1. We agree with the Government's objectivesthat
the customer should be at the heart of economic regulation and
that the regulatory process should be more open and transparent,
accountable, predictable, consistent and effective. We believe
that current and proposed legislation falls short of this ideal
and our intention in this submission is to propose legislative
provisions which would contribute to achieving our common objectives.
2. We note that increasing pressures on
water resources and the impact of climate change cause ever more
pervasive Government intervention in the activities of the water
industry. This is no surprise in view of the industry's dual role
as the provider of services to its customers and as guardian and
protector of the environment. We believe that the resulting Government
interventions need to be formalised in legislation to ensure that
these reflect sound principles of regulation, and are open and
transparent, accountable and predictable, consistent and effective.
3. The Environmental Audit Committee (EAC)
Seventh Report recommended that the Director General should have
a specific duty to have regard to sustainable development. It
is proposed to create a new power for the Secretary of State to
issue statutory guidance to the Director General on social and
environmental matters. We do not support this proposal because
it will blur accountabilities.
4. There are three elements of sustainability:
economic, environmental and social. In broad outline, the first
two elements of sustainability are the responsibility of the Director
General and the Environment Agency (EA), and the third that of
Government. The Drinking Water Inspectorate has a role to play
in relation to public health and drinking water quality. We believe
that this specific allocation of responsibility is useful but
it is not right for unelected regulators to balance the three
elements of sustainability, which should be a political decision
for Government and the Government's responsibility.
5. We believe that such consideration of
how best to pursue sustainability in the water industry is particularly
relevant in the light of the proposals for abstraction licensing.
We are concerned that Government is not putting in place the necessary
building blocksregulatory transparency and co-ordination
between regulatorswhich would enable the new licensing
regime to function satisfactorily. The resulting increased costs
of the revised abstraction regime would be passed to water industry
customers, who would therefore be funding Government's environmental
6. Abstraction licences which damage the
environment may be justified if they satisfy important needs of
certain members of society. An adequate and reliable supply of
water has been recognised as an important factor in the advances
made in the last 150 years in public health and hygiene. Decisions
on the granting and withdrawal of abstraction licences, like other
decisions related to sustainability, involve balancing the complex
environmental, social and economic needs of society. Strategic
decisions on these issues should be taken by Government, which
should then be reflected in the decisions made by regulators.
Much of what we support in the proposed improvements to the regulatory
framework of the water industry is for the purpose of improving
the transparency and accountability of these balancing decisions.
7. Protecting the environment is a society
objective. The potential conflicts between the environment and
the needs of customers can be minimised if they are managed carefully
in a co-ordinated way by the quality, environmental and economic
regulators. The Bill must provide for this collaboration, overseen
by DETR. This process would permit a continuous debate on sustainability
issues. Without an effective debate the proposed revision of the
abstraction licensing regime could be unnecessarily restrictive
in terms of water supply, unresponsive to environmental needs,
8. We have already highlighted the need
for greater regulatory co-ordination in our evidence to the EAC,
when we suggested that DETR and the regulators should provide
a clearer long-term focus, and develop more "joined up"
regulation. We felt a more strategic vision was needed, in which
the periodic review process had a less dominating role, with all
the disadvantages that that implies for an industry where long
term vision is of key importance.
9. The EAC recommended "that the DETR,
companies and the regulators ensure that the five year investment
programmes of the periodic review are set within a comprehensive,
clear framework of longer term policies and goals including those
relating to water resources and environmental quality and serviceability
goals." The EAC went on to say that it believed "that
the DETR should take the lead in setting out the policy framework
and environmental future at the outset of the periodic review
10. Therefore, in the light of the strategic
direction given by the DETR, there should be a joint duty on the
EA and OFWAT, not only to consult, but to agree a common environment
programme whereby the impact on investment and infrastructure
of the abstraction licensing policy of the EA is fully accepted
by OFWAT, and the EA does not impose requirements that are unfunded.
11. We also feel that many long-term issues
need to be resolved through collaboration among regulators with
Government oversight. We suggest that the best way to take this
forward is for the Secretary of State to set up a national forum
with the remit of looking at sustainability and long-term issues,
and that the draft Water Bill should make this a requirement for
the Secretary of State.
