UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 674-ii

House of COMMONS

Oral EVIDENCE

TAKEN BEFORE the

Environment, Food and Rural Affairs Committee

Draft Water Bill

Tuesday 30 October 2012

Yve Buckland, Tony Smith and Robert Leask

Regina Finn

Evidence heard in Public Questions 52-138

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Oral Evidence

Taken before the Environment, Food and Rural Affairs Committee

on Tuesday 30 October 2012

Members present:

Miss Anne McIntosh (Chair)

Thomas Docherty

Barry Gardiner

Mrs Mary Glindon

Dan Rogerson

________________

Examination of Witnesses

Witnesses: Yve Buckland, Chair, Consumer Council for Water, Tony Smith, Chief Executive, Consumer Council for Water, and Robert Leask, Senior Portfolio Manager, Scottish Procurement, gave evidence.

Q52 Chair: Good afternoon and welcome. Thank you very much indeed for joining us this afternoon for our second evidence session of the Draft Water Bill inquiry. You are all extremely welcome. In advance, we are expecting at least one vote, so I will adjourn for that. Do bear with us; we will come back as quickly as we possibly can. Could I just ask you to introduce yourselves for the purposes of the record, perhaps starting with Mr Leask, on the left?

Robert Leask: My name is Robert Leask. I am from Scottish Procurement, in the Scottish Government.

Yve Buckland: Hello. My name is Yve Buckland. I am Chair of the Consumer Council for Water.

Tony Smith: I am Tony Smith, the Chief Executive of the Consumer Council for Water.

Q53 Chair: Thank you very much indeed. Can I put the opening question to the Consumer Council for Water, and Yve Buckland? Is there anything that you at the Consumer Council for Water believe has been omitted from the Draft Bill that you would like to see included?

Yve Buckland: Firstly, we welcome the Bill and lots that is in it, and I am sure we will come on to talk about that today. We welcome its pragmatic and practical style. In terms of the Bill, there is a broad welcome. There are probably two areas where we would have liked the Bill to have gone further. The first issue is the issue of affordability. I am sure it will not surprise you that that is an issue that we feel is a very important one. You will all be aware of current economic problems, and the current debt that is carried by every customer because of those who cannot or will not pay their bills. I know many Members of this Committee are from the southwest, where 20% of customers are living in water poverty. There is a real issue there.

We are supportive of the approach to social tariffs set out in the Bill, and customerfunded social tariffs. Indeed, the Consumer Council for Water is very actively involved with each water company at the moment, talking to customers about social tariffs and crosssubsidies, and testing their appetite to fund social tariffs. But-and I suppose this is the issue-we know from our research there is a limited appetite out there from customers for more than £1 to £2 going towards funding the bills of other customers. We also know, from evidence that is available nationally, that we probably need £400 million to £500 million if we are going to start to address the problem of affordability and ensure that we can bring people’s bills down, below that 3% water affordability cap. So it needs more money, and customers say to us time and time again that they do not believe that is their job; they think that should come from somewhere else, be it the benefit system or whatever.

What can be done about it? What we are doing is still working very actively with the companies out there locally to look at what can be done in terms of immediate social tariffs. But what we would want to represent here is our fears about the fact that there is not enough money in the system, and customers are looking for that to come either from the Government or from companies. Our research shows that customers have a greater appetite to contribute to customerfunded social tariffs if they feel it is part of a game where the Government is giving some too, through the benefit system; they also feel increasingly that water companies themselves ought to be looking at this in terms of their profits and returns to shareholders and investors. That is an omission.

The other omission that we would raise here is the area in the Bill that is about complaints and the need to better streamline the complaints systems that are around at the moment. This may end up in the final Bill, but we believe that the complaints that are currently handled by Ofwat could be better streamed if they came to the Consumer Council for Water. This is a point that David Gray also made in his review; he felt there ought to be better streamlining and suggested that there could be powers given to the Consumer Council for Water to help with this. We offer the Consumer Council for Water in this respect because obviously customers know where to come to and we can deliver high levels of customer satisfaction with our service-about 75%-which compares very well with other sectorlike ombudsmen. We have a lot of experience in dealing with complaints. We are grounded; we have arrangements at individualcompany level. Last year we resolved more than 93% of our complaints within a twomonth period, which again benchmarks well. That would be the second area that we would draw to your attention. As I say, potentially that may end up in the final Bill, and we would like to support that here.

Q54 Chair: What benefits do you expect the Draft Bill’s proposals will bring directly to consumers?

Tony Smith: There are three major benefits that we can see. Firstly, in the market reform area, it will hopefully give business customers a choice that they have long wanted. A very large percentage of business customers, whether they are large or small, are very keen on having that choice. There are two crucial things: one is to make sure that a competition regime works in the way those business customers expect it to, and that it gets implemented in a way that does not cause problems in terms of switching in the future. We just need to make sure that the system works. The second thing is, very importantly, that market reform does not happen in a way that causes detriment to ineligible customers-domestic customers and small business customers-because those customers are far less positive about the idea of competition at all.

The second area of benefit of the Bill is the changes to the merger regime. We think that more mergers in the sector could be beneficial to customers. It is very important, though, that the emphasis is placed on Ofwat to make sure the benefits of mergers are shared with customers, rather than being kept exclusively for shareholders.

The third area, for a very specific group of customers, is the issue of connection charges. David Gray pointed out that the current water regime does not work very well for developers and companies that want to lay their own pipes or sewers. I think developers should welcome the greater clarity that will hopefully come out of Ofwat being more specific about rules and the way that connections are charged in the future. That is a big area for those very important customer groups.

Q55 Chair: Could I just ask you one thing about the previous consultation in December on proposed changes to licence modification under Section 13, which Ofwat have now revised and brought forward again? The water companies are concerned that this may affect their credit under Moody’s forecast. They are saying that this cost could only be met by increased customer bills. Does the Consumer Council for Water have a view about whether that is possibly a risk?

Tony Smith: It is very important that the system works for customers. There is a sanction if the companies really do believe that; they can go to the Competition Commission and argue their case. We would look to the Competition Commission to make sure they are looking very hard at it and making sure that customers are not disadvantaged.

There is a broader point here, as well, which is the issue that David Gray raised, about where the distinction is between regulatory discretion and government policy. We would take the view that it is important that the regulator remains independent of Government, because that is beneficial to all customers, but, on the other hand, if the regulator does something that destabilises the sector, that is a major concern to all customers, because it could increase the cost of capital, and therefore the extent of their bills. We would therefore be very concerned if Ofwat was not taking that very seriously now.

Q56 Chair: Are you concerned?

Tony Smith: We hear the messages back from water companies, so we would be concerned if anything caused the cost of capital to rise. You only need a 1% increase in the cost of capital to add £20 to the customer’s bill, on average. We will be looking very closely at that consultation. On the one hand, it gives Ofwat, at least in theory, the discretion they need to implement some of these market reforms, but the question is whether they are going beyond that and trying to keep open a more openended discretion, which would be a big concern to us.

Q57 Chair: Would you say that the appeals procedure, after the Draft Water Bill, remains as robust as it is currently, in terms of companies appealing?

Tony Smith: It depends what the issue is. If it is about licence conditions, they can go to the Competition Commission.

Q58 Chair: Now?

Tony Smith: Yes. They will be able to afterwards, as well, as far as I understand.

Q59 Chair: So they do not have to revert to a judicial review.

Tony Smith: There are different rules. If Ofwat try to fine a company, they have a legal redress there. As far as these issues about licence conditions or price setting, they can go to the Competition Commission.

Q60 Chair: Just to conclude on that point, you believe that this discretion, if exercised responsibly, could be a good thing, but if Ofwat oversteps the mark, it could potentially be destabilising.

Tony Smith: It could be very destabilising. We have faith that the regime, in the form of the Competition Commission, will address that. We would expect to be giving evidence to the Competition Commission along those lines, if it goes to the Competition Commission.

Q61 Chair: Who regulates the regulator?

Tony Smith: That is a very good question. That is what I was referring to earlier. I think it is very important. We do need to emphasise the importance of the independence of an economic regulator, because if the Government gets too closely involved it can be problematic for customers, as well as investors. There is an issue about how far water policy is to do with Government, and at what point, then, the regulator’s discretion arrives. David Gray highlighted that issue, and that is an issue for all the regulated sectors, as far as I can see.

Yve Buckland: Indeed, one of the issues that we have made very clear in our discussions with Ofwat and more broadly in the industry is that we think regulators need to be accountable to customers, just as they need to be accountable in terms of the broader sector. It does not always go down too well, but we believe that it is terribly important, not to customer representatives, but that we make sure that customers are as satisfied with the regulation of the system as the outcomes of regulation, and are engaged in those discussions.

Chair: We stand adjourned.

Sitting suspended for a Division in the House.

On resuming-

Q62 Dan Rogerson: Good afternoon. I wanted to pick up on your earlier comments about social tariffs, in particular, and your disappointment over that area. I am interested in whether you had examined or thought very much about the inregion versus national social tariffs. Regarding the consultation you have had with customers about their potential support for a tariff, is that an issue that you have looked at?

Tony Smith: Yes, we did. We researched a whole raft of things about what customers would think was the priority in terms of helping customers. That work tended to suggest that they want to support customers on affordability issues first, but they also, slightly separately, recognise the issue of unfairness, rather than affordability, which is to do with the very large difference in bills, particularly in the south-west. Customers, even in other regions, are prepared to help with that fairness issue as well as with the social tariff issue.

