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The role of Ofwat

This is a good moment for a stocktake, immediately after the general election, on where the water industry stands and its future shape.

I start off by saying that it is not my role to shape the industry. I am preceded and followed by representatives of the real shapers: Chris Mellor, responding to all the various influences that affect an equity based company, and Michael Meacher for the Government. (Incidentally it is a huge tribute to IEA's foreknowledge that months ago they were able to print a brochure confidently asserting that on 19 June the Minister for the Environment would be Michael Meacher – the fact that they wrongly forecast the name of his department is incidental.)

But I do not underrate the role of the regulator. In the water sector, we are talking about regional and local monopoly companies where by definition market forces are constrained. Economic regulation has a key role to play in the defence of customer interests and will continue to have that role for the foreseeable future.

Where are we now?

An obvious question, but there is no generally agreed answer. The last periodic price review, taking effect from April 2000, had a major impact. It cut bills on average by 12.5%. It is a tribute to the industry in its current shape that over the 12 years since privatisation it has made substantial efficiency gains. It is delivering a high-quality service, attested by our drinking water quality and our environmental progress. Despite this, bills including the current year have risen in real terms by only 19.5% since 1989-90. Economic regulation of the water sector has helped achieve that success. Since 1989 Ofwat has built up its comparative data in a way that enables us to push for efficiency not on the basis of supposition but of known best practice from the leading edge companies.

The companies have just been announcing their preliminary results in respect of the first year of the new price limits set in 1999.

Almost all claim to be on track to meet or beat our assumptions. This is welcome news. There have been grumblings about the last review. Some have said that the cost of capital assumed in price limits was too low (4.75% post tax which equals over 6.5% pre tax for the bigger companies, more for small ones). Questions have been asked about the companies' ability to fulfil their functions in the medium to longer term - maintaining their infrastructure and making the necessary environmental improvements, while still providing a fair return to investors.

Two smaller companies took these issues to the Competition Commission. The Commission confirmed Sir Ian Byatt's judgement on the cost of capital whilst making other changes. I note that Ofgem has used very similar figures for the electricity distribution and transmission companies. I note too that some companies have been raising finance on terms which meet or beat the PR99 assumptions. Of course we shall look at the issues afresh as we approach the next PR. But we have no need, I believe, to refight the battles of the last PR now.

I am reinforced in my view by the companies' June Returns for 2000-01. We are working on them now. The levels of service and financial performance and expenditure reports will be published next month. These are 2 of the 5 reports which reinforce comparative competition. Early signs are that we will have some positive messages.

That said, the share prices of quoted companies seem to have been running below their regulatory capital values, by and large, for the last 18 months. I say `seem to' because it is difficult with diversified businesses to isolate the regulated element. This is not necessarily indicative of a fundamental disconnect between markets' perception of risk and the regulator's view, as has been suggested. At this stage in the price control cycle, it is not too surprising to see some discount for the risk that companies may not succeed in meeting or outperforming the regulator's target. Nonetheless, overtime, if efficient companies are to be able to finance their functions – one of my primary statutory duties – they must be able to reward adequately those who invest in them. It would be a cause of concern if widespread discounts were to prove persistent. I believe that there are a number of reasons, many going wider than the water sector, for the present position. I note that sector share prices have recovered very significantly since this time last year. But one of the factors cited by investors and their representatives in the City for weaknesses in the price is the whole issue of 'regulatory uncertainty'.

Some 'regulatory uncertainty' is unavoidable if the regulator is to do his job properly on behalf of customers. But it is my job to reduce that uncertainty to the necessary minimum. To that end, I have begun holding regular briefings for City interests, which I shall maintain. As we begin to plan for PR04, I am also considering how the periodic review might be improved, to reduce uncertainty and ensure the proper balance of incentives.

I recognise the potential impact on the cost and availability of capital of the uncertainties that are created by regulation. Ofwat is committed to deliver transparent, rational regulation, as predictable as changing circumstance allows. We are trying to be transparent in our approach to financing the industry. Our aim is to avoid sudden shocks for companies or investors, whilst we shall remain rigorous in pursuing the interests of customers both now and for the future.