12. We are concerned by the proposals to
reform the abstraction licensing regime, as we said in response
to Government's original consultation in 1998. We are disappointed
that our comments then do not appear to have been included in
the current proposals.
13. We fully subscribe to the objectives
of the reformof improving the quality of the environment
for allbut we believe that the proposals will result in
a reduced reliability of water supply for domestic customers and
greater costs, without necessarily being more effective in improving
14. The water industry has a statutory duty
to supply water for domestic use and act as a supplier of last
resort. So far, the industry's licensing rights have reflected
its duty of supply of last resort, these rights and duties being
two sides of the same coin. In this connection it must be recognised
that the supply of water to customers is demand-led. Any significant
reduction in the availability of abstraction licences could affect
the ability of the industry to guarantee security of supply.
15. On security of supply, we are surprised
by the proposal to revoke without compensation, licences which
have not been used for four years (called "sleeper"
licences). The industry keeps such licences in reserve for a variety
of reasons, for instance to provide emergency supplies in case
of drought. But droughts do not happen every four years and, therefore,
the water industry needs to retain spare water abstraction rights
which it may need only rarely.
16. The revocation of "sleeper"
licences is particularly puzzling as the proposed Water Bill would
make it a duty for companies to agree Drought Plans with the Environment
Agency; these plans, which may rely on "sleeper" licences,
may therefore be incapable of implementation if these licences
17. It is also puzzling to see "sleeper"
licences under threat since, by definition, they are not used
and do not damage the environment. If the proposal was driven
by consideration of competitive access to water, we believe that
it is misguided at this stage. Competitive access to water needs
a proper framework, on which Government has consulted on several
occasions, with a decision document promised for later in the
year. Meanwhile, patchwork intervention is unlikely to be productive.
18. The industry may have to strive to discharge
its duty to supply at the same time as its abstraction rights
are curtailed. The cost of abstracting wateras an inevitable
consequencewould increase. One reason is that, as abstraction
licences became short in duration and more uncertain, assets which
the industry builds and maintains for abstraction purposes would
need to be planned for the short term, with a short pay-back period.
Its annual cost would therefore increase.
19. Also, because of increased uncertainty,
water companies could not reap all the economies of scale and
scope that they would otherwise be able to use. For instance,
it may be efficient to anticipate increases in demand when building
abstraction-related plants, but this would be pointless if the
abstraction licence was short-term. Also, the existence of a greater
risk to the supplies of raw water and increased planning challenges
would increase the risks in the water supply business generally,
which would increase the cost of capital.
20. Moreover, we are concerned that Government's
proposals relating to compensation for the loss of licensing rights,
would in fact further increase the amount of environmental costs
which will be borne by customers. There are provisions at the
moment which allow compensation to be paid to the water industry
for the increased costs arising from the loss of abstraction rights.
Such compensation would protect customersto some extentfrom
the costs of the new abstraction licensing regime. However, Government
is proposing that such compensation be paid by the Environment
Agency out of the revenue it receives from abstraction licensing.
This is a circular arrangement, which would increase the cost
of the remaining abstraction licences to compensate for the loss
21. We therefore find it difficult to believe
Government's stated intention that its proposals should have a
minimal impact on customer bills. We believe that Government is
mistaken in this respect. We are particularly surprised by its
regulatory appraisal in which it asserts that there will be few
cases where abstraction licences do not cause environmental damage
(paragraph 2.22). Our understanding is that the revised abstraction
regime is proposed so as to curtail environmental damage where
it exists. Government's regulatory appraisal is silent on both
costs and benefits in such cases.
22. Moreover, we find it difficult to believe
that the proposals will indeed incur little costs for customers,
in the absence of a conclusive demonstration in the regulatory
appraisal. Government has said that, when a non-time-limited abstraction
licence is removed and replaced by a time-limited one, there will
be a presumption of renewal unless there is environmental damage.
We have two difficulties with this statement:
There is no presumption of renewal
included in the relevant clauses of the draft Bill.
The Bill does not put any burden
of the proof on the Environment Agency to demonstrate damage,
but leaves it to the industry to demonstrate that no damage is
committed; asking for such a negative proof is not consistent
with a presumption of renewal.
