorkshire Water which was very comprehensively turned down by your predecessor. You have recently given the green light to the Glas Cymru proposals for Welsh Water following the takeover of the company by Western Power Distribution. May I ask you some questions about that and also how it would affect other proposals which may come forward within the general restructuring within the industry? In giving the green light you said that there were unique factors in the Glas deal which meant that you would not stand in its way. The implication of the word "unique" is that these factors could not happen in any other company or in any other sort of procedure. Is that in fact the case or is the Glas Cymru/Dwr Cymru deal really setting a precedent for how other companies may wish to take alternative ways of financing forward? Are you not really looking at this as a pilot project for an alternative way forward for parts of the industry?
  (Mr Fletcher) It was actually a week before Ian Byatt handed over to me that he made his announcement about Kelda. It was right that he should do so, otherwise Kelda might have been waiting an age while I got my feet under the table. It was his decision but he did consult me and I very much agreed with what he said. There are genuine differences between the Kelda proposal as put forward and the Glas proposal which led to the different outcomes. Is it a precedent? Clearly it is a proposition that others in the industry interested in the possibility of restructuring for various reasons, including reducing their cost of capital, will look at with interest to see how far what I have said matches their situation. The things that it seemed to me were interestingly different about the Glas proposition, briefly, a company limited by guarantee, with no shareholders. The nearest analogy we have been able to think of is BUPA in terms of current British companies operating in this sort of way on a significant scale. Debt financed holding. First of all, there was a very clear separation between the seller of the company and the prospective buyer of the company. Western Power Distribution (WPD) had bought Hyder, always intending to focus on its energy business rather than its water business and therefore were looking for an opportunity to sell on the water business in an appropriate way and get right out of it. They were obviously looking for a market price but they accepted a market price significantly below the regulatory capital value of Dwr Cymru. The regulatory capital value is the amount enshrined in the Periodic Review and therefore the amount around which the whole pricing structure works. A price below regulatory capital value (RCV) means that the company starts with an effective cushion, an equity cushion, even though it is an equity cushion no longer held by the normal shareholders, which was one factor in the view I took. One of the concerns I do have about this sort of company is the potential for it to be brittle. It was one of the concerns about Kelda. It is all very well to say you get the cost of capital down, but if the consequence is a risk that the normal ups and downs of business in this particular water sector might put the company in trouble, as at least arguably Hyder had been in trouble, then it should not just simply flow through into customers having to carry the can for that. Another factor I was looking for which Glas have actually proposed, is a very substantial level of reserves to help guard against this potential brittleness. A further factor was the point you raised earlier which was how far the people of Wales were behind this. With all the reservations which I appreciate about how far the ordinary customer really found this a fascinating topic and was deeply into the differences, nonetheless, it did seem to me that not least through the representative democratically accountable body, the National Assembly, there was a very clear move to say that this is what they would want. Although that by no means decided the issue, it was a factor to take into account. Those factors together, plus the care which Glas had devoted to trying to develop their proposals, and a series of conditions which I set and on which I am waiting a response but which I expect to be one accepting the conditions. This includes other things like directors whose pay structure will be all around delivering performance and not simply sitting back, as we all know could be the risk with a mutual type company: Just letting the revenues roll in and then only doing the minimum necessary to deliver what a regulator requires. So there are other factors there which make me believe that if they can finance it, if they will sign up to the conditions I have set, then this one should be allowed to go forward.

  65. The proposals had very strong support from the National Assembly of Wales, very strong support.
  (Mr Fletcher) Even though the Assembly itself said subject to Mr Fletcher satisfying himself that they are not going to fall on their face the moment they start business.