Q63 Dan Rogerson: So there was some support for a national social tariff, as opposed to it being parcelled up into the regions?

Tony Smith: Yes.

Q64 Dan Rogerson: That is interesting. Secondly, briefly on the regulation issues you were talking about there, in my opinion, you do an excellent job of articulating customers’ concerns. We now have people from the industry saying that they have concerns about the regulator being given further powers, as well. Is there a communications problem here with the regulator? You would expect either the companies or the customers to be happy with what the regulator was doing; if neither are particularly keen on what the regulator is doing, have they got a problem?

Yve Buckland: In some ways, it is the nature of the beast. There is something in this system that is about balancing a whole series of different views. From a customer’s perspective, we want to see more and more that customers’ views are taken into account formally and on the record, not just through good working relationships. Wherever possible, we have been advocating-we can see some of it in this Bill-that customers and their representatives ought to be formal consultees. As I said, earlier we have been advocating, in other debates outside of this Bill, that the whole industry needs to hold itself into account in terms of general levels of customer satisfaction. That is so important, and that would include the regulator. Good working relationships help with all of that, but you cannot just rely on personality; you have to have systems in place.

Q65 Dan Rogerson: I want to move on to a couple of things about the introduction of competition, which was the second area you moved on to discuss. Are you confident that the introduction of competition for nonhousehold customers will eventually see household customers also benefit from increased efficiency savings?

Yve Buckland: We believe that there should be benefits for domestic customers. There should be benefits in terms of greater efficiency and more service innovation; we are hoping those benefits would be apparent through trickledown. It is important that companies would also have a better understanding of their costs; that could also have benefit.

There will also, absolutely, be potential risks for household customers, particularly if there is less focus on domestic customers, if there are things like stranded assets, if the noncontestable element of the Bill bears costs, or if there is uncertainty over the cost of capital. Ofwat needs to make it clear to household customers and business customers what the benefits are, and assure those that will not experience competition that they will not see higher bills or worsening service as a result of it. In particular, customers will need strong protection-penalties and incentives-and strong representation. It is very important to learn the lessons of competition in energy. There is a legitimacy issue about taking customers with you through all of this. There is often a credibility gap, among domestic customers, as to whether competition in energy has really delivered them a lot, in terms of lower bills or a more reliable service. We can see that without a strong customer voice, all sorts of parties are now getting engaged in that debate. We need to learn from those lessons and not repeat them in water.

Q66 Dan Rogerson: If I can turn to Mr Leask in particular now, I would like to talk about how the Scottish public sector benefited from the introduction of retail competition in Scotland, in terms of financial benefits but also improved service.

Robert Leask: To put things into context, the public sector in Scotland spends £73 million per year on water and waterassociated services. That accounts for somewhere in the region of 20% of the competitive retail market. We tendered that requirement as a single entity and, certainly in terms of savings, we exceeded the toplevel savings targets that we had put in place. Just to give the Committee an idea of what those were, prior to tendering the requirement, the public sector as a whole was receiving savings somewhere in the region of £1.4 million per year for its entire water bill. In the first year, the tendered requirement delivered just under £5.2 million, and in the current financial year we are targeting £7.7 million. In the final year of the contract we believe that we will achieve £9.4.million of savings. In addition, the appointed licence provider has helped the public sector to identify other efficiency savings, in terms of both financial and water savings. Those savings amount to an additional £4.6 million over the duration of the contract, and, in terms of looking at water savings by the end of the contract, we believe we could be in a position to have saved 2 billion litres of water in the public sector.

Looking at the service elements, what we found during the tender process was that the dominant incumbent in Scotland was forced to up its game in terms of customer service, and we saw a stepchange in terms of performance. That stepchange was matched by other competitive elements in the market, and when the contract was eventually awarded, it did come down to price. It was only the incumbent dropping its price at the last minute that ensured that it won the competition.

Moving forward, we are seeing a significant increase in customer satisfaction levels reported-in excess of 90%. When we have surveyed our customers, the satisfaction levels have been consistently high. Indeed, we are seeing the provider innovate in terms of customer service, for instance installing a new customer portal-a customer relationship management suite of software. That is facilitating the ability for the public sector, in terms of its billing, its consumption, its water usage, managing its site portfolio and data, and there will indeed be a trickle effect, as other elements not in the public sector will benefit from those, too.

Q67 Chair: You may not have the figures at your fingertips. I wonder if you could possibly write to us about the benefits for public sector institutions like the NHS, because I would imagine they will have benefited.

Robert Leask: Yes, the NHS has benefited. Prior to the contract being introduced, the net benefit they were getting was about £240,000. In year one it was just over £1 million. This year it is £1.5 million, and next year it will be just over £1.9 million.

Q68 Dan Rogerson: Just briefly on that, Mr Smith, on the issue of national versus regional in terms of the social tariff, is that something we have already had in terms of written evidence, or could you give us some data on that?

Tony Smith: I think we have given it to you previously.

Dan Rogerson: Yes, but not for this inquiry. If you could share that with us again, that would be helpful.

Q69 Barry Gardiner: The abolition of the cost principle that is proposed, and its replacement with these market codes that you will be instrumental and involved in preparing, seems to have given rise to a dispute between the water companies, on the one hand, who are saying that the abolition of the principle could see bills for householders rise if revenue from the non-contestable household market is used to offset lower bills in the nonhousehold sector, and, on the other hand, Ofwat, who are saying that because you are proposing to separate retail price controls-one for household and one for nonhousehold-it would not be possible to make that compensation between sectors.

From a consumer point of view, I am sure that you would be concerned that there is this apparent confusion in the first place, and if you can do anything to clear it up, that would be very helpful. I would also ask whether you believe it should be clear on the face of the Bill that that sort of arbitrage between the two sectors should not be permitted.

Yve Buckland: In answer to the last point, yes, it should. I will defer to Mr Smith to explain why.

Tony Smith: The cost principle was a problem in the past because it constrained competition, because there was insufficient margin for business customers and new entrants. However, part of the reason for that is it does protect ineligible customers; that is the big attraction of the cost principle. It should be possible to identify a different way of setting access prices in a way that does not cause costs to go into the noncontestable market to the detriment of domestic customers; that should be possible. However, I think that such would be the pressure for costs to do that in the future, it would be highly beneficial that it is made very clear that that is not the intention. Arguably, it would be useful for that to be on the face of the Bill.

Q70 Barry Gardiner: I am just trying to get clarity here; I do not have an agenda that I am trying to advance. I just want clarity. At the moment, regarding the sort of compensation that is going on, the water companies are saying there is some sort of offsetting going on here, which is beneficial to householders. Is that correct?

Tony Smith: It is not beneficial to householders. What the cost principle does is start with the price that the business customer pays, and then when they lose a business customer they have to take off the costs that directly relate to that customer. That means that any cost, therefore, that the company avoids as a result of that potentially gets passed to the new entrants or to the customer that switched. That, by itself, protects domestic customers. The danger with a new way of setting access prices is it could mean some costs, which it cannot allocate very clearly between different customer groups, may, because it would be in the company’s interest, be pushed into the non-contestable market, because all customers would have to pay for it. That is the risk, and I think it is a very real risk.

Q71 Barry Gardiner: So the ARROW costs, as they are known-the avoidable, reduced and recoverable costs-are taken off under the current system, but what you are saying is that under the new system there will still be a residual costs that will remain, albeit that under Ofwat’s proposals they will not be able to be compensated for by raising household bills. Who will bear them, and how do we ensure that is the fair allocation?

Tony Smith: The answer to that is that it has to be the regulator’s job. It must be the regulator’s job to make sure that happens. The principle for legislators is to make it clear what you expect to happen: that it should not disadvantage ineligible customers. That is the crucial thing. To some extent, it already happens when there are insets, or new appointments and variations, where it can benefit customers who are subject to the competitive regime, but can be not beneficial to the remaining customers in a company’s area. There is already that concern there, and that is why we think it should be for the legislators. It goes back to that point about making the policy clear, so that the regulator has to deal with that policy. It is not beyond the regulator’s job to be able to identify a new access pricing regime that does what you want, but it is very important that the nature of that regime is very clear to all companies, as well as to all new entrants.

Q72 Barry Gardiner: Is this why the companies are complaining that there will be costs that they are left with, such as overhead costs and capacity costs? I am sure you read the transcript from last time. Is this where these costs, which they are concerned they will be lumbered with under the new upstream competition, come from? Is that how they arrive?

Tony Smith: That will be part of the problem: the question about who ends up paying for the costs that are very difficult to allocate. Are they allocated appropriately between customers who can have competition and customers who cannot? It is a problem in all regulated and competitive sectors; it will be a problem in water. The rules have got to be made very clear, particularly in the case of water because in other regulated sectors all customers, including domestic customers, have the benefit of competition-in energy, in telecoms. For the foreseeable future, there will be no competition for domestic customers, so it is extremely important, in this particular industry, that those domestic customers are protected.

Q73 Dan Rogerson: One of the other issues that water companies have expressed concern about is this issue of the regional de-averaging of prices. It sounds like I am special pleading again here, but we could look at an area like mine, where there is some distance involved between the conventional items of kit that are there and some consumers, as opposed to others. Should the Bill make clear, on the face of the legislation, that regional deaveraging of prices needs to be avoided?

