Select Committee on Environment, Transport and Regional Affairs Memoranda

Memorandum by Severn Trent Water Ltd (DWB 19)


  1.1  In defining the primary duties of the DGWS Clause 27 of the draft Bill closely mirrors the model adopted for other Sector regulators under the Utilities Bill 2000 viz:

    —  To protect customer interests.

    —  To ensure the proper carrying out by undertakers of their statutory functions, and

    —  To secure that undertakers are able to finance the proper carrying out of their functions.

  1.2  As noted Severn Trent supports this general structure. We are concerned, however, that the current requirement on the DGWS under section 2 of the Water Industry Act 1991 to enable an undertaker to secure a reasonable return on capital employed has been omitted from the draft Bill. We would make a number of points in this regard, not least the need to recognise the particular circumstances of the water industry which are different in a number of important respects from other utility sectors.

  1.3  First, in the energy sector where the reference to earning a return on capital (and indeed, financing of functions) has been removed under the Utilities Bill, competition is now well established. In Water, however, competition is less well developed (and is likely to remain so for some time) with the result that some form of price cap regulation is likely to remain very much the dominant feature of the sector.

  1.4  Secondly, relative to electricity and gas, water has been, and continues to be, subject to major capital investment programmes. Over the five years to 2005 the industry will invest some £15 billion, equivalent to some 50 per cent of the total revenue receipts from customers. It is also reasonable to expect a similar level of investment will be needed in the quinquennium following 2005 reflecting a combination of continuing water quality and environmental pressures, (not least the EC Water Framework Directive), increasing base maintenance needs and the longer term impact of climate change on water resources and sewer capacity requirements.

  1.5  This combination of factors makes it all the more critical that the legal provisions for the water industry should not introduce ambiguities into what constitutes the "proper" financing of functions. In the final analysis it is the market, not Government nor the regulator, which decides the necessary returns for making funding available. Any suggestion that securing a reasonable return is no longer central to "proper financing", and that the DGWS may reinterpret his duty differently in the future, risks adding to market perceptions of regulatory and political risk.

  1.6  Such an outcome would have the perverse effect of raising the cost of capital, hence the prices passed on to customers at the next review. To prevent this, it is essential that the existing explicit reference to securing reasonable returns should be reinstated as part of Clause 27.

  1.7  As part of a re-drafted Clause 27 the new Bill also provides an opportunity to address some of the concerns recently expressed by the House of Commons Environmental Audit Committee (EAC) following their examination of the recent AMP3 Price Review covering the period 2000-05.

  1.8  The EAC's conclusion (paragraph 208), that OFWAT's treatment of capital maintenance amounted to "intellectual neglect" was especially damming. In particular, the Committee echoed many of the concerns previously expressed by the industry that OFWAT's "no deterioration policy" and excessive reliance on historic serviceability indices was inherently flawed and risked systematic understatement of longer term maintenance requirements to the detriment of future generations of customers.

  1.9  To address this issue, and ensure that asset removal and capital maintenance is given the priority it deserves, we believe there should be an explicit duty on the DGWS, as part of Clause 27, to ensure that the "proper" financing of functions includes "adequate provision for the financing of longer term capital maintenance requirements, in a manner best calculated to secure continuing services to customers".


  2.1  We see the need to improve regulatory transparency as a major priority. To achieve this, it is essential those directly affected by regulatory decisions should understand what has been decided, how that decision was reached and why. This includes, inter alia, access to the relevant evidence (data and analysis) supporting such decisions.

  2.2  These principles have not always been applied in practice. The recent EAC report for example, cited a number of instances where OFWAT's approach to the recent price review was deficient. Examples included:

  Access to Regulatory Data: The Committee found that companies were not able to access information when they wanted to explore the reasons for specific assumptions and the outcomes relating to them. This applied especially to the financial model used by OFWAT which was not fully made public; a situation which the EAC criticised as analogous to "being given a car without an engine" (paragraph 100). Consequently they recommended that "OFWAT makes the full financial model as used for the Periodic Review, including equations, publicly available". A similar lack of transparency was also noted by the Competition Commission in their recent reports on Mid Kent and Sutton and East Surrey. Commenting on a key aspect of the Periodic Review (allowance for capital charges to fund asset maintenance) they concluded: ". . . the information made available to (the companies) during the Periodic Review was not in our view sufficiently detailed to enable the companies to challenge the Directors' findings. In fact (the companies) only received the relevant information during the course of our review" (Competition Commission September 2000).