23. We have already commented on the need
for "joined-up" regulation, long-term planning and Government
leadership on sustainability. Concerning regulation by the Environment
Agency, we are therefore surprised to find that the regulatory
reforms proposed in the draft Water Bill for OFWAT are not applied
to the processes whereby the Environment Agency will make decisions
on the allocation of abstraction licences. We believe that the
EA should have a duty to make transparent and auditable decisions
on the amount of water which it deems should stay in the environment
and the amount available for abstractors. It should also have
to demonstrate how, when making this assessment, it has discharged
its duty under the Section 15(1) of the Water Resources Act 1991
to have regard to the water industry's duty to supply.
24. We agree with the proposal for an independent
Consumer Council for Water, although we would prefer that it is
named Customer Council (we have "Customer Services Committees"
at the moment). "Consumer" is a vague term that blurs
the distinction between the responsibilities that water companies
have to the people whom they supply with water and sewerage services
and their broader accountabilities to the country and its citizens,
which are largely regulated by the Drinking Water Inspectorate,
Environment Agency and the Government. The word "customer"
would define the Council's stakeholders more accurately. It is
used from now on in this memorandum.
25. The Council should represent domestic
and business customers; this needs to be made explicit. Council
members should demonstrate a genuine concern for customer issues,
and its staff should have appropriate experience of customer service
and complaints handling. Regulated companies should be asked to
co-operate to ensure Council staff have extensive knowledge of
the water industry.
Functions of the Customer Council
26. We agree that the Customer Council should
act in an advisory role and not be part of the decision-making
process. However, we believe that the Council should have a more
important role in relation to service standards; it should be
responsible for agreeing them with companies and, then, make recommendations
to the regulator. The role of the regulator should be to approve
and enforce the standards. [Similar arrangements are being used
in postal services regulation where the regulators, the Postal
Services Commission, has asked its independent customer body,
the Consumer Council for Postal Services, to agree service standards
with the Post Office and make recommendations to the Commission.]
27. Primary legislation should define the
roles of the Council and the regulator. The Memorandum of Understanding
between the Council and regulator should not undermine its independence.
28. Water UK agrees that the Council should
take up a complaint only after the company concerned has had an
opportunity to deal with it. We do not support the involvement
of the regulator in developing a streamlined system for dealing
with complaints. (This may confuse customers who will be unsure
which body to complain to). The regulator's involvement in complaints
should be limited to determining disputes as required by the Water
Industry Act 1991, and determining policy issues on cases referred
to it by the Council.
29. The draft Bill reintroduces clauses
previously introduced in the Utilities Bill but subsequently dropped.
Generally we agree with the Government's objectivesthat
the customer should be at the heart of economic regulation and
that the regulatory process should be more open and transparent,
accountable, predictable, consistent and effective. We have a
number of suggestions for improvement set out below which aim
to achieve better regulation.
30. Our concerns about the last water price
review were put to the Environmental Audit Committee (EAC) inquiry
into Water Prices and the Environment, which reported in November
2000. The detail of the draft Bill should be modified in the light
of that report and the general principles established by the Competition
Commission (CC) reports on Mid Kent Water and Sutton and East
Surrey Water published in September 2000.
Duties of the regulator
31. It is important to consider whether,
in the light of the CC and EAC reports, the balance of duties
should be revisited. Greater emphasis should be given on protecting
the long-term interests of customers, and on the obligation of
the regulator to act transparently, predictably and consistently.
32. The regulator could be required to take
proper account of available evidence on customer views and to
ensure companies are adequately funded to maintain assets properlythese
may be implicit in the existing duties of the regulator but given
the experience of the last review they should be made explicit.
33. The CC established certain general principles
in its two reports on Mid Kent and Sutton and East Surrey, some
of which are outlined later in this submission. However we are
concerned that the DG appears to take the view that the reports
are specific to the two companies concerned, contrary to the view
expressed by the Competition Commission.
34. The draft OFWAT forward work plan issued
in November 2000 says "The Competition Commission broadly
accepted OFWAT's approach to price setting but concluded that
prices for customers of these two companies should be slightly
higher than OFWAT had determined..." The recent draft interim
price determinations for Tendring Hundred, Dwr Cymru (Welsh Water)
and Anglian Water made selective use of the Competition Commission
findings, although the changes between OFWAT's draft and final
determinations are more reflective of Competition Commission principles.