On transparency, we are developing a new financial model, for the next review. We have listened to stakeholders' views and we will share the model, software, equations and the rule book. The industry - and the City - have welcomed that initiative.

Our commitment to increased transparency goes wider. We published far more in the last review than in 1994. But there is more to do. When we explain our decisions, for example, we need to set out how we have taken account of stakeholders' views.

I am committed to ensuring that our work, and the decisions we make, are communicated and explained. For example, the recently-published tariffs report for the first time included a report on our decisions on those proposals from the companies that either we did not approve, or we deferred for consideration next year. Our objective is to ensure that interested parties cannot say they do not understand our decisions. Informed stakeholders are better able to contribute to debate and so encourage better decisions.

There have been calls from the industry for a radical Government led review – a vision for its future. It is for Michael Meacher to respond, but I have to say that as I see it the building blocks for the future are being steadily put in place. They include developing work on supply and demand, contributions towards thinking on the future scale of the capital programme, and the development of competition in the sector.

Restructuring

There has been much discussion of restructuring in the water industry. The successful financing by Glas Cymru in its purchase of Dwr Cymru has shown that the markets are willing to invest at reasonable cost. No other company has yet announced major restructuring proposals (although several have raised the issue). It is for the companies not the regulator to decide whether to bring forward proposals in the future.

It is not my job to dictate the operational or capital structure of the industry. I firmly believe that these are matters which should be market led – a centrally imposed model for the industry which seeks to work against the market, rather than with it, will always run the risk of failure. Moreover, I welcome innovation, and I believe the industry should have the incentive to seek out and bring to fruition new methods that can deliver benefits for all concerned.

That said, the equity model has worked well. It is delivering improving efficiency savings and levels of customer service, whilst enabling the companies to deliver huge environmental improvement programmes.

Whatever the structure, it is our job to ensure that customers' interests are protected and that we maintain regulatory effectiveness. For example, we would not want to see companies gearing up now, if this might impair their ability to finance future investment programmes at reasonable cost in the long term. I shall look at any further restructuring proposals with this in mind.

The issues of principle raised by the Kelda and Glas proposals are still relevant.

Thus:

1. Can incentives for improving efficiency be maintained in the absence of shareholder pressure?
2. What are the benefits and risks for customers?
3. In competitive outsourcing, how can safety be maintained? This is not negotiable. Licence modifications can be put in place to underline the fact that all responsibilities remain with the licence holder. If necessary the licence holder can be prosecuted for failure by its contractors.

Risk, and whether it can be reduced as a result of restructuring, has been the subject of some debate. One company argues that a heavily geared structure does not reduce risk, it simply reallocates the levels of risk between different stakeholders. Another argues that well thought through restructuring can reduce risks and thereby benefit all stakeholders

That said, the debt markets demonstrated a significant appetite for the Glas issues. The company secured funds at a cost consistent with its financing plan and below what we assumed at the last periodic review. Amongst the reasons they gave for their success were:

• mitigation of default risk through credit enhancement;
• elimination of diversification risk through restrictions in the articles of association and bond deeds; and
• specific creditor protections, including pledges over shares, prioritisation of calls on cash flows and step-in-rights, always subject to the operating licence and the Water Industry Act.

However, I do not see the Glas model as a straightforward template for others. There were some particular factors in that case - not least the existence of a willing seller and a willing buyer independent of one another and the role of the National Assembly for Wales. The success of Dwr Cymru in delivering efficient services to customers, within a sufficiently flexible capital structure, can only be tested over time.

Whatever the structure, I shall seek to ensure parity of regulatory treatment for all water companies. I issued MD166 at the time of my decisions on Glas and that set out a summary of the regulatory framework as it affects investors, which I hope goes some way to dealing with regulatory uncertainty.

Competition

The Government announced on 30 March 2001 the outcome of the consultations it started a year ago. We welcomed the statement and look forward to taking this initiative forward. We note, however, a key missing element in respect of economic instruments to facilitate trading.

We are not waiting around for an eventual Water Bill. We are making progress under existing legislation. But we should find it easier with sector specific competition powers.

