Philip Fletcher speech: Dimensions of sustainability, IWO Conference, Peterborough

TALK

IWO CONFERENCE – PETERBOROUGH

'DIMENSIONS OF SUSTAINABILITY'

SUSTAINABILITY AND ECONOMIC REGULATION

PHILIP FLETCHER

27 APRIL 2001

Anyone who works at the top of a 20-storey building is in danger of being accused of having an 'ivory tower mentality'. So in my first nine months at Ofwat I have made a point of getting out of the office and have now visited almost all water companies on their own ground. I have also visited environmental groups, customer representatives, investors and City interests.

Since I was last closely involved with the water industry, at the time of privatisation, it has notched up many significant achievements which should be recorded. They include improvements in the quality of drinking water; river quality; sewage treatment work compliance; and since the 1995 drought, a significant reduction in leakage.

There has of course been a price to pay. Bills are up by 19.5% in real terms. But the efficiency gains made possible a reduction of 12.5% in customers' bills last year, a reduction which in effect shared the benefits of greater efficiency equally between customer and shareholder. Whilst paying tribute to the industry, I should add that this achievement is in part at least due to the pressure of the three regulators – Ofwat, the Environment Agency and the Drinking Water Inspectorate – on what are still local and regional monopolists to improve their performance.

My visits have also given me a clear view of my own job. It is not to manage the companies. It is not to dictate forms of ownership. It is not to determine how companies will do their jobs.

It is to provide a framework and incentive within which companies can deliver a first class service to the customer. It is to enable efficient companies to finance their functions and to stimulate the less efficient to improve further.

My strongest card in regulation is my ability to compare. From my ivory tower I do not say to a company, 'I think you could do better'. Rather I can point to other companies which are already doing better and provide the evidence for it. In all our work, Ofwat needs to be fair and to strive to be transparent, predictable and also flexible. I need to take account of external developments. Which brings me to the subject of my talk.

Is this a contradiction in terms? Last year, the Environmental Audit Committee produced a report on the last periodic review (water prices and the environment, HC597-1). It criticised Ofwat for appearing to demonise the environment. The Committee noted that Ofwat does not have a specific duty to promote sustainable development, by contrast with the Environment Agency. It referred to a previous 1998 Committee report claiming that Ofwat had seen its role 'in terms only of protecting the consumer from rising bills'. It noted that current water industry legislation already provides for me to be given environmental and social guidance by Government in carrying out my job. But it suggested that in addition, when new legislation is passed, I should have 'a specific duty to have regard to sustainable development'.

The recommendation was made very soon after I arrived at Ofwat. My initial reaction was to question whether the Committee's recommendation was appropriate. Clarity and transparency are key parts of my job. I need to provide a firm framework of economic regulation within which companies have the incentive to carry out their functions as efficiently as possible, to the benefit of both shareholders and customers. And it is my job through setting price limits to ensure that customers receive a fair share of the benefits that flow from the greater efficiency of companies which continue to enjoy effective monopolies across their geographical area. Would it cause confusion between Ofwat and say the Environment Agency if both of us had a duty to take account of sustainable development?

Sustainable development is not just about the environment. As the Government has made clear, it is also a matter of focusing on the long term. Their stated objectives were:

All this is to be within ten guiding principles including taking a long term perspective; taking account of costs and benefits; creating an open and supportive economic system; respecting environmental limits; the precautionary principle; using scientific knowledge; transparency, information, participation and making the polluter pay. All of these elements are already part of Ofwat's thinking in our approach to economic regulation. If I pick out one, it would be our particular emphasis on the need to take account of costs and benefits in whatever we undertake.

So when I gave evidence to the EAC about their report six weeks ago, I said (I think slightly to their surprise) that I agreed with their recommendation and that I would be happy if and when a Government gets round to a new Water Bill, that Ofwat as well as the Environment Agency is made subject to a duty to take account of sustainable development.

I do not see this as marking a sea change in Ofwat's approach to regulation. Rather, I believe that it would help to continue to focus our thinking on key aspects of the regulator's task. Thus, I welcomed the original intention that I should share this platform with Baroness Young as Chief Executive of the Environment Agency. Sustainable development duties or not, Ofwat and the Environment Agency have key complementary roles to play in the regulation of the water industry, joined with our colleague Michael Rouse, the Chief Drinking Water Inspector. We shall continue to have a lively debate on the various issues and specific investment proposals as the next capital programme, AMP4, is developed. But I believe that we shall start from a common platform of understanding, to the benefit of the industry, its investors and its customers.