  66. Yes. My understanding is that you had quite an iterative process with the Glas company in putting questions to them, particularly as regards what you have just mentioned about the equity gap that they needed to have to start with. Being highly critical you could say that if any company bid cheap and had large political support it would therefore get the green light from you. Is that a fair comment?
  (Mr Fletcher) That would be altogether simplifying things too much. Any English company, or come to that a Welsh company, looking at the proposition would have to weigh very carefully their own particular circumstances, not just in relation to this regulator or to the other regulators, but, going back to it again, the Drinking Water Inspector had to be happy that the licence conditions imposed would satisfy him that he could still go in and prosecute, the Environment Agency equally. All three of us had to be satisfied that Dwr Cymru, which will outsource its business as intended, will never lose control of its business, never be able to hide behind a contractor and say "Not my fault something went wrong. I'm not accountable". They will remain accountable. Their licence modifications will insist on it. That was another factor. Any company getting into this business is going to have to go through the same sorts of hoops. The business of talking to the companies is something I do all the time in confidential circumstances if they want to put ideas to me before they are ready to go public on them.

  67. That is the company side of it as it were. What about the customer side of it? In our earlier questions about the consultation, by implication you said that it would not have moved off base one really unless it could meet the customer protection you were looking for. By implication therefore, Kelda in both your predecessor's eyes and your own eyes did not have that ability. What does Glas Cymru there and the particular range within Glas Cymru have to offer to the customers in the Dwr Cymru area both in Wales and England of course? You have touched on the efficiency part of it in terms of the relationship with the directors' pay, but what about protection from risk, the environmental quality, the importance we attach in Wales to drinking water and beach water quality? What had you seen in the Glas Cymru proposals and the way they put their proposals together that was different from the Kelda mutuality model which gave you more faith in this particular model?
  (Mr Fletcher) If I take the contracting out part of it, where Glas Cymru will be a very small company in terms of its staff and will be managing the business through contracts, this introduces another element of potential risk into the equation which concerns me. Outsourcing is common across the water industry but here we are talking about a step change in which virtually everything is outsourced, everything is managed through contractors. It is therefore vital that the company manages that properly, both in structuring the contracts to get best advantage, looking to mature markets, sizing their contracts properly, having them of the right duration to get best benefit, ensuring that the contractor and the client, Dwr Cymru, together have an interest in driving through efficiency. If it works well, they will be picking some of the best companies in particular specialist lines where there is customer care or operational maintenance and will be able to go on building on the efficiency of the company. They do, incidentally, have some way to go. They finish embarrassingly low in the Ofwat league table at the moment on efficiency issues and therefore have potentially a lot to gain from improvement. If you like, there is a bit of a down side but there is an up side, if they can get it to work properly. The other factor is that they are looking to reduce their cost of capital by being wholly debt financed, if they can make significant inroads into the cost of capital that will be to the long-term benefit of their customers, provided that they maintain that advantage, which is another question. The financing costs are around one third of bills, so it does not need to be a whole percentage point to make a very significant potential gain. Reducing customer bills is not the first job of Glas. Their first job is to ensure that they are managing the company properly and that they are building up their reserves to cope with the normal ups and downs of business life. Although I am asking them to produce the equivalent of a dividend policy statement—in a normal equity company that gives shareholders a yardstick by which to judge whether their company is serving them properly or not—I am looking to Glas to say they will look to reduce bills by X over and above what the regulator is asking for by such and such a date. They have to come back to me to say whether they are prepared to sign up to that.

  68. You mentioned earlier your conversation with them around the directors' pay structure. My understanding of the structure of the company, Glas Cymru, is that as well as directors there will be something like 100 members of the company, which the directors will appoint from the Great and the Good of Wales—possibly England as well—to look after the interests of the company and the customers. In the past your predecessor said, if I remember rightly, that the equity model worked well.
  (Mr Fletcher) I have said it and he said it too.