35. For the avoidance of doubt, the DG should
be under a duty to extend the general principles established in
Competition Commission inquiries to all other companies at future
36. It seems premature to drop the existing
duty on the regulator to secure a reasonable rate of return on
capital employed, given the high and continuing level of investment
in the sector. It is still not clear whether the financial markets
are prepared to finance the current investment programme at the
cost of capital set by OFWAT in the 1999 review. Railtrack, for
example, has been given a higher rate of return that reflects
its need to raise equity as well as debt to fund the large investment
programme it has to deliver.
37. In the Utilities Act there is a duty
on the Secretary of State for Trade and Industry and Ofgem to
consult the Health and Safety Commission on health and safety
matters relevant to the carrying out of their functions. This
should be extended to the Secretary of State for the Environment,
Transport and the Regions and the water regulator, to ensure in
particular that tough efficiency targets are not set for companies
in price reviews that put safety at risk.
Getting the periodic review methodology right
38. In view of the criticisms of methodology
that have been made by the CC and the EAC, in particular relating
to the handling of capital maintenance, we think that the process
for settling the methodology that OFWAT uses in price reviews
should be more rigorous. At present OFWAT may "consult"
but it can end up adopting a methodology that fails to achieve
the right result.
39. The EAC's conclusion that OFWAT's treatment
of capital maintenance amounts to "intellectual neglect"
is damning, and of particular concern to the industry since we
offered to work with OFWAT on this issue as early as 1996.
40. The CC was particularly critical of
OFWAT's approach to broad equivalencethe proposition (principle?)
that accounting depreciation charges and expected expenditure
on maintaining assets should be the same over a reasonable period.
The CC did not receive persuasive evidence to justify the adjustment,
they were concerned at the way the introduction of broad equivalence
was managed, and they criticised OFWAT's failure to share the
calculations with the companies.
41. The CC also took the view that both
the cost base analysis and the econometric modelling for capital
maintenance may be subject to margins of error which could be
material. Their efficiency adjustments were more cautious than
42. In reviewing OFWAT's assessment of service
performance the CC criticised OFWAT's retrospective approach.
"We do not think it right that a price adjustment scheme
based on relative scoring should be wholly or partially based
on relative performance before the scheme had been sufficiently
established by May 1998 for the company to know what was required
of it in terms of service performance" (CC Report on Mid
Kent (MK) paragraph 2.204). The principle of no retrospection
is of key importance in all other areas of price setting or service
standards where the aim is to influence incentives and performance.
43. The CC rejected OFWAT's long-standing
doctrine that growth is self-financing. "We agree with the
Director that companies operating in a competitive market would
have to recover the growth investment costs from their customers
in the long term without raising prices, unless there was a corresponding
increase in the value of their product. However MKW does not operate
in such a market" (MK paragraph 2.140).
44. Companies have also told us that OFWAT
made last minute changes to their methodology without consultation
in order to squeeze price limits.
45. Our conclusion is that there needs to
be a mechanism for independent review of OFWAT's methodologies
well in advance of a final price determination. One possibility
is that companies might have the right of appeal on particular
methodologies, not just the package as a whole, to the Competition
Commission or to the Advisory Panel planned under the Water Bill.
46. Another possibility is that OFWAT should
formally commit to stated methodologies and agree a licence amendment
with companies that codifies the principles to be used in price
reviews. In the event that a company disagrees with this amendment,
it could of course appeal to the Competition Commission.
47. The draft Water Bill provides an opportunity
to put in place a process that achieves earlier resolution of
methodological issues that, with respect to the 1999 review, we
are still debating now and ensures that consultation is more of
a two way process.
Predictability and consistency
48. We think it is important to achieve
greater predictability and consistency of regulation. To quote
from the Government's Green Paper on Utility Reform. "Regulation
must be as predictable and consistent as possible in order to
serve the long-term interests of consumers, companies and shareholders".
49. These are fine words, but in practice
OFWAT has fallen well short of achieving this objective, to the
extent that it appears that they have abandoned their commitment
to the medium term basis of price regulation.
50. Although a number of changes to the
tax system and to environmental and quality obligations were announced
well before the 1999 review was complete the then DG refused to
make proper allowance within price limits.