Tony Smith: We would say that the answer to that is "yes". We can see that upstream competition can help all customers if it causes water to be allocated more efficiently than it is at the moment. That is beneficial. The problem will be-and this is probably inevitable-if there is pressure for local pricing, because if there is local pricing, that could cause the bills of some customers, who are in lowcost areas to serve, to go down, but the opposite would be true in areas where the costs are higher. Again, in other sectors you do see pressure for deaveraging as a result of competition. The same thing applies: with domestic customers not having the direct benefits of competition, it is really important that they are protected from this sort of thing. Therefore, we again think we can see the benefits of upstream competition for everybody-domestic and business-but if you were to make it clear that there should not be deaveraging, that would be helpful.

Q74 Dan Rogerson: Following on from that, there are issues around regional versus local. Should it be done across a regional water authority area? Should that be a thing, or should there be some element within that of a subregional thing, or should it be on the system? Again, looking at an area like mine, you effectively have a number of separate water and sewer systems that do not necessarily connect to each other. What should be the basis for ensuring that there is some kind of levelling across an area?

Tony Smith: Generally speaking, the unit of consideration for most of the industry at the moment is company region, though there are some companies that actually have subpricing within their regions already. That is the obvious thing to do at the moment, on the grounds that that is the way that companies decide what their water resource management plans look like, and that is what decides what their bills are and what the billing impact is on different customers. There will, I imagine, be quite a lot of pressure from new entrants, and possibly from competition authorities, to go much more local than that. That is the point at which you do need legislation to help, to say, "No. The unit of consideration here is probably the company’s area."

Q75 Dan Rogerson: Do you have some ideas about how that might look in terms of an amendment?

Tony Smith: I think we would have to think about that.

Q76 Dan Rogerson: And could you share that with the Committee?

Tony Smith: Yes.

Q77 Barry Gardiner: I want to turn now to investor confidence. You will recall that earlier this year, in the summer, Moody’s said that they believed that the reforms planned by the Government and Ofwat "create a degree of uncertainty and somewhat increase the credit risk for UK water and sewerage companies". Mr Smith, you said to the Committee earlier this afternoon that every 1% rise in capital cost was a £20 rise in domestic bills. That was the figure you quoted to us. Therefore, you would be very concerned and very troubled to see Moody’s latest issue on 29 October, where they talked of "continuing uncertainty for [the] UK water sector with proposed licence changes". In particular, there are two paragraphs there that I would welcome your comments on and your thoughts about, around the issue of investor confidence. They said, "It appears that the biggest area of dispute between the companies and the regulator is around future flexibility. Ofwat considers it important that the services and activities covered by the proposed wholesale controls can be adjusted over time, so that it can create the right incentives and adjust the framework as appropriate. To provide this flexibility, the regulator has proposed that in any price control it would be able to move activities accounting for up to 20% of total revenue outside of the wholesale price control. There would also, it is proposed, be a further cumulative cap on activities moved outside of the wholesale business set at 40% of total revenue. The degree of flexibility that Ofwat is seeking is surprising given its estimate that about 90% of companies’ assets (on a current cost basis) would remain as part of wholesale activities. We also note that the credit profile of a company where 40% of revenue is subject to as yet undefined price controls and/or competition will be different to that of the rated water companies today."

Given what you have said about the effect of a rising cost of capital on domestic bills, can you analyse for us what you believe Moody’s are saying in terms of rising bill prices?

Tony Smith: I think Moody’s, in the past, have made it clear that they are not too concerned about retail business competition, because actually the impact on companies of customers switching in the numbers you might expect is not huge. I think their concerns are about the way Ofwat is going to regulate the noncontestable retail market and indeed the wholesale market, which is what you are referring to there.

The key question for us is about the extent to which Ofwat needs to make these changes in order to enact what the Government is choosing to do, or whether it is going beyond what it needs to do immediately. We are going to be exploring that over the next few weeks, because Ofwat have just put out their final consultation on that particular issue. The concern is that Moody’s are correct and that the benefits of competition, which are significant but not huge, could be wiped out by the costofcapital effect, and we, as customer representatives, would share that concern if that were to be true. Because of the leveraging effect of the cost of capital, you could see how that could be true.

Q78 Barry Gardiner: I do not want to interrupt you, but do you think that there is a certain irony, in that the Draft Bill did not go down the route that Martin Cave proposed about separation, because of a concern with investor confidence, and yet now, the way in which the implementation of the upstream reforms and the introduction of competition there is taking place, we precisely have a problem of investor confidence?

Tony Smith: Yes, and I think the issue relates very much to the licence condition consultation, rather than the market reform regime. The market reform regime can, particularly on the upstream stuff, create uncertainty for investors. Again we would be concerned about that, because a customer’s number one priority is a safe, reliable, longterm water supply, so anything that jeopardises that-in terms of investment in reservoirs, if that is needed, or the cost of capital-would be a concern. This is more an issue around the licence condition changes than it is about the underlying competition regime that is proposed here.

Q79 Chair: If you are looking at this and you reach a view within, say, three or four weeks, could you possibly share it with us?

Tony Smith: Yes. We only received the final document from Ofwat on Friday, and obviously we are going to be looking at that very closely.

Chair: It is linked to the question I asked earlier about the cost of capital potentially impacting on customers’ bills.

Tony Smith: We will be happy to give you that.

Chair: That would be very helpful indeed.

Q80 Thomas Docherty: If I have understood correctly, what you have said is that it is the licensing conditions or the conditions of the licence that are causing you some concern. Very quickly, what would you look for, on the licensing, to avoid that concern?

Tony Smith: Ofwat need to give us very clear reasons as to why they need to go further than just the ability to set separate prices for wholesale and retail, because that is all the regime needs at the moment, as I understand it. Ofwat would need the facility to do that, but that is very narrow, and somewhat narrower than what Moody’s were concerned about. That is the thing we will be exploring with Ofwat-why they need to go beyond that very narrow definition of change, because the concern tends to be about the broader discretion that Ofwat will have. Ofwat may have good reasons for that, but we need to explore that over the next few weeks and give a view.

Q81 Chair: Just before we move on, do you think that possibly Ofwat might have overstepped the mark?

Tony Smith: I do not know. It is too early for us to say, until we have had that conversation.

Thomas Docherty: It is a shame that she has not chosen to come in.

Chair: I did ask her if she wanted to.

Q82 Thomas Docherty: I think that is disappointing. Mr Leask, how have you sought to exploit the competitive market in Scotland, to ensure that the public sector gets the best value for money?

Robert Leask: In terms of how we went about exploiting the market in Scotland, the public sector set out some clear objectives at the start of our procurement. One of those was to tender the requirement, to ensure that the supplies of water and wastewater services were compliant in terms of the procurement rules. We sought to maximise competition by creating a level playing field for all the licence providers operating in the market, and, arising from that, we sought to engage effectively with the market and the market structures. We did the latter primarily through workshops held by the Water Industry Commission for Scotland. At those workshops, we initially saw wholesalers and licence providers having a debate about what customers really wanted from the market and engaging in fairly technical discussions about how the market operated. It was very clear that, at that point, they were really lacking a strong customer input, and we engaged, over a period of 10 or 12 months, on some key issues that the regulator was looking at.

What we saw, over that period of time, was that the market developed very rapidly, mainly in areas about trade effluent connections and disconnections, and metering, in terms of AMR metering. Prior to tendering the requirement, we met with all the licence providers, explaining what our requirements were and where we were going, and gave them an indication of what the tender was likely going to look like. We were very pleased at that point that some of the licence providers said that, if that was going to be the form of the tender, we would have delivered as much as they could have asked for in terms of a level playing field.

We then went through the tender exercise. In effect, we structured the tender across two different lots; they were about equal size in terms of value, but with very different customer requirements in those lots. We delivered competition across both of those lots, and, as I previously pointed out, the incumbent won both of those lots, but was pushed very hard in terms of customer service and customer delivery. The final assessment really did come down to price. The key aspect of how we delivered that was that the public sector behaved as one entity and one requirement, and we spent a lot of time-about 12 months-consulting with the public sector, through various workshops and independent visits, really understanding the requirements of the public sector and pulling those together. We can say that 99% of the Scottish public sector are benefiting from the contract.

Q83 Chair: Is that higher than you expected?

Robert Leask: At the start, we had anticipated about 85%. That was because there was one sectorspecific deal already in place in the public sector. Prior to us going to market, there was a belief that, because of the requirement for the dominant provider to publish its prices and its discounts as part of its licence conditions, we were not really going to deliver much more in terms of competition. By pooling and amalgamating the demand, we clearly set a new benchmark in terms of discounts and discount structures moving forward. When we looked at the deal that was in place, that was delivering about 5% benefit. The average that we have delivered is over 10%, so it doubled the best requirement that was in the public sector before.

Q84 Thomas Docherty: What is your best guess of the value of that 10% saving, either on an annual basis or over the first 10 years?

Robert Leask: Over the duration of the contract-it is a scale basis, because the discounts escalated-the maximum discount in year one was 8%; in year two it is 11%; and in year three it is 13%. Those discounts are based on a combination of factors, including paying annually in advance for water, paying by direct debit, taking consolidated billing, and so on. Public bodies take a measure of discounts, and we estimated at the start that we would deliver somewhere between £18 million and £25 million of benefit to the public sector over the threeyear contract duration. We are very much on track to deliver at the top end of that.

Q85 Thomas Docherty: And that £18 million to £25 million is over the three years.

