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
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
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