The water industry, as you know, has undertaken a huge programme of capital investment since privatisation, a programme which represents roughly a doubling of the level of investments seen in the 1980s. Much of that investment has been to fulfil our obligations under European directives, obligations which have already achieved significant improvements in terms of sustainability.

Equivalent levels of investment will continue to be needed under AMP3. These should enable the water industry to achieve the largest improvement programme ever undertaken for environmental ends including specific projects to improve or prevent deterioration in almost 4000 kilometres of river (and more as an indirect result of other projects). It includes provision for improving 1800 sewage treatment works and 4500 unsatisfactory overflows from the sewerage system, as well as over 500 projects at water treatment works and 22000 kilometres of water mains renovation further to enhance drinking water quality.

The capital programme pays continuing attention to public health. Since AMP3 was established, Michael Rouse's thinking has developed and the Drinking Water Inspectorate's approach to meeting the new lead standards now focuses initially on plumbo-solvency control rather than moving straight to lead pipe replacement. This approach also deals with lead in household plumbing.

Also, the extent of cryptosporidium monitoring is developing in the light of reviewing risk assessments.

The AMP3 programme has the flexibility to cope with such developments. We shall expect water companies to work within the totals agreed in the programme, although the emphasis is being switched. The interim determination mechanism is there if needed to cope with major changes. Ofwat, of course in the interests of customers will be attentive to ensuring that increases are justified and significant. In just the same way we are continuing to take a close interest in the value of those schemes which were not at the time accepted into the quality improvement programme by the Government – mostly those schemes where the cost of improvement appeared to be very high in relation to the benefit. One such scheme, in Wales, was accepted in the interim determination for Welsh Water which took effect on prices this month. Others are still under debate.

Looking forward, it is too soon to say what level of programme is going to be needed for AMP4. But the water industry and the regulators recognise the need to do our thinking together. One big topic will be the level of investment required in capital maintenance. I know that Chris Binnie is due to speak to you later. I have to say (to get my view in first) that I do not think that the right approach to achieving sustainable development is simply to renew all those assets in a poor condition. Judging by individual companies, nor does industry. The focus should continue to be on serviceability – do these assets continue to be fit for their purpose? Overall during the 1990s serviceability has, we believe, been at least stable and in most cases improving – the reason we cannot know for sure is that the base data for the period immediately after privatisation was inadequate. It is now much better.

But it is essential that we should not simply shout our respective views at each other. That is why I welcome the work being undertaken by UKWIR for the industry on serviceability, in which Ofwat will play a full part. It will complement, I believe, the work which is jointly being done by Ofwat and DWI on the serviceability on drinking water assets. The results of phase 2 of this study will be published shortly and should help us to develop better service indicators of serviceability in time for the decisions on AMP4. Similar work is in preparation between Ofwat and the Environment Agency on the waste water service.

Debate on the implications of climate change are another part of the equation. Ofwat is staying closely in touch with that debate as it develops. In the interests of sustainability it is essential that we tread the fine line between doing nothing in the hope that nothing will go wrong, which would be complacent, and, on the other hand, seeking to anticipate and to invest wastefully in infrastructure that may at best be unnecessary and at worst exacerbate problems.

But I want to use my remaining time to say a little more on other issues bearing on sustainability and regulation and in particular the lively debate around restructuring in the water industry and the development of competition for the market.

Of course historically there has always been an element of competition for the market – that is for the provision of outsourced services to water companies. The recent proposals by Glas Cymru for Dwr Cymru/Welsh Water take this further in proposing to outsource all operations and customer services to third parties. Glas is a new company, which was formed for the sole purpose of purchasing the assets of Dwr Cymru. It is a company limited by guarantee and owned by its members rather than shareholders and will be wholly financed by debt. The proposals represent a novel way of operating and financing a regulated water company. Following consultation I announced a few weeks ago that, subject to a number of conditions, I was content for Glas Cymru to go ahead and seek financing for the acquisition.

However each element of this proposal raises potentially difficult regulatory issues:

2 What are the benefits and risks for customers? Have they been properly consulted? Is the purchaser independent of the seller?

3 The proposal requires competitive outsourcing. For Welsh Water, United Utilities has now won the operational contract, and Thames the customer services contract. Client and contractor must be fully aware of the overriding importance of safety. This is not negotiable. But neither is it insurmountable and Glas has agreed with the safety and environmental regulators licence modifications to underline the fact that all responsibilities must remain with the licence holder, Dwr Cymru. If necessary they can be prosecuted for failure by their contractor.