51. For example neither the climate change
levy nor the supplementary business rate outlined in "Modernising
local government finance" have been funded within current
price limits. Nor has the extra cost of cryptosporidium monitoring
and the schemes OFWAT rejected in 1999 which were sent back for
52. The consequence of this is that prices
have fallen initially but will be rising in future in part because
of interim price determinations. The EAC roundly criticised "roller
coaster prices (which) confuse customers". In addition, the
EAC criticised Ministers for interfering in the process by suggesting
that 10 per cent price cuts were feasible. They recommended "that
in future Ministers should respect the role of the independent
Complexity and transparency
53. The CC were particularly concerned about
process. They say "We also observe that the modelling of
K has become extremely complicated, to the point where the precision
sought in a number of areas appears to us to be disproportionate
to the degree of estimation and judgement required in the Periodic
Review process. The Director might wish to consider how this could
be simplified" (MK paragraph 2.211), (CC report on Sutton
and East Surrey (SES) paragraph 2.194). We hope that the DG will
take this review forward immediately in full consultation with
54. This conclusion contrasts sharply with
the outcome of the OFWAT review of the periodic review process
(summarised in its letter MD 164), which claims that the process
was successful and only the water companies felt it was less than
perfect. OFWAT's review does however accept the process might
be shortened to two years and that the issue of the transparency
of the financial model should be looked at.
55. The EAC report in para 100 recommends
"that OFWAT makes the full financial model as used for the
periodic review, including equations, publicly available."
This requirement should be included in the draft Water Bill.
56. We have argued repeatedly that OFWAT
needs to share its financial model with companies. We put this
to the last DG but he refused to do this. This has led to an excessive
burden on companies in trying to understand OFWAT's sums, and
a waste of public money because OFWAT used expensive consultants
to validate their model even though peer review by companies and
others would have been equally effective.
57. On broad evidence, the Competition Commission
found that "the information available to MKW/SESW during
the Periodic Review was not, in our view, sufficiently detailed
to enable the company to challenge the Director's broad equivalence
findings. In fact, MKW/SESW only received the relevant information
during the course of our inquiry" (MK paragraph 2.191, SES
58. The requirements to provide reasons
for decisions included in the draft Water Bill should help but
needs to be bolstered to alter OFWAT's behaviour and lead to better
Code of practice on decision making processes
59. In the July 1998 DTI response to consultation
on utility regulation, in the section on transparency and predictability
of regulation, conclusion 7.3 said "The Government confirms
that it intends that each regulator will be placed under a statutory
duty to consult on, publish and follow a code of practice governing
their consultation and decision making processes." This commitment
to prepare a code of practice has been omitted from the Water
60. In part OFWAT's "Having your Say"
document on consultation processes meets this requirement, but
nothing has emerged from OFWAT on "decision making processes".
We think that OFWAT should now produce a code of conduct relating
to their decision-making processes and it would be helpful if
it became a requirement in the draft Bill. We have a number of
suggestions about matters that might be included.
61. The principles set out in the draft
Bill apply only to the economic regulator. We think the principles
of better regulation, providing reasons for decisions for example,
should be extended to the Environment Agency and the DWI, to ensure
that they apply to all regulators whose activities affect costs
and ultimately prices to water and sewerage customers.
Clause 22, Water Advisory Panel
62. We believe that the establishment of
a Water Advisory Panel, to advise the Director General is a step
forward, especially as the Secretary of State may require the
Director to refer certain matters to this Panel. We look forward
to hearing more about the expertise of the people who will be
appointed to the Panel and hope that they will include people
with experience of the industry.
63. We would like to see the Panel's advice
published in line with the aim of achieving greater openness and
transparency; at present the draft Bill does not provide for this.
Clause 26, forward work programme and annual reports
64. The DG is already attempting to comply
with the requirement to produce and consult on forward work plans,
and this is a helpful and welcome development.