Robert Leask: Over the threeyear period, yes.

Q86 Thomas Docherty: As an MP, my maths is not fantastic. Over the first decade, would it be as simple as saying that it is three times that, or would the numbers drop significantly, or would they grow?

Robert Leask: It is difficult to know, because we will be going into a new pricing review in around 2015. The price controls set at that point may have a bearing on it. Certainly for the remainder of this price control period, it would deliver, on average, 10%.

Q87 Thomas Docherty: Are there any aspects of the Scottish system that you think act, inadvertently or deliberately, as barriers to more effective competition?

Robert Leask: There were a couple of unusual aspects, in terms of the Scottish market, which we saw at the start. There was the requirement for licence providers to prepay for water, prior to delivery and usage by, in our case, public bodies. We realised that the financing of that pre-payment was quite a significant cost, in terms of the market, and so when we engaged with the licence providers in the market, we sought for the market to come up with a solution for that pre-payment that was in effect costneutral, i.e. to minimise the cost both for the licence providers and for the public sector. In our tender documentation we did not dictate how that should be done, but we made clear it very clear to the licence providers that we were looking for the market to provide a solution to that.

Q88 Thomas Docherty: Again, I am not the brightest boy in the world; is the reason why that is an inhibitor because if you are not a large utility with the money to stump up funds, it is a challenge to raise the money in the first place? Am I right in thinking that?

Robert Leask: It is a cost of capital. We did some assessments several years ago, and we reckoned that just financing that would cost the public sector somewhere in the region of £1.5 million a year in prepayment, and we thought that was a big enough number to attack in terms of the tender process, and that is what we duly did.

Q89 Thomas Docherty: Obviously you have now had a number of years of experience. Looking back-hindsight is always wonderful-are there any aspects of the introduction of competition that you think, on reflection, could have been handled better? If there are, have you had the opportunity to pass that advice on to Defra?

Robert Leask: The key element that we saw was customer engagement: really engaging as the market develops, and really putting customers’ views forward, in terms of looking at the various issues. I noted earlier today that connections and disconnections popped up; that still rumbles on, in terms of the Scottish markets and difficulties around connections and disconnections, and how that is handled. So there are a number of areas in which there are issues as the market develops. Importantly, I think customers still should continue to engage on those issues and put forward what their experiences are on those issues, and really drive for the market to come up with a solution.

Q90 Thomas Docherty: My last question: you have obviously had a number of years. You have highlighted the savings but also the challenges. After your experiences, do you think that opening up the market has been of benefit, on balance, to the public sector in terms of reducing costs?

Robert Leask: I think it has been very beneficial in terms of costs. The clear desire that came forward from the public sector was that what customers really wanted was an accurate bill, detailing usage and cost. Up until competition, they were struggling to get that. Now, through competition and enhanced customer service, we are beginning to get accurate bills.

Q91 Mrs Glindon: I would like to direct my question to the Consumer Council for Water members. Are you satisfied that the Draft Bill makes sufficient provision for the interests of consumers to be represented, both as the reforms are implemented and once the competitive market is up and running?

Yve Buckland: We welcome that consumer representatives are being consulted, but actually we think it should go further. There needs to be sufficient provision to make sure that there is customer representation in a number of really key areas that we have touched on today-on charges, on the regulation of price setting, and on the way the market reforms are designed and implemented. Clearly, there are lots of issues for both domestic and business customers in these reforms, both as they are implemented-we must make sure that their voice is heard, and that there is clarity about how their voice will be heard and how the regime extends to sewerage services-and once the market is up and running. We must make sure that customers do not lose out on mergers. It is about making sure that there is not customer detriment by engaging customers, making sure that we avoid the risk of customers experiencing problems when their bills arrive, giving domestic customers strong representation during the changes in the industry, and also speaking up for small businesses.

We were pleased with, and would obviously endorse, the point that the Federation of Small Businesses made, saying that they feel there is a very strong role for the Consumer Council for Water and for strong cross-customer representation, to help them for three years after the market has opened. We are not trying to make a pitch here for the Consumer Council for Water, but we feel the consumer voice has to have knowledge of the sector, must be able to represent business as well as domestic customers, and must be grounded in the reality of daytoday service provision, having the capacity to engage with individual companies, not just highlevel or just dealing with small sectors. So the big issues for customers: yes, there needs to be stability, and I refer back to the point that we should learn from some of the issues there have been around energy and make sure that they are not repeated, by taking customers with the reforms and alongside the reforms.

Chair: Thank you for your patience during the interruption, and for being with us and sharing the evidence with us in our inquiry? We are very grateful indeed.

Examination of Witness

Witness: Regina Finn, Chief Executive, Ofwat, gave evidence.

Q92 Chair: Good afternoon and welcome. Thank you very much for being here this afternoon. I apologise for having over-run because of the earlier vote. We are delighted that you are here with us to help in our inquiry on the Draft Water Bill. Just for the record, could I invite you to give your name and position?

Regina Finn: Regina Finn, Chief Executive of Ofwat, the water regulator.

Q93 Chair: I am going to start on the Draft Water Bill in a moment. Since we last met formally, Ofwat has very recently published revised proposals for licence modifications; I think it was last week. You will have seen that Moody’s have warned that continued uncertainty will be creditnegative for the sector. How do you react to that response to your revised notification?

Regina Finn: The reason that Ofwat published a clear proposal, with a time scale for companies to consider and respond, is precisely because of that: because it is time for decisions to be made and for the sector to move on. We do note that Moody’s says, in particular, that those companies who might find it difficult to adapt to a changing environment may find this difficult. That is the entire challenge ahead of this sector. The proposals that we have put in place, which we have been consulting on with the industry for an extensive period, are designed simply to allow the changes that we know are necessary to give effect to the Water White Paper, the Draft Bill, and the more general objectives, which I know we have discussed at this Committee before, of delivering a sustainable sector. Regrettably, because of the way the sector is set up, every individual company has to agree to licence changes. All of the 20plus companies were unable to reach a common agreement, so the way of dealing with this uncertainty is for a clear proposal to be put there, and each individual company is now in a position to be able to make its decision about that. There is, through the Competition Commission, a clear and very transparent route of appeal if companies decide that they do not want to do that. We agree it is necessary to conclude this process, and that is why we have published our proposals at this stage.

Q94 Chair: There has been a 10month interval since the proposals were proposed in their original form. There has been 10 months in which an agreement could have been sought, so it would be helpful to have an indication as to why you think possibly there is resistance from the water companies. Also, what is your reaction to the expression that Moody’s used in their statement, where they say, "The degree of flexibility that Ofwat is seeking is surprising"? In particular they say that "90% of companies’ assets (on a current cost basis) would remain as part of wholesale activities". Moody’s note that "the credit profile of a company where 40% of revenue is subject to as yet undefined price controls and/or competition will be different to that of the rated water companies today". Are you confident that you are acting under your existing powers, and that Ofwat is not seeking to act under powers that are in the Draft Water Bill but obviously are not yet in legal effect?

Regina Finn: Absolutely. I can confidently say that. Perhaps I can just start with your process question, Chair. Yes, there has been a considerable period of time, because we published initial proposals that would have modified companies’ licences to make them quite similar to those in other utility sectors like the energy sector, which raise capital on very similar terms and at similar cost to the water companies. However, we heard from companies and some investors that they had concerns about this because it represented a change. Therefore, we paused our process. We engaged in extensive consultation, including facetoface meetings with every company at Chair and Chief Executive level. There was extensive investor engagement. We established a forum to work with companies whereby we were seeking to see if they could come to agreement. As I said, unlike other sectors that have a majority mechanism, whereby licence modifications can be made, in our sector every individual company must agree. We worked with the companies, in a working group, to see if they could agree, and all companies could not agree. Quite a number of the companies, at that stage, were urging us to make a proposal, because it was necessary for this to be moved forward.

We have made a proposal, which is significantly different from the proposal made 10 or 11 months ago. 10 or 11 months ago we were proposing to allow a range of flexibility to allow us to change the way we regulate and target our incentives on companies’ management, in particular, because what they do is different in different parts of the value chain. Having listened to the concerns, we picked out the big concerns and we changed our proposals to address those. For example, there was a concern that our modification took away the link to RPI on the face of the licence. We currently regulate using a linkage to RPI. We have committed to putting that in on the face of the licence; that is a change that we have made. We did not intend to change that, but there was a perception that we would change it, so we put it back in.

Similarly, we have given assurances that we would continue to use the RCV mechanism, linked to the RPI, to regulate the wholesale asset-intensive part of the business. Let me be clear: the RCV is not in the licence. It never has been in the licence, but investors are very confident in investing on the basis of it, because we have a track record of regulating using it, and we have given very clear written statements and commitments that we will continue to do that. Then what we have done is we have limited to a very significant degree the ability to which we may evolve price limits. What we have not changed, and could not change even if we wanted to, is the safeguards that companies and investors can be assured are in place. We have a twofold primary duty: to protect customers, and to ensure that efficient companies can finance their functions. We cannot operate ultra vires those primary duties. Any change we make to any part of our regulation is subject to those duties, and companies can be assured about that. However, we have gone further and given them quite significant assurances insofar as we have said that in the limited areas where, over two price control periods-about 10 years-we may consider change, if we are considering changes we will consult on them, and if we do make changes they will be fully appealable; any company can appeal the changes on their merits to the Competition Commission. If they are outside of our powers, the Competition Commission is there to safeguard the company’s rights. But any changes we do make will be limited to those parts of the business that are not at all asset intensive, but where we may need change to deliver on the vision of the Water White Paper, and the ambitions of the Draft Bill. In particular, the Water White Paper and the Bill both talk about the need to get more efficient use of water: allocate water better; use it more effectively; move it around. It may be that, in order to do that, we need to target our incentives on companies around resource management. That might mean we need to have a different set of incentives for that part of the business, but that part of the business is not asset intensive. As you say, at minimum 90% of the assets based on net book value are in the wholesale price control, which we have committed to continue using RCV for, and index linking to RPI.

