Memorandum by Severn Trent Water Ltd (DWB
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
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
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
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
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
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
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
There should be adequate safeguards
Competition only takes place
where total costs will be reduced or services improved (to prevent
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. WATER RESOURCES
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
(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
(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).