  69. Continuity there as well. The shareholder pressure was contributing to those efficiency savings and was working well in the model. We have a completely different model here. There is no shareholder pressure whatsoever. The only pressure in effect is from yourselves I would suggest, as the regulator. What new things can you suggest to the Committee you are considering in order to ensure that pressure is still there on the company? One hundred members of a company would not have any relationship with the customers whatsoever and their only dedication is going to be almost in terms of public service. It may be an old fashioned idea that they are dedicated to seeing that this company works for the good of its customers. Is that enough and what other pressures can you bear on the company to ensure that it happens?
  (Mr Fletcher) We are still talking primarily about a monopoly business and we have yet to see whether competition up front for customers is going to put a squeeze on the less efficient companies in the water sector. I have views on that but that is perhaps for another time. If I felt that the only pressure for efficiency was coming from Ofwat, that would concern me greatly because Ofwat basically is looking to ensure that all companies are constantly pushed for efficiency. It is not our job to look for that extra half, quarter, point one per cent over and above what the regulator is demanding of everybody. It is my job rather to try to set a level playing field within which all companies will work and those which manage to beat me, so much the better, because they are really pushing the efficiency hard. The members, 50 initially and then it may grow beyond that, do not have a financial stake. Glas is saying they will be selected with a very clear remit that they are not there to cozen the company into doing things it should not, to spend all its money, however virtuously, on rugby football or other good works, rather to ensure that they are holding the directors to account for the overall performance of the company. The board itself will have a majority of non-executive members whose remit again will be to ensure that the executive are very firmly focused on continuing to deliver that efficiency gain. The bondholders will have a stake. It is not the same as a shareholder; I entirely accept that. Their interest is just in ensuring that the agreement with Glas, their interest payments and the eventual repayment of capital is delivered. It is not the same stake. I would not put too much weight on it, but they are going in for what is called a credit wrapper, effectively a guarantor of their credit rating status, almost an insurer is the nearest analogy I can offer, who will be effectively very much out of pocket were Glas to fail to maintain its credit rating by poor performance. All those factors taken together do not entirely reassure me. I am not saying this is the best in the best of all possible worlds. I am saying here is a proposition which has been put to me and which I have to weigh up and decide whether on balance I think in the interests of customers and of my statutory duties it should be allowed to go forward or not and on balance I think it should.

  70. I appreciate that. I must say that I am not convinced either that there are sufficient pressures there to make this company work in the best interests of all customers. Could I ask you therefore whether you have looked at the draft Water Bill to see whether there should be any legislative changes or any changes in your operation or any changes for the future of the industry? We could see more proposals like this coming forward. The debt model, if it really is cheaper than the equity model, will be looked at as an enticement by other companies. Is it not time for the Water Bill now to be looking at what might be happening in future restructuring and to be taking these things on board and perhaps some other elements coming into the process to ensure that the pressures remain there on the companies? You opened this session by saying what achievements had been made and we do not want to lose sight of that. If some changes and restructuring happen, these must give us the same leverage on the companies in the future.
  (Mr Fletcher) The first obvious enough point to be made is that it is any company's job however it is structured to seek to ensure that it is getting its capital at the best rate for it. That is very much the company's own job. I make assumptions in the Periodic Review. It is up to the company to try to beat those assumptions and those that are committed to the equity model may nonetheless be considering whether their gearing is appropriate and whether they should have more of a bias towards debt than equity, taking account of the way the markets now work and are structured. As for the Water Bill, there one of the issues again is the gap. If we see significantly developing competition in the water industry then at the very least there are important issues which were consulted on by the Department of the Environment, Transport and the Regions last year, in fact almost a year ago, on which no answer has yet appeared, suggesting one set of issues are around how the licence is constructed. It is very important that however the licence is constructed there should be no doubt about who is accountable, who is responsible for delivering the safe high quality drinking water and all the other duties of the company. It may be appropriate to have a rather clearer separation of licences if, for example, an incoming company were only interested in the retail end of the business rather than the distribution or the initial supply end of the business. Those are all questions which need to be worked through and would be relevant to questions around restructuring as well. Meanwhile, I am confident that under the legislation as we have it, we can maintain that accountability by Glas or any company which might come along.

  71. I think there is an element of piloting and experimentation in this.
  (Mr Fletcher) When the press have asked me about this I very much try to avoid the word experiment which sounds as though it is taking some sort of deliberate risk with the customers of Wales. If we had thought we were taking such risks that a company should not be asked to take, then the decision would have gone the other way as it did for Kelda.


  72. Could you have stopped the Glas deal if you had wanted to?
  (Mr Fletcher) That is a nice question.

  73. That sounds like a no.
  (Mr Fletcher) It is noticeable that Kelda, having got a very heavy frown from the regulator, immediately withdrew its proposals rather than seeking some other way of pushing them through against the regulator's wishes. The practical answer is yes.