Q95 Chair: To be clear, apparently the companies are saying that they would be agreeable to make changes immediately for retail market reforms; that separate price controls for retail and wholesale services and wider changes to companies’ licences do not need to be made now; that they could be considered in the future, presumably when the draft Water Bill has gone through. Is that the nub of the disagreement?

Regina Finn: Companies have put forward a range of proposals. Their proposal to us was that we actually go much further than that, and embed things in the licence that are not currently in it.

Q96 Chair: Are you trying to embed in the licence issues that are before us, the Committee, in the legislation that has not yet gone through?

Regina Finn: No, we are not going outside our powers, and we are not seeking to do anything beyond what need to do to regulate the sector effectively. I think it is very important to recognise that. We have been consulting for some considerable time on how we can improve our regulation, target our incentives and deliver better outcomes. The changes we are proposing are, in the first instance, to allow us to do that. In the second instance, one of the things we are doing, by setting separate retail price limits, is clearly in anticipation of the proposals in the Bill, as well as because we wish to target incentives on companies to deliver better outcomes for consumers. I really can assure you, we are not going outside our statutory powers, and we are not going ahead of proposals in the Bill and doing things that are still subject to prelegislative scrutiny. That is absolutely not the case.

What we are doing is creating a regulatory framework. This has nothing to do with provisions in the Bill or with market opening in the first instance. It is to do with targeting our incentives and our regulation on the different parts of the value chain, depending on what they do.

Q97 Chair: It might be semantics, but we will proceed. Martin Cave said that legal separation should be compulsory except where there were "unavoidable and unacceptably large bill increases". Yet the Bill before us does not require legal separation of companies’ retail operations. The Bill relies on Ofwat using its powers "smartly" to prevent incumbents discriminating against new entrants. Do you believe those companies that voluntarily choose to legally separate their retail and wholesale arms should face a lightertouch regulatory regime?

Regina Finn: We recognise Government decided not to require that separation. The reasoning that Martin gave for requiring that was because, if the separation is there, it is transparent and easier to police and regulate. We acknowledge the Government has said that is not going to happen. Therefore, we will need to police and regulate that interface between the retail and wholesale businesses more intrusively than we otherwise would have to have done.

This is something the Committee, through its report on the Water White Paper, really helpfully highlighted. I think the debate on this has moved forward significantly; it just shows the value of the sort of scrutiny the Committee brings. Since the Committee’s report on the Water White Paper, the issue of the potential for companies to voluntarily separate has come back on the agenda. I think that is a very useful debate. We do see about half of the water and sewerage companies now saying it would be helpful to have the ability to do that, but not to be forced to. Clearly, in a case where the company did have the ability to do that and did implement that separation, it would be much more transparent in terms of the nondiscrimination requirements that would be on it. That would mean, yes, we would need to be less intrusive in how we regulated in that instance, because, quite simply, the confidence of other market players would be assured by the fact that they could see a legally separate company interacting with the wholesale company. We would have to police using Water Industry Act powers for non-discrimination, and using Competition Act powers because of the lack of transparency and separation, so there would definitely be a difference in how we would regulate.

Q98 Chair: If that is the case, would it not be better that a requirement was on the face of the Bill, with guidance produced by the Secretary of State? Would that not be preferable to leaving it to your discretion?

Regina Finn: The requirement to regulate differently if a company is separated?

Chair: Having lightertouch regulation in the event that they voluntarily choose to legally separate.

Regina Finn: I do not think it is necessary to have it on the face of the Bill, because it is effectively already a duty on us. We are subject to the Better Regulation Principles. We operate on the basis of applying proportionate and targeted regulation. We have a duty to ensure that we do not regulate onerously where we do not need to, which applies not just in this instance but to all our regulation. That is, then, already inherently part of our duties. I think repeating it in this one instance on the face of a Bill might complicate matters, because frankly it is something that should apply to all of our regulation.

Q99 Chair: Earlier, we did establish that there is unease among water companies about the discretion being given to Ofwat under the Bill. What are the advantages of the Draft Bill’s delegation of responsibility to Ofwat for developing the detailed market reforms?

Regina Finn: This has been an interesting debate, and we have been trying to unpick where the stakeholders’ concerns are, because they seem to be around a small number of issues. The first issue seems to be around the ability to make consequential amendments to licences to give effect to the Bill. I find it quite surprising that companies are concerned about that discretion, because it is exactly the same discretion that Ofwat was given in the 2003 Act. It is bounded, because these can only be changes to give effect to the Bill; we cannot go beyond that, or else we are subject to appeal. So I find that one strange.

Q100 Chair: With the greatest of respect, that might be the case, but the potential for opening up the market to competition is the exciting feature of this Draft Water Bill, so it is actually going much further than the 2003 Act. That might explain the unease among investors and the water companies.

Regina Finn: The provision for making consequential amendments is a very standard one, and is bounded. If the concern is that the Bill itself is making changes that companies are uncomfortable with, frankly, vested interests will have discomfort with things, and will want to say they do not want them; I understand that.

Q101 Chair: I do not think that Moody’s are a vested interest.

Regina Finn: We have been trying to tease this out because there are a number of things happening here; it is not just one thing. One issue is about the consequential amendments. I do not think there should be concern about that, but I can understand why companies will generally not want to see discretion and change. The second issue is the licence modification proposal that I talked to you about a while ago. That is the one I think you, Chair, were referring to. Frankly, the issue there is: where we do need to make some changes, they need to be evolutionary. However, it is understandable that the sector, the same vested interests, may not want to see that change. We can understand that people want to protect their positions. It is important for us to give appropriate reassurances that, while the change can happen, investors will continue to be protected, which they will, and companies will be able to continue to finance their functions, which they will.

There are a couple of other areas where companies have raised the question of whether the Bill gives too much discretion around things like setting up market codes, governance and managing the market development. Again, I do not think the Bill offers too much discretion, but if there are concerns about how we might use that discretion, that points to a need for engagement, communication and understanding. We would be open to that debate with companies.

Q102 Chair: Reassure us. What are the appeals procedures going to be under the licensing modification proposal and the market codes and access pricing regime, if the Bill passes in its current form?

Regina Finn: There are a variety of mechanisms of appeal for water companies, so I apologise if this seems long, but I do want to reassure you that the appeal mechanisms are there and are quite extensive.

Q103 Chair: They are there now. The Committee wants to be reassured that the appeals are not being removed or downgraded, leading to a judicial review rather than a reference to the Competition Commission.

Regina Finn: They are not being removed or downgraded; I can assure the Committee of that. There are some areas where our decisions are subject to judicial review, where we make a decision that a company might think is unreasonable or ultra vires, and that continues. Companies are quite comfortable using judicial reviews. I have had a number of judicial reviews in this business. Most recently, I have had two, from Thames Water and Welsh Water, against decisions about issuing licences to new entrants. Both companies used the judicial review to appeal whether we were within our powers. In both those cases, the courts said we were, but I am quite comfortable that companies should be able to appeal those things, and that remains.

In terms of all our price determination decisions, any price control decision, any revenue affecting decision for any company at any stage, is fully appealable on the merits to the Competition Commission; that does not change. Companies’ full rights of appeal remain intact on any decision we make that affects their revenues. I can assure the Committee that that is not changing. Finally, there are appeals to our decisions under the Competition Act to the Competition Appeal Tribunal; so there are appeal mechanisms there for companies.

When the companies were discussing appeal mechanisms, there was perhaps confusion, with different types of decisions having different appeal mechanisms. We are happy to provide you with a briefing note on the detail of that, if it would be helpful. But I can assure you that Ofwat works within very, very clear statutory boundaries. We understand our duties; we understand the importance of our track record; and we understand the importance of the safeguards of the appeal mechanisms, which are not in any way being undermined.

Q104 Chair: You will act with discretion, but entirely proportionately?

Regina Finn: Yes, absolutely. We have an absolute duty to do that in a proportionate and reasonable way. If we do not, companies have a right of appeal.

Q105 Chair: It would be helpful to see that in writing. What opportunities will Parliament and we as a Committee have to scrutinise the detail of the market codes and access pricing regime before the reforms are introduced?

Regina Finn: In terms of accountability, there is the legislation in the first instance, then there is specific guidance.

Q106 Chair: The point is that the legislation gives enormous discretionary powers to Ofwat.

Regina Finn: I would say that the legislation gives discretionary powers that are on a par with other sectors and are bounded by our primary duty. If any access pricing rules that we set were ultra vires-for example, if they meant an efficient company could not finance its functions-then a company could appeal that; that is fully appealable. But there is another accountability: the Bill provides for the Secretary of State to issue guidance to Ofwat, which will set out what we have to take regard of when setting those access pricing rules; I think that is helpful, too. In addition, there are strategic policy statements, and social and environmental guidance that we need to have regard to. Finally-and I genuinely mean this-Ofwat is always open and willing to come before this Committee, because its scrutiny, in terms of providing transparency and openness around these different points of view, is very helpful. Ofwat would never refuse to come here and explain those developments.