The March announcement proposes legislation to enable me to license new entrants into the market for production and retail activities. The incumbent water companies would remain vertically integrated statutory undertakers, retaining their important strategic water resource and environmental duties. Other companies would be given clearer rights to enter the water market, providing the opportunity for innovation and efficiency gains to give customers better deals. Public health, the natural environment, and the high quality of drinking water would continue to be safeguarded. I welcome those proposals, but there is a deal of work needed to turn them into useable form that will develop competition whilst avoiding excessive regulation.

We still await important further proposals from Government before a coherent Water Bill is available. The published elements of a draft Bill were silent on how access to water, the basic raw material, can be more effectively opened to competition. The draft included a number of reforms to the abstraction licensing regime, but on the issue of competition in this area we await specific proposals. The Government consulted separately last year on proposals to make licences more easily tradable and to sharpen incentives in charging for abstractions, but it is still to publish its response. It is vital that the legislation should be drafted with the links between reform of abstraction and the development of competition in mind. We need a regime that is flexible and adaptable allowing for competition to emerge, while protecting the environment. In the right framework, competition could sharpen the incentives to use water more efficiently, with benefits for both customers and the environment.

Competition - recent work

There has already been some limited progress in effective competition, mainly for business and industrial customers. Much of our current work is based around the new obligations on companies to comply with the Competition Act prohibitions on anti-competitive behaviour and abuse of a dominant position:

• Common carriage guidance

One company – Severn Trent - has taken the lead in developing ideas about common carriage, including the possibility of a single access code. We welcome this as a valuable contribution to the debate.

We too are active in this area. In August we will launch a consultation on best and reasonable practice for the companies' access codes for common carriage. We will invite the companies, and others, to take part in a workshop in September. We are not looking to replace companies' existing codes, or produce a single code for all companies. Instead, the outcome of this work will be to develop a set of core criteria which companies should adopt to minimise the risk of their codes breaching the Competition Act.

Mergers

Finally, a word about possible mergers. Could we manage with fewer comparators, having already gone from 39 to 24 since privatisation?

All the water companies are now above the asset threshold set down in legislation. This means that any merger proposal that includes two England and Wales companies, would result in an automatic reference to the Competition Commission and the final decision would rest with the Secretary of State for Trade and Industry. The Commission would need to assess the public interest detriment and decide on any possible remedies that could mitigate or eliminate this detriment. In the last three cases the MMC (as it was then) concluded there was a substantial detriment to the comparative regime and that there was no satisfactory remedy that could mitigate or eliminate the harm. The SoS accepted the Commission's advice and the mergers were blocked. The MMC was also conscious that, as the number of independent comparators reduces, the harm increases.

The other side of the coin is whether the proposers can demonstrate a reasonable likelihood that measurable benefits will be realised which can be shared with customers.

This brings us to the issue of national champions - including take-overs of British companies by foreign owners. Regulators are sometimes blamed for tilting the playing field by our approach to regulation. But the issue of national champions is not one for Ofwat. Regulation and ownership are not directly connected issues. Our job is to encourage through regulation the development of efficient companies that can deliver good value to their customers – who owns the companies is irrelevant provided they are fit and proper persons. Business combinations involving a holder of an existing water appointment in England and Wales are subject to normal merger control regulations, including the mandatory Competition Commission reference provision of the Water Industry Acts in respect of combinations between two (or more) holders of existing appointments. Size may indeed be a relevant factor for new entrants in international markets, but in the UK context our comparative work does not suggest any clear correlation between size and either efficiency or quality of service to customers. In general, the UK water industry is among the most efficient and technically advanced in the world. But experience gained in other markets or sectors, where different conditions prevail, may help the development of new and better practices that can also benefit water customers.

Conclusion

Last week the 'influential' Lex column in the Financial Times predicted that the 'new' Minister for the Environment and the regulator would 'hear but not listen' to the troubles of the industry. I assure you that I am both listening and looking. But I am listening to all stakeholders, including customers. I believe the industry can take credit for many of the successes of the last 12 years. I also believe that with fair and transparent regulation it can rise to the inevitable challenges of the next decade and beyond.