  74. I accept that you are trying to steer away from the word "experiment", but how long do you think it will take before you have a clear idea whether the form of ownership is a success.
  (Mr Fletcher) I have talked about concerns if "significant" numbers of English water companies were in the near future to want to dive down the same path. I have deliberately not tried to put a definition on "significant" or "near future". Obviously the first thing which has to happen is whether Glas succeeds in convincing the potential financiers that their money is safe at the appropriate credit rating. That is not by any means a foregone conclusion and it is up to them to make their case. I have made it clear that the regulator is not in the business of giving a soft deal to Glas. I shall regulate them as I regulate the other water companies in England and Wales on a level playing field. That is part of the regulatory framework which I have set out in one of these circular managing director letters to be clear to both Glas and anybody else who wants to read it how the system will operate.

  75. Will it become clear within your five-year period whether this is successful or not?
  (Mr Fletcher) I would have thought that at least initially there will be lessons from that. The point which Mr Thomas was raising and which is an absolutely legitimate concern is whether a company of this sort, having started in a great burst of enthusiasm, will keep that enthusiasm going without the shareholders constantly niggling them to go on delivering and delivering and delivering. I believe Glas is seeking to set itself up to achieve that virtuous cycle but it will be quite a long time before we really know.

  76. "Quite a long time" means ...?
  (Mr Fletcher) Who knows.

  77. Four or five years?
  (Mr Fletcher) We will have some fairly clear lessons from that. It is noticeable that companies, even in the water sector, which ought to be a relatively low risk, relatively stable environment, have turned over enormously since privatisation even.

  78. In the meantime you are not encouraging anybody else to go down this road.
  (Mr Fletcher) I am certainly not pushing anybody else. The equity model has actually got significant achievements to its name over the last 11 years, which is not to say another model is not a possibility. I am certainly not pushing any company which thinks it is against its interest to look to restructure and advising any company which wants to restructure that there are these very significant questions they need to have addressed very carefully before they come out with a public proposition.

Joan Walley

  79. May I go right back to something which was covered earlier about stakeholders and consultation with the public? I wanted to flag up with you and get your response to a concern that I have which is that I do not think many people in this country really do realise what responsibilities they have as householders in general in respect of the part of the sewer they are responsible for, where it goes from their home right up to where it links up to the main sewer and the financial responsibilities that there are there. In view of the research which Mr Grieve referred to, about what people want and how that then shapes what comes out of the Periodic Review, does this concern you as well? Do you think the Government perhaps or Ofwat or somebody ought to be embarking on some kind of campaign as to what responsibility currently householders have or should this be something which should perhaps be of concern in your 11 serviceability standards and perhaps looking at some ways of having an integrated system as happens in other countries, possibly New Zealand? Is this a matter of concern to you?
  (Mr Fletcher) We do have a pretty integrated system. My postbag to a degree bears out your point. It is one of the major irritants when someone has problems of flooding for example, which are down either to their pipe, or worse still somebody else's private pipe rather than the pipe of the water company. Most companies do offer to householders now either a free repair or some system to help, bearing in mind that a householder sometimes really does not know where to turn for a plumber or someone more serious in the contracting line who has to dig up the garden to get at the pipe. The whole business of education in water efficiency and responsibility is one which is a duty on the water companies now and which we believe, because we push them on it, they are taking seriously. Their performance varies. You can turn to one of our five regular annual reports to see our league table there of how the companies respond. I was being questioned about this issue by the Committee of Public Accounts earlier this month. One of the things that the National Audit Office found for their study in advance of the report to PAC, which is quite encouraging, is that 88 per cent of customers reckon they are taking action to save water. At least something, perhaps it was partly the drought five years ago, which had all sorts of other down sides, has really brought it home to people—a bit hard in the current deluge—that saving water is an important thing and that as we move into more unpredictable weather conditions which are likely to be linked to global warming they cannot count on it going on raining for ever and everybody needs to make their contribution.

  Chairman: Thank you very much indeed and also to your colleagues as well. We have had a very useful session.

previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2001
Prepared 4 April 2001