I think there is more that we can do. In particular, this is where, as I say, we are happy to engage with companies. Our preferred model for market governance would involve a significant amount of industry ownership. We would like to see industry codes owned by industry, with Ofwat granting approval of changes only where there are disputes. That is an example whereby we would seek industry involvement in this, and therefore some accountability with the industry as well as Ofwat. These are things have been done in other sectors, and can be done in a way that is effective, with communication and engagement, and we do understand that.

Q107 Barry Gardiner: We are bringing the big guns out against you, aren’t we? It is good to see you fighting back. They do not like clause 23 of the Draft Bill much, do they, because it gives you what you consider to be necessary and expedient powers to amend their licence conditions for two years? Of course, the change there is from previously just "necessary" to "necessary and expedient". I guess they think that your view of what is expedient and their view might not be the same. Is that right?

Regina Finn: I hear the feedback that companies consider this too wide a discretion. I admit to being surprised by it, because it implies Ofwat might make a consequential change-because it does have to be consequential-that was somehow not intended to deliver on the intent of Parliament in passing the Bill.

Q108 Barry Gardiner: But it has to be, in order to implement the Bill’s provisions, so they cannot maintain that.

Regina Finn: I agree.

Q109 Barry Gardiner: So it is not the "necessary", because "necessary" you already have. It is "expedient". So it gives you an element of discretion, as the regulator, which they are afraid of, aren’t they? Why?

Regina Finn: The point about the enabling modification is it has to be necessary, but it still has to be expedient to deliver what is in the Bill; it cannot be expedient just because we would like it. We are very conscious of that. We are also bounded by our primary duties. If we made a change that we considered expedient, but which was contradictory to our primary duties-I can assure you we would not do that because we are a creature of statute, and are bound by those duties-companies have an absolute protection, because that would be unreasonable and ultra vires and could be appealed.

When the companies are nervous, we are trying to reassure them that their rights are protected, and that, furthermore, the stability of the regime, which is underpinned by those primary duties, is also protected. However, it is understandable that those companies that do not want change, those who consider that change would be difficult for them, those who are in the camp that Moody’s said might find it difficult to adapt to a changing environment, would prefer not to see that there. Companies that are beginning to see they are less efficient than others, and feel they are coming under pressure, might find it difficult. I can understand, in their own particular positioning, companies will have to take a view on that and tell you what it is.

However, we are here, remember, to balance the interests of the customers with the interests of these big monopoly companies. Our duty is to get that right, and we must comply with those primary duties in exercising this discretion.

Q110 Barry Gardiner: For those reasons that you have very clearly and ably set out to the Committee, you do not believe, I take it, that a more effective appeal mechanism is required.

Regina Finn: It seems to me the appeal mechanism is comprehensive and companies’ rights are protected. If the Committee or anybody gives to me or to Government a clear case that there is a gap in that appeal mechanism-which they have not-it would absolutely have to be considered. I cannot see gaps in these appeal mechanisms right now.

Q111 Barry Gardiner: So why are they afraid? Is it simply because they see their monopoly base being eroded? Or is there a genuine fear that the costs of capital could rise, which, as we heard from the previous witnesses earlier this afternoon, could have a very damaging effect on the consumers’ bills? For every 1% rise in cost of capital, we heard there was a potential increase of £20 on a consumer bill. Is there a genuine fear there, or is that something you can absolutely scotch to this Committee now?

Regina Finn: I would bring you back to the starting point here: we have a duty. Our primary duty is to protect the interests of consumers and to ensure that efficient companies can finance their functions. We have been very clear. We have come before the Committee, and we have welcomed the White Paper and the Bill, because what it is doing is giving us the tools to do just that in a long-term, sustainable way. What we need to do is ensure that the cost of financing remains as efficient as possible; that is one of our goals. Also, we need to ensure that the finance raised at that low cost of capital goes into the right investments for the long-term future of this sector. That is important: you could have a very low cost of capital and invest a lot of money in assets you do not need, and customers’ bills would be higher than they otherwise would have been. We do not want that. On the contrary, you could have fewer assets and a dreadfully high cost of capital, which could drive up customers’ bills. We do not want that either.

We want a balance here. We want to maintain the most efficient cost of financing, consistent with sustainable investment in the assets customers know will be delivering now and for the long term-for their children, for their children’s children, and for the environment. I am not saying it is not a balancing act; it is. But with regard to the reforms in the Bill, the impact assessments the Government did included sensitivity analysis around potential impact on cost of capital up to 250 basis points. That still came out with £2 billion pounds of net present value for this economy and for customers. So these changes, evolutionary and gradual as they are, can and will be done in a way that is in the interests of consumers.

Q112 Chair: What about potential stranded assets?

Regina Finn: One of the things we have said quite clearly as part of our reassurance to investors is that we continue to use the RCV; the RCV is allocated to wholesale control; we will continue to use RPI indexation for as long as appropriate, noting some of the changes to the broader environment that are outside of our remit; and, finally, efficiently incurred investment up to the end of the current price review period will be reflected in whatever controls we use.

The point here is about reforms going forward. It is about reforms to send signals to companies to invest in the right assets in the future at the best possible cost. It is about avoiding assets that might need to be stranded in the future; that is a key driver of making sure that companies have the right incentives. I know I have shared this example with the Committee before; under the current arrangements, we have talked about the potential bias towards capex and a focus on particular types of assets: companies might seek to develop new resources or build desalination plants in their own areas. We want to incentivise them to build different assets where they are more efficient, perhaps with interconnection between companies to allow for more resilience and to allow for water trading. It is about changing the incentives to drive those behaviours for the future.

Q113 Thomas Docherty: On the issue of Moody’s and the City, can you remind me what percentage has been knocked off the share price of utilities in the last year as a result-5%, 10%?

Regina Finn: Nothing; it has been going up. And companies have been changing hands at very significant premiums. People do not buy a company if they are not sure they will get a longterm return. We have seen companies sold at premiums between 25% and 30% of RAB, which is a pretty significant premium.

Q114 Thomas Docherty: So it does not actually look like there is any-

Regina Finn: We have not seen any impact on share prices; we have not seen any impacts on dividends and return to shareholders of any negative kind.

Q115 Thomas Docherty: It is probably fair to say that separation is an issue where you and your Scottish counterpart are at one. The new entrants think there should be separation. There is a mixed view among existing water companies. Will some degree of separation be required in order to give a level playing field for new entrants coming in to compete against existing water companies?

Regina Finn: The answer is the minimum we will do is price control separation; that will be essential. That is one of the reasons we are proposing separate retail price control. So there will be a minimum need for price control separation. Beyond that, we will need to require-this is where the regulatory burden increases-demonstrable Chinese walls between the retail and wholesale arms within an incumbent. We will need very transparent transfer accounting, charging and cost allocation between the two. That is what happened in the telecom sector. There was no separate retail arm. New entrants came in; they had to compete with the incumbent, who owned both the retailer and the wholesaler. There, what you do get is quite a lot of necessary oversight and regulation to ensure nondiscrimination. New entrants ask quite a lot of questions, which means you have to force quite a lot of transparency through regulation.

That is the minimum that will be necessary. The Committee’s report on the White Paper really helpfully brought this into focus. Since then, the power of the Committee’s report has come through. A number of companies, which together represent about half of the value of the industry by customers, are now thinking that the voluntary ability to separate might help them do that in a more efficient way. So I think that has been a really useful debate to have on the table. But at minimum, there will be price control separation and regulatory oversight of the interface.

Q116 Thomas Docherty: Are there different perspectives about where that requirement for separation will be placed? I think I am right that one option is on the face of the Bill; another option would be in guidance produced by the Secretary of State; and the third option is to leave it to your discretion as the regulator. Where do you think that requirement should be set?

Regina Finn: The final option is, rather than there being a requirement, that there be enabling of companies to separate fully if they want. In terms of the minimum level of separation, price control separation and policing of nondiscrimination do not need to be on the face of the Bill because it is already a requirement on us, given our existing tools, the existing obligations on companies and competition law. There are obligations to police for undue discrimination and unfair behaviours already in legislation. I do not think it is necessary to say it again, because those requirements are there. It would be helpful if the legislation simply allowed the further evolution of your list there, which is that there be an ability for the market to evolve, and companies to make commercial choices that in the end should benefit customers.

Q117 Thomas Docherty: Everyone but the Minister appears to support the establishment of an exit route. If, however, the Minister does not listen to everyone else, could we have effective competition in England without an exit clause? Could you explain briefly why?

Regina Finn: We will put in place all the provisions we can to ensure effective competition with that constraint. Yes, we can have competition with that constraint. There will be an impact without the ability for retail exit. Frankly, retailers who are inefficient will be required to stay in business and will be unable to allow more efficient retailers to take over their business and thus provide a better service at lower cost to customers. So the effect would be that prices will be higher, and services less good to customers.

In the absence of an exit route to deliver those benefits, we will want to regulate in a way that maximises the level playing field and allows the maximum benefit to customers within that limit. But there is a limit; it will definitely cause a limit. It seems to us that, if we get to a stage where those benefits are not realisable for customers, we may well end up having to use more of Parliament’s precious time to revisit this. In terms of what is in the Bill, it is not that we think there should be requirement for the change, but if there is a barrier to the market evolving, and the only way to move that barrier in future will be primary legislation, that will have to be the route we come back to, to change it, if it is considered appropriate.