  Business Advisors: During the periodic review process, independent Business Advisors were appointed by the then DGWS. The Committee noted, however, (paragraph 102), that the advice provided to the DGWS was never published and that where such advice was referred to in the Final Determination, it was primarily to reinforce the Director's decisions. The extent to which the panel may have held different views on other (unspecified) matters was never made clear.

  2.3  The new Bill provides a valuable opportunity to address these concerns. In this context, we particular welcome and support the draft provision (Clause 39) which requires the DGWS to publish reasons for his key decisions. It is to be noted, however, that in July 1998 DTI response to the consultation on utility regulation, it was stated (conclusion 7.3), that: "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" (emphasis added).

  2.4  Given this commitment, we are disappointed to note that the requirement to prepare an appropriate code has been omitted from the draft Bill. Our view is that the scope of the current draft should be extended so that each of the sector regulators, DWI, EA as well as OFWAT, are given a statutory duty to produce, follow and publish a code of practice governing their key decisions, including the requirement to publish and explain the reasons for their decisions.

  2.5  We also welcome and support the setting up of an advisory panel to advice the DGWS (Clause 22). However, under the current draft provisions the DGWS is only obliged to "have regard" to any advice that is provided. There is no guarantee that the advice will be heeded in a way which promotes either consistency or predictability. While it would be unreasonable to fetter the legitimate exercise of regulatory discretion, there would be considerable merit, consistent with the views expressed by the EAC, in requiring the DGWS to publish the advice given by the panel. We see this as an essential link in promoting proper accountability and transparency in regulatory decisions.

  2.6  In addition, to prevent the undue exercise of regulatory discretion and restore confidence in the regulatory process, there must be an effective appeals mechanism whereby key regulatory decisions and/or judgements, can be referred for independent third party scrutiny and adjudication. This applies particularly to the outcome of periodic reviews.

  2.7  Regarding the latter, current arrangements, which require the whole of the price review to be opened up for re-examination, are seriously deficient. They are too time consuming, (typically taking up to 6-9 months), involve a significant distraction of management time and effort and, most importantly of all, add to the already considerable regulatory and political uncertainties felt in the capital markets.

  2.8  Without a proper appeals mechanism, companies are effectively disenfranchised from the regulatory process. To rectify this, the existing mechanism should be broadened so that matters of principle or untoward and sudden changes in regulatory approach can be challenged before these become enshrined and bricked in as part of the final determination and before the debate becomes bogged down in consideration of detailed numbers. To address this issue we suggest there should be a requirement on the DGWS, in advance of each price review, to consult on, publish and follow a defined methodology for price setting to be incorporated into Company Appointments so that companies could then refer disputed changes in the methodology to the Competition Commission.

  2.9  The fact that referral to the Competition Commission is not a costless process, and that companies would be extremely sensitive to possible public censure from the Commission, makes it extremely unlikely that this extended right of challenge would be abused. Such a provision, however, would provide a significant safeguard against poor regulation and should increase investor confidence in the underlying process. The consequent reduction in their perception of regulatory risk would reduce required returns and hence prices to customers. This is a major prize with little (if any) downside.


  3.1  The current draft Bill says little about competition, other than the Government's stated intention of ensuring the continued protection of drinking water supplies by enabling the DWI to prosecute anyone who supplies, or causes the supply water unfit for human consumption. Further provisions are to be considered following publication of the Government's conclusions on competition later this year.

  3.2  For its part Severn Trent continues to lead the pursuit of a sustainable competitive water industry. Properly managed and regulated we believe competition could benefit both our customers and the company. Safeguarding public health, however, must remain the number one priority. Furthermore, a situation in which competition simply operates to the benefit of some customers leaving others to face potential additional costs ("cherry picking") will neither be economically nor politically sustainable over even the short term.

  3.3  The latter point is extremely important. A particular feature of the water industry is its dependence on Rateable Value (RV) based charges, particularly for domestic customers. Given there is only an extremely loose correlation between RV and consumption, this operates to the significant advantage of low RV customers (who tend to have low incomes) and the disadvantage of those living in high RV properties.

  3.4  An unwinding of this cross subsidy to meet a possible competitive challenge targeted on high RV customers, who tend to live in the low cost urban areas (see below), would be extremely regressive in its impact. Available calculations show that in Severn Trent's case alone, this could involve almost 1.5 million customers having to pay an increase in their water bills averaging around 30 per cent.

