Select Committee on Environment, Transport and Regional Affairs Appendices to the Minutes of Evidence

Memorandum by Dr Dieter Helm (DWB 33)


  1.  The draft water bill attempts to address four separate strands of public policy. These are:

    —  the utility regulatory reform agenda, from the DTI's March 1998 Green Paper, "A Fair Deal for Consumers: Modernising the Framework for Utility Regulation", to the Utilities Act 2000, from which water was dropped;

    —  the government investigation into water competition, and the competition policy more generally, including the Competition Act 1998;

    —  the sustainable development policy, climate change, the drought experience and the preservation of wetland and coastal habitats; and

    —  concerns over safety and network security, in the light of experiences in the railway industry and proposals to separate assets from operations for Welsh Water, Kelda and others.

  2.  This is a very demanding agenda, and requires a reassessment of the challenges facing the water industry, and the institutional structure, power and duties of the various regulatory bodies. It also needs to have proper regard to the possible changes in the structure, finance and organisation of the industry. The draft bill does not meet these requirements: in each of its parts, while including a number of incremental improvements, it is unlikely to be sufficient, and, in consequence, either substantial revisions to the bill, or further legislation, will be required.

  3.  All regulatory changes have consequences for the companies and their shareholders. Customers' interests need to have regard to the costs of financing the creation of the new infrastructure, and the incentives for efficiency in delivering the day-to-day utility services. The existing regulatory regime has substantially damaged the financial position of the privatised companies, with the result that the cost of equity and debt capital is high by international standards. It cannot be in customers' interests that the market value of water companies is below the value of their regulatory asset bases, and recent attempts to mutualise parts of the companies are the consequent exercises in financial engineering, which are likely to seriously compromise the sustainability of the industry.

  4.  The connection between the precise form of regulation and the costs of capital and efficiency incentives is necessarily complex and subject to much debate. However, there is now little doubt that there is a connection, and, in the UK, political and regulatory risk has led to significantly higher costs of capital. The draft bill fails to recognise this problem, and, in its current form, is likely to exacerbate rather than ameliorate the weaknesses in the current regime.


  5.  The draft bill proposes significant changes in the regulation of the companies, the duties of the regulator and his sanctions, and the structure of OFWAT.

  6.  In widening the scope of the general duties to the all-encompassing protection of the interests of consumers, and upgrading the competition duty to "promote" rather than "facilitate", the financial duties of the regulator will necessarily take a weaker role, and this has the consequence of creating greater risk and uncertainty for investors.

  7.  General duties are the main source of the regulatory discretion of the regulator, backed up by the personalisation of regulatory offices by placing these duties on an individual Director General rather than a board. This problem was explicitly recognised in the Green Paper on regulatory reform, and the policy was to reduce personalisation. The new general duty makes this discretionary problem worse.

  8.  The Utilities Act 2000 creates a board structure for the Gas and Electricity Markets Authority, and a similar structure is proposed for OFCOM in the Communications White Paper. This is a necessary condition for reducing the personalisation of regulation, and improves the quality of decision-making.

  9.  It is therefore recommended that if the general duty of promoting customers' interests is imposed, then the financing of functions duties should be strengthened, and a statement issued by the parties as to its interpretation in practice, in relation to key financial ratios and the cost of capital set by the regulator.

  10.  It is also recommended that the post of Director General be abolished and replaced by a chairman of a board, in which the powers are vested. The proposals for an advisory panel are unlikely to make much impact on the problems of personalised regulation.

  11.  A further source of regulatory uncertainty arises from the regulatory "competition", overlap and conflicts between OFWAT and the Environment Agency (EA). At privatisation, it was intended that the then National Rivers Authority (NRA) would be in charge of setting the environmental requirements in consultation with the relevant government departments, and in line with the European requirements, and OFWAT would ensure that these were financed and delivered efficiently. The first Director General implicitly subverted this by introducing the "affordability criteria". The consequences have been almost entirely detrimental: the companies are caught between the environmental regulatory regime and the economic regime (especially if a fines regime is introduced). It is recommended that the draft water bill readdresses this relationship in respect of periodic reviews, in addition to adding powers to the Environment Agency.


  12.  Competition in the water industry will require significant legal and regulatory changes. Competition does not happen spontaneously: it requires the definition of property rights, access terms, dispute resolution, quality standards and so on. Therefore, substantive revisions will be needed to the draft bill if competition is to be promoted.

  13.  There are different kinds of competition, and the form of the legal and regulatory regime will vary as to which type is to be promoted. Simply giving a duty to promote competition to the regulatory is not particularly helpful, since it in effect hands over the shaping of its evolution the regulator without specifying what sort of competition is to be promoted.

  14.  It is therefore recommended that the government set out a clear vision of the type of competition it has in mind, and sets out a timetabled and staged programme for its establishment. The electricity and gas models suffered many faults in their execution, but nevertheless provide examples of how timetables and programmes focus the industry's attention and provide a practical way forward.


  15.  The draft bill strengthens regulatory control over the abstraction licensing regime, adds directing powers in times of drought, and allows the government to give guidance on environmental (and social) matters.

  16.  These steps are in general to be welcomed. There are, however, two regulatory details that arise: the question of a specific environmental duty on the Director General of Water Services, and the financial consequences for the companies.

  17.  The key issue here is to sort out the relative powers of the EA and OFWAT on environmental expenditure, ahead of the next periodic review. It is unsatisfactory to leave the situation as it is, as the Environmental Audit Committee report on Water Prices and the Environment (2000) rightly noted. Giving a duty to OFWAT is not the best way forward: rather, OFWAT should have to effect the decisions of the EA in these areas, subject, perhaps, to an appeal to the Secretary of State to resolve disputes. This would be to formalise the intentions of the original model at privatisation.


  18.  The existing regulatory regime was designed for integrated water companies, with management's focus being on the delivery of the licensed services. That model has largely disappeared: companies have diversified; ownership structures have changed; and substantial restructuring is being proposed. In these new circumstances, it is important to review the controls over licensing, powers to regulate quality and the penalty regime.

  19.  It is far from evident that the draft bill properly addresses these issues, other than a general taking of greater powers to the DWI, EA and through the penalty regime. It is unlikely that these will be adequate.


  20.  This memorandum has indicated that:

    —  the draft bill is an inadequate and generally insufficient attempt to address the major challenges facing the water sector over the coming decade;

    —  the draft bill omits to address seriously the competition and economic instruments opportunities, both of which will need legislative changes;

    —  the costs of the water regulatory regime are significant, particularly on the cost of capital. The draft bill will probably increase regulatory risk further, and hence raise the cost of capital;

    —  the widening of the general duties to an all-embracing consumer objective will increase regulatory discretion;

    —  the proposal for a water panel, while retaining a Director General in whom the powers are vested, should be dropped in favour of a water authority, with a chairman and board, consistent with the Utilities Act 2000;

    —  the relative roles of the EA and OFWAT should be clarified, with the EA having the superior powers with respect to environmental requirements at periodic reviews, which were compromised by OFWAT in 1994-95 and 1999-2000 periodic reviews. A duty on sustainable development should not be placed on the Director General of Water Services;

    —  water competition requires a clear programme and timetable, which legislation should support. The draft bill will need to be heavily amended and revised when such a plan becomes available; and

    —  the restructuring of the water industry requires a very considerable reconsideration of the regulatory powers. The draft bill addresses this only in a very general way. A more thorough examination of the issues is required before finalising the bill.

January 2001

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