Q118 Thomas Docherty: A scenario has been suggested to me whereby, if the existing companies cannot sell, or indeed merge, and there are half a dozen new entrants over a decade, you could end up approaching, on paper, 30 retailers. However, a number of them would have one person sitting in an office with a brass plate, not having any customers, not doing any activity. Could that scenario exist?

Regina Finn: It is potentially inefficient. In the scenario you are describing, the way things sit at the moment, if I am operating an incumbent water company and I have a retail business, I have the licence obligation to provide that retail service. If, however, I am not very good at it, where in a normal market I would sell that, realising gains for my investors-and the new retailer would be giving a better service-if I cannot do that, I will try to do all sort of other things, such as potentially to outsource it and cut my costs. But at the end of the day, I retain the licensed obligation, so if something goes wrong with that retail business, Ofwat, the regulator, will come after me for that licence enforcement. So I will need to retain some overheads. That might be your one person in a room with no customers; that might be what is behind that scenario. I am not sure how this would pan out, but there are potential inefficiencies built into this approach.

Q119 Dan Rogerson: You have made it clear you do not think the abolition of the costs principle will necessarily result in increased bills for householders at all. Given the level of concern that has been expressed about it, do you think that determination to avoid it should be on face of the Bill?

Regina Finn: We need to come back to the fact that protecting consumers and ensuring efficient companies can finance their functions will always be our overriding duty, within the frame of guidance. One of the things we have collectively learned from the fact that the costs principle is in primary legislation, rather than in secondary or guidance, is that writing something on the face of the Bill, which is very difficult to change when you might find out it is necessary to change it, is not very efficient. So we have delayed customers getting the benefit of competition by more than 10 years by writing that on the face of the Bill last time round. We need to be very careful what we write on the face of the Bill.

In terms of removing the costs principle, the Bill provides for guidance to Ofwat about the pricing and access rules that should replace it, so that will help ensure the point you are making can be made in that guidance. It is still secondary to the fact that our primary duties require us to protect customers anyway, so we will not be in the business of replacing the costs principle with something that is bad for customers. If we did, frankly, we should be appealed on it, because that would be an incorrect regulatory decision. So we already have that safeguard, and it is probably not necessary to put it in twice.

Q120 Dan Rogerson: Colleagues in other debates and elsewhere have explored the concern about the very complicated structures of companies in the sector; that there is tier after tier of company, in some areas more than others. Is this something you think you should have a view on, or that the legislative framework should look at as well? Or do you think it has just been a very efficient market, it has been fine and has encouraged investment, and therefore it is okay? There is a suspicion that costs go one way, and any profits go another, and that, while they meet the strictures you place upon them, some of these structures allow them to pass the risks on and to take the profits.

Regina Finn: If you think investors are concerned about uncertainty with Ofwat, if you opened that up you would find a huge amount of concern. To be fair, we have to recognise that one of the things the UK regime does very well is to regulate a regulated business to protect the customers of that regulated business, and to allow a huge amount of discretion, if I can use that word, to company owners in terms of how they structure the ownership of the business. There is a clear view that the commercial sector is best placed to manage those risks and put in place the most efficient financing structure. That has delivered a lot of benefits to the sector; it has delivered a low cost of capital; it has delivered a huge amount of investment.

I recognise the point you are making: people are concerned about the structure of companies, and whether that structure somehow or other is transferring risk to customers and away from owners. That is the concern. From our point of view, there are safeguards in the regime to protect customers, and they are incredibly important. We have provisions in licences; we have managed to put in licence changes over many, many years. These include the regulatory ring-fence: if a regulated company looks as though it is getting into trouble in any way that might jeopardise service to customers-whether because of its structures or not-we engage that licence condition, and there is a cash lockup provision; the cash remains in the business and it cannot be taken out of it to any of those broader structures. It must remain in the business to service the business. If the company goes even further and ends up in serious difficulty, there are provisions for special administration; the company can be sold on.

Those provisions do work; we saw them work when Enron, which was the owner of Wessex, got into trouble. It was at that higher level of complex structures that the problem happened, but the customers of the water company were protected through these regulatory provisions and it was sold.

Q121 Dan Rogerson: You have picked up on a view of the relationship between an acceptable level of profit and what is regarded as the cost to the consumer. Are you as a regulator confident that none of that is obscured from these relationships, and when you are saying, "This is an acceptable price increase," or whatever, that is very much based on the total reality of where the money is going in that nest of companies, rather than there being anything hidden there?

Regina Finn: We do regulate the RegCos, the regulated companies, not the HoldCos, the holding companies-I am going into jargon now. It is a fair point. One of the reasons we have heard it raised is because a lot of these companies are now privately owned, because they are so attractive in terms of longterm returns and the stability of the regime, and that sometimes leads to a slight lack of transparency about what is happening. It is an interesting question as to whether greater transparency might be appropriate. That is something we are happy to look at, but transparency is different from direction or oversight, and we are very firmly, within our powers and duties, focused on regulating the regulated company. But customers are entitled to see what is happening with their money; that is a fair point.

Dan Rogerson: "Interesting question" is good; we can come back to interesting questions another time.

Q122 Thomas Docherty: You, I think, personally are a member of the High Level Group; is that correct?

Regina Finn: The High Level Group for market reform? My Director of Markets and Economics sits on it. Ofwat is, yes.

Q123 Thomas Docherty: How many times has it met since it was set up?

Regina Finn: The High Level Group has met once.

Q124 Thomas Docherty: Is there a date in the diary for the next meeting, yet?

Regina Finn: There are dates in the diary for a number of meetings. The important thing about the High Level Group is that it is a "high level group" for a reason. I do not think we are going to deliver market reform through meetings; we are going to deliver it through activity, action and deliverables. While the High Level Group is set up to agree certain highlevel principles, I think the real activity has to happen in the engine rooms. I am very keen to see the industry step up its role here, because there is an opportunity to shape the market. We are certainly looking to increase that work, and will be publishing some consultations around governance to get it going more quickly. We could do with a little bit more effort at that level.

Q125 Thomas Docherty: Can I press you to give an assessment of the progress of the High Level Group, particularly on the Anglo-Scottish market? As a group itself, what is your assessment of its progress?

Regina Finn: The High Level Group’s initial meetings-

Thomas Docherty: Meeting.

Regina Finn: There were discussions beforehand and around meetings. I beg your pardon.

The High Level Group has taken the initial road map away, kick the tyres and come back and see if it will work. I think that is perfectly reasonable. What is important is not that we have loads of High Level Group meetings, but the work the High Level Group needs to have done in order to give its guidance and overview as to how things are going needs to get going; that is where the real pressure needs to come.

Q126 Thomas Docherty: You have heard the call in the previous session from the water industry lobbyists for an implementation group to sit below the High Level Group to provide more focus on the detail. What is your view on that?

Regina Finn: The High Level Group has already identified three key workstreams. For me, what is more important than another group meeting is that those three workstreams get their work plans together and get a programme of work that will deliver. That is the focus that I would like to see happening.

Q127 Thomas Docherty: Do you share a concern that the reason the water industry lobbyists want more meetings is that they do not really want to make great progress?

Regina Finn: I am not sure. I was recently looking at a TED lecture that I am very fond of, and which I had seen some time ago, by Jason Fried. It was about why work does not get done at work, and he was saying it is essentially because you spend most of your time doing meetings. I have a little bit of sympathy with that. You do need meetings, but you really need work plans, deliverables and output to get things done.

Thomas Docherty: I will take that as a yes, then.

Q128 Barry Gardiner: One of the potential unintended consequences of upstream competition has been identified by the companies as a de-averaging of bills, with those customers who are located closer to treatment works able to bypass the existing infrastructure and therefore get lower bills. Are you confident upstream reforms can be introduced without that regional de-averaging, to some extent?

Regina Finn: There seems to be a conflation of more than one issue here, which seems to be confusing the thing. In terms of retail pricing to households, these companies will continue to have a monopoly on that service; those prices will continue to be regulated. Clearly, that can ensure there is no undue de-averaging that would be seen as inappropriate or unhelpful to customers. For example, I see absolutely no reason why prices to those customers would need to be de-averaged between rural and urban customers. That is a myth; it does not have to happen. That is one thing that has been thrown in there as a potential impact of upstream competition. It is not true.

The second issue is-

Q129 Barry Gardiner: I don’t want to stop your flow, but I do want to make sure we are clear on this. Are you saying the incumbent company does not need to introduce deaveraging of prices in order to ward off competition, or that they will not be allowed to introduce that?

Regina Finn: I would say they do not need to. They certainly do not need to on household customers, because there is no competition allowed for those customers, so there will not be an issue there. It isn’t going to happen.

The second point I was going to come on to was: where there is choice, where we are looking to develop upstream competition over time, we are looking to send the right price signals to people as to where to locate, for example, waterintensive industries. So, if the UK started to attract new waterintensive industries, we would want them to go into a place where it was most cost effective to deliver that water service to them. In that instance, it would be very important for the company to understand the relative costs of developing and supplying that product to the end user.