Clause 27, objectives and duties
65. This Clause has already been discussed
earlier in this submission. Generally we support the new three
part primary duty, and we have made a number of suggestions that
modify the secondary duties to clarify the responsibilities of
Clause 28, guidance to DG on social and environmental
66. We understand that this guidance is
designed to ensure that the economic regulator work towards sustainability
together with other regulators. We welcome the objective of this
Clause, as we said earlier. However, we do not believe that the
issue of guidance is an efficient way of achieving this end. Beside
the reasons discussed above, such as the need for explicit collaboration
between the regulators, we are concerned about the principle of
issuing guidance to which the regulator need only have regard.
67. Guidance on what is required needs to
be clear and agreed between all parties. One concern we have relates
to how this might be applied in practice. Recent guidance on social
matters from DETR has not been well drafted, and OFWAT have had
their own social agenda differing from that of DETR. Companies
have been caught in the crossfire between the two.
68. In the case of environmental objectives
OFWAT issued guidance on the handling of changes to companies'
obligations in its final determinations document (Appendix E)
that was not agreed with DETR or the Environment Agency. The EAC
criticised this guidance in its report. We think that it is the
responsibility of the DETR to lead on this guidance in consultation
with all the regulators and the industry.
69. The cost of all new obligations needs
to be funded within price limits. A continuing concern we have
is that support for vulnerable groups that should be dealt with
under the social security budget is being paid for by other water
customers. This cross subsidy will prove to be increasingly impossible
to maintain as competition develops in the water industry.
Clauses 29 and 30, standards of performance in
relation to water and sewerage
70. Subject to what we said earlier about
the role of the Customer Council in agreeing standards with companies,
we are content with these clauses as long as regulatory impact
assessments are properly conducted, and the Secretary of State
seeks to balance the costs and benefits and minimise the regulatory
burden. We suggest the Secretary of State should be placed under
a duty to estimate the impact on prices to customers at the time
a new standard is put forward.
Clause 36, financial penalties
71. This extends to the water industry provisions
that are part of the Utilities Act for gas and electricity, which
were widely criticised by the companies affected, the Electricity
Association and the CBI. We consider this Clause ill judged.
72. Companies are already subject to penalties
in the form of regulatory action at price reviews if they fail
to deliver outputs, and under the guaranteed standards scheme
they are required to provide compensation to customers if service
standards are not achieved. Adding this clause to the draft Bill
exposes companies to double or possibly triple jeopardy.
73. A clear concern is that the clause could
encourage defensive behaviour by companies not in the wider interests
of customers, given the uncertainty over the likely behaviour
of the enforcement authority (OFWAT), and the very high upper
limit on penalties.
74. We are concerned that the economic regulator
can define the penalty regime without formal clearance by Government
or Parliament. Section 22B(5) is particularly weak "an enforcement
authority shall undertake such consultation as . . . it considers
appropriate when preparing or revising . . . its statement of
75. During the passage of the Utilities
Act Ofgem published draft guidance on their policy towards penalties.
There is no sign that OFWAT are planning to do this, but clearly
they should do so as a matter of urgency before the Committee
has completed its review of the draft Bill.
76. We are also concerned that appeal rights
under the clause are limited to matters of process; it is important
to extend appeals to matters of substance.
Clause 38, links between directors' pay and standards
77. The industry has no difficulties with
this proposal. Executive remuneration packages are already in
part linked to performance targets based on service level parameters
set by the regulator. Data on executive pay, and service levels
are in the public domain already.
Clause 39, reasons for decisions
78. The industry supports this proposal
and, as noted above, considers that the proposal should go further
to include a code of practice relating to decision making processes;
it should also be extended to the Environment Agency and the Drinking
79. Government first announced a review
of competition in the water industry in March 1999. It eventually
published a consultation document in April 2000 asking for responses
in June. It also published a separate consultation on the trading
of abstraction licences (ie economic instruments) in April 2000
asking for responses in July 2000. Since then we have been expecting
proposals on competition to appear in the draft Water Bill.
80. We are concerned that there is no indication
that Government is making progress on competition. All that it
is currently reported is work in progress, with further documents
promised in the first half of 2001.
81. Government says that any Clause relevant
to competition will be added to the Bill when it is introduced
to Parliament. We think this is much too late. Clauses on competition
should be introduced in advance, so that this Sub-committee has
an opportunity to conduct an inquiry into it. It would be useful
if the DETR could give such an undertaking.
82. Our position is summarised at the front
of this submission. We include extracts from our June 2000 response