  3.5  In addition there is the further point that, unlike gas and electricity, water companies do not operate fully integrated systems. There is no national grid and, even at the region level there is only partial integration, based on what are effectively locally discrete systems displaying significant cost variations around the regional average. In addition to removing the RV subsidy, an unwinding of these geographic cross subsidies to meet a competitive challenge targeted on the low cost (predominantly urban) areas could see more than half a million rural household customers facing further increases averaging around 20 per cent.

  3.6  Such outcomes are neither politically desirable nor sustainable and are clearly matters which need to be addressed in the forthcoming legislation. In particular there needs to be explicit provision for the continuation of regional average charges on terms which do not disadvantage the incumbent company. Failing such provision, there must be clear regulatory and political ownership of, and accountability for, the consequences of unwinding existing cross subsidies as companies respond to competitive pressures.

  3.7  As previously noted, effective and fair competition, operating to the benefit of all customers is to be welcomed. The current legal framework, however, is wholly inappropriate to achieve this. At the very least, water services customers should be afforded the same legal protection and safeguards as applied in other utility sectors. This was recognised in Parliament during consideration of the Competition Bill when Mr Nigel Griffiths, the then Minister for Competition, noted: ". . . the issue of competition in that specific utility [water] is best dealt with as it has been in other utility sectors by specific primary legislation."

  3.8  Drawing on the lessons from other utilities it is essential there should be absolute clarity of legal responsibilities at all points in the water services process. This requires that:

    —  Legislation be put in place to ensure that all involved in the input, treatment, transportation and delivery of water, incumbents and new entrants alike, are independently licensed and subject to the same legal and regulatory requirements.

    —  Those inputting water to a network should be subject to a new legal offence of "causing a supply of water of an inadequate standard to be entered into a network." The current situation where the incumbent supplier could be judged the guilty party irrespective of where the fault lies, is unacceptable and contrary to natural justice.

    —  Each water services provider should be required to operate within a uniform National Access Code Framework and,

    —  There should be adequate safeguards to ensure:

      —  Competition only takes place where total costs will be reduced or services improved (to prevent "cherry picking").

      —  Regional average charging can be retained on terms which do not disadvantage existing suppliers (see paragraph 3.6).

      —  There are appropriate financial arrangements so that supplies can be made available in the event of failure of a new entrant (supplier of last resort provisions).


  4.1  Severn Trent supports the emphasis given in the draft Bill to the better management of water resources. The Government's guiding principles of transparency, accountability and putting customers first, however, should be applied, not just to the processes of economic regulation, but also to the abstraction licensing regime and environmental regulation generally.

  4.2  In this context, it is essential the new Bill should address the issue of long term sustainability and the need to secure a proper balance between environmental concerns and the continuing provision of adequate and reliable drinking water supplies. This was seen as a key priority by the EAC who suggested (paragraph 220) that the DGWS should be given an explicit duty to promote sustainable development within a long-term policy framework set by the DETR.

  4.3  Addressing this issue requires that all the industry's regulators should work together in a co-ordinated way. This could be promoted in the new Bill by imposing a statutory requirement on each of the sector regulators, EA, DWI as well as OFWAT, to work together to promote long-term sustainability under the auspices of a national forum directed and co-ordinated by the Secretary of State.

  4.4  To develop a sustainable framework for water resource and environmental management also requires that, in the exercise of its powers under the Water Resources Act, the Environment Agency should be given a new three fold duty. Consistent with the principles noted in 4.1 above, this would involve:

    (a)  proper and full regard to ensuring all reasonable demands for drinking water can be met at reasonable cost;

    (b)  preparing, and laying before Parliament for approval, transparent and auditable proposals for the amount of water to be reserved for the environment and the amount available for abstraction;

    (c)  preparing, publishing and following a code of practice governing its key decisions, including the requirement to publish and explain the reasons for those decisions (see section 2, paragraph 2.4).

  4.5  In the case of the EA, the key decisions governed by an appropriate code would be those relating to:

    —  The imposition of an expiry date upon an abstraction licence.

    —  The imposition of conditions upon an abstraction licence (and/or discharge consent).

    —  The modifications of the conditions of an abstraction licence (and/or discharge consent).

    —  The revocation of an abstraction licence (and/or discharge consent).

January 2001

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 29 January 2001