You could call that de-averaging, but it happens already anyway. It happens in some cases where, for example, a developer will move what he is going to develop closer to a treatment works; he gets a better price because he has to pay less costs. That happens, and it is sensible. It should happen in a way that is transparent as upstream markets develop. That is a good thing; that is positive. What has been confusing is the concern that, somehow or other, household customers would see this rural/urban divide come in. I see no logic in that concern. Nothing is changing around that aspect. Companies have not been able to explain to me why they are saying that; I cannot answer the detail of their argument because I do not know it.

Q130 Barry Gardiner: Might I put a gloss on it? Of course, I do not want to put words into your mouth, but might that simply be seen as scaremongering, given that upstream competition does not apply to the domestic sector?

Regina Finn: It seems to be a confusion, I would say.

Q131 Mrs Glindon: In your written evidence, you acknowledge the importance of investor confidence in the sector, but water companies argue that the Draft Bill’s proposals, particularly on upstream reforms, are likely to increase the cost of capital. Are you confident that such sweeping reforms can be introduced without denting the confidence of the investors?

Regina Finn: This comes back to, from my point of view, the overarching duty of the economic regulatory regime to balance protecting customers with ensuring efficient companies can finance their functions. The work that has been done in developing the proposals in this Bill has taken place very much in the context of that debate. When I talked to the Committee last time about the Water White Paper, in the context of investor confidence, I spoke of managing the scale and pace of change carefully. That would help manage investor confidence, as would adequate protection for investors both in primary legislation and in their licences, the track record, the appeals mechanisms. So would ensuring clear understanding and communications as we develop the proposals.

Coming back to the Government impact assessment of the changes in the Bill, that did do a scenario analysis of what if the cost of capital did rise to a degree. It still came out with a net present value benefit of the overall reforms. It is important that you combine what you invest in and how much you invest, with the cost to invest in it. Against that backdrop, and with our duty to ensure efficient companies can finance their functions, it is very important that we bring investors with us, so they understand that these changes are positive for them as well. I think we can do that and preserve investor confidence.

I know water companies are saying that reforms may impact here, and we are listening very carefully to investors who are saying that this causes concerns. It is important that we disentangle the true investor concerns from other drivers of concern. Investors want reassurance around the stability, transparency and predictability of the regime. We want to ensure they get that, while understanding that the changes are necessary to ensure their investment is sustainable in the long term. We mentioned earlier stranded assets; the worst case scenario for investors would be, because we do not regulate effectively and we do not allocate water efficiently, they invest in something that turns out to have been terribly inefficient, and we will be questioning that. That would cause a lack of confidence. We do not want to get there; we want them to continue to invest in sustainable long-term assets.

The Chair talked about Moody’s comments, and various other comments. The concern is around "companies that are unable to adapt to a changing environment", which says to me companies that can adapt and deliver for their investors and customers are actually going to be quite confident in this environment.

Q132 Mrs Glindon: Could the upstream reforms be introduced in such a way as to protect the resilience of the industry in terms of continuity of supply?

Regina Finn: Yes, it absolutely can be done in a way that protects resilience and continuity of supply. Indeed, reforms can help contribute to resilience and security of supply. The key area it can do that in is the upstream reforms we have been talking about, because what they are designed to do is not just get water companies developing water resources in their own geographic area, but allow other people with water resources to sell water to water companies. At the moment, water companies take about half of the available water out of the environment for public supply in a time when they might need more water, for example a drought. In this new world where these provisions are in place, somebody who has a right to water could sell that water to a company, therefore making their provision of service more resilient, so they could have access to a wider source of supplies. It will help with resilience if water companies begin to source water from elsewhere, like that.

Another way it will help with resilience is that our reforms, which are complementary, encourage them to trade water between themselves. We should also see them building more interconnection between their networks, and that clearly is important for resilience as well, if one bit of the network goes down and you want to be able to move water from somewhere else. So I think these reforms will help deliver a resilient long-term system.

Q133 Mrs Glindon: Would it lead to more fragmentation?

Regina Finn: I do not see that it will lead to fragmentation that will damage resilience. As we have said, these companies are going to remain monopoly network operators; there is a natural monopoly in this business, so we will not see any effect on that. We do want to see the incentives on those companies to build more resilient networks, to find the best places to build those networks and the best and most efficient way to use them. Frankly, a third of our catchments are already over-abstracted. We cannot just keep taking water out where it is convenient. We need to be smarter about how we use it and move it around. I think that is what these reforms go to.

Q134 Chair: Are you surprised there is not more emphasis on resilience measures, flood protection measures and moving water around in the Draft Bill compared with what was in the White Paper?

Regina Finn: I can see the evolution from the White Paper’s ambition, which is what we want to achieve, to the Bill, which is how we will achieve it. Of necessity, how we will achieve it involves amending issues around the upstream market and putting in place the tools that will enable the evolution to deliver the vision of the White Paper. That is the difference between a piece of legislation and a White Paper, which can be much more ambitious. The Draft Bill takes really significant steps towards delivering on that vision. Let’s be honest, it does not do absolutely everything. Frankly, to do everything, we would need the perfect piece of legislation. I am not sure we could ever get that, but it takes significant steps in the right direction.

Q135 Dan Rogerson: Would you support the inclusion in the Bill of a provision that would allow a water company to seek the rollout of universal metering, not just those in areas of serious water stress?

Regina Finn: That is very much a Government policy issue. We appreciate and work within the framework of the Government policy. As an economic regulator, we support metering; we think it is the fairest way to charge. We accept that Government does not believe that compulsory rollout of metering is the way to go, so we will work within the framework. The fact of the matter is by about 2015 we do expect that half of household customers will be metered. Some companies are rolling out compulsory metering schemes because of water stress. Beyond that, I think we are seeing a rising understanding, by the companies, of the wider beneficial reasons for rolling out metering. There is a natural progression of metering that will happen, and we will work to make sure that happens within existing policies. This is one where it is definitely an issue of Government policy, and we, as the economic regulator, will implement that.

Q136 Dan Rogerson: I understand the distinction, and there are some other regulators who maybe do not quite understand that structure yet.

To follow up on the issues you have discussed of investment and the confidence on the part of companies to invest, do you think the Bill or the thrust of Government policy generally does enough to incentivise non-capital-intensive things, such as dealing with waste water? That does not show up on the balance sheet, but might be an issue in the future. Do you think the regime is flexible enough for that, or could the Bill go further in that respect?

Regina Finn: There has been quite a lot of work looking at whether there is a bias among water companies towards capital expenditure, and, if there is, how we can deal with it. There have been a range of barriers identified. We have not needed the Bill to start to address quite a few of those. For example, one of the potential issues was the water resource management planning guidelines, which could be strengthened around this. And they have been; we have worked with the Environment Agency to do that.

Frankly, it is one of the reasons we are changing our regulation. One of the reasons underpinning our licence modification, which companies are concerned about, is that we need to be able to incentivise them to move away from that capex bias, to make them indifferent, or make them choose the best solution, even where the solution may not be capex. One of the reasons we needed that modification is we want to move from treating capex and opex separately-sorry, jargon again: capital expenditure and operating expenditure-to treating them together as total expenditure. Doing that requires us to change some of the way we regulate, and we need to ensure we have the flexibility to do that. That is the kind of flexibility that we as the regulator need to deliver on the White Paper ambition: to drive more sustainable solutions where they are potentially opex rather than capex. So I think the barriers identified were not ones that needed primary legislation, but needed us to change our regulation, and needed the Environment Agency to change some things that it is doing. We expect our Social and Environmental Guidance and Strategy and Policy Statement from Defra to reiterate this. We want sustainable solutions, and will be working hard to make the changes we need to. I do not think it needed primary legislation.

Q137 Dan Rogerson: Bearing in mind, then, what you said about Bills not coming along that often and opportunities being missed in previous Bills, we are not missing an opportunity here on that; we are okay.

Regina Finn: I do not think we need primary legislation. We are doing an awful lot without it.

Q138 Chair: There is a huge amount in the White Paper about abstraction and reform of the abstraction regime. Are you surprised there is not a great deal in the Draft Bill on abstraction, particularly setting out a timetable and progress to reaching it? Do you think that is because there needs to be further consultation on secondary legislation? Can you think of any reason why it has not been included in more robust form in the Draft Bill?

Regina Finn: My understanding, in the debates we had on the White Paper and the useful debate we had here with the Committee, was that Government considers that there is-and no doubt there is-a considerable amount of work to be done to develop a sustainable solution for a form of the abstraction regime. There is a very clear acknowledgement that there needs to be reform, which is positive. It is excellent that it is in the White Paper. I accept, similarly to what we have been discussing recently, that without some of the detail of how we are going to do that, it appears quite difficult to write it into this piece of legislation. We acknowledge that.

There are two things happening. One is that Government will be working, and definitely needing to consult on what further changes would be needed to reform that regime across the board. We will be doing everything we can in the meantime to try to drive more efficient use of water resources through our regulatory regime and working with the Environment Agency, because we firmly believe that is the first set of steps towards a more sustainable abstraction regime. That is why the upstream reforms in the Bill are particularly important; they are a first step towards that. They are the first step towards at least trading water, and using the raw water more efficiently. We will probably be able to learn some lessons from that that will help inform how we might use the abstraction licences more efficiently. We are very happy to do a lot of work on the economics of that to support Government’s consultations.

Chair: Thank you. You have been very helpful, and it has been a marathon session. Apologies again for the delay at the start. On behalf of the whole Committee, thank you for being so fulsome in your evidence and for contributing to our inquiry. We are very grateful indeed.

Prepared 6th November 2012