4 Of course exposing companies' costs to the rigours of market-testing is important. Where this leads to further efficiency savings then it is to be welcomed. This will depend crucially on whether or not the market for service provision is sufficiently well developed. The anecdotal evidence suggests that there should be a healthy competitive market for the provision of these services.

I don't however see the role of the regulator changing - as some have recently suggested - to one of simply monitoring the competitive tendering process. I don't accept that this would be in the interests of customers. We would have no way of knowing whether, had the services been provided in-house or let in a different form, its costs would have been lower. So, comparative competition will remain in force. There will be no automatic pass through to customers of outsourced costs.

5 The outsourcing of the operations is integral to the second element of the proposals - the intention to finance the company entirely by debt. The proponents and their financiers see the outsourcing as a key element in reducing the risks faced by the company and enabling them to secure lower cost debt-financing. The markets now need to make up their own minds.

There were a number of factors particular to the Welsh position: the clear separation and independence of buyer from seller; the discount to regulatory capital value which provides an initial reserve – the equivalent of an equity cushion; and the support of the democratically accountable body, the National Assembly for Wales. So I do not see the proposal as a model for the industry as a whole. The current shareholder-owned model has worked well. It is delivering efficiency gains for the benefit of customers and shareholders whilst the water companies have been carrying out their greatly expanded capital expenditure programme. A company needs to have good reasons to change that model.

More water companies and potential entrants are emerging to join the few that were already actively considering how and where to compete. In particular, the prospect of common carriage becomes stronger as the first opportunities are being explored. And the Competition Act began to make its presence felt, with receipt of the first complaints alleging anti-competitive behaviour by companies.

But by comparison with other regulated industries, competition has yet to take off properly. In electricity, the 14 regional public electricity suppliers have been joined by 14 new suppliers to business, five of which also supply households. In gas, the number of new suppliers is even greater. Customers have a real choice.

Is the water industry just behind the game compared with gas and electricity? There is more to it than that. The difficulties include – water resources are not evenly distributed throughout England and Wales – wet West, dry East. In relation to its sale price, water is expensive to move around. The development of new sources of supply may be costly. There is no "national grid" either for water supply or wastewater disposal. Most domestic customers pay not on the basis of consumption through meters but on the basis of rateable value – a yardstick outmoded for almost every other purpose.

Safe drinking water is a key indicator of quality of life, although safety is also essential for gas and electricity. But the gas and electricity suppliers' job ends with delivery to the premises. Dealing with wastewater safely and in accordance with environmental requirements is almost as complex and expensive as the supply of safe palatable drinking water. And water provision is a very different business from wastewater disposal. So the prospects for competition need to be considered separately for each. The lower average household bill for either utility - £103 for drinking water – is a lot lower than energy bills - £250 for electricity and over £300 for gas. So the scope for financial savings/profit may be less.

All of these factors suggest that a national market may take a while to develop. But that is no reason to give up. I believe that there is a lot of scope to move beyond our present position.

Progress has been slow so far. But there has already been some limited progress, mainly for business and industrial customers.

The threat of competition has, I believe, had a significantly bigger effect than actual price competition so far. Companies, wary of competition, have introduced more cost reflective tariffs for large customers. They have sought to understand better their needs and produce a more sophisticated service for them. They have introduced more sophisticated tariffs including seasonal and interruptible variations and combinations of standing charges and volumetric rates. I welcome that.

More recently, Ofwat has undertaken three significant pieces of work aimed at increasing effective competition in the industry. Two of these are based around the new obligations on companies to comply with the Competition Act prohibitions on anti-competitive behaviour or abuse of a dominant position. Ofwat has new, stronger powers to investigate complaints and suspected breaches of the Act, and to apply remedies where infringements have been found to take place.

We have nearly completed a survey of companies' policies and practices. We will consult shortly on what we see as sound practice. We expect house builders and developers to be able to choose who lays the new mains and provides other infrastructure. Powers under the Competition Act and the sectoral legislation enable us to ensure that companies put in place workable policies.

Last autumn the water companies published their access codes – the terms for access and operation of a common carriage arrangement. Much of the content of the codes followed guidance provided by Ofwat on reasonable terms for access. But publishing a code is not the end of the process. Negotiations between companies over the first few opportunities for common carriage have shown that having a code, and reaching a common carriage deal, are not the same thing. We have had some complaints about incumbents' behaviour towards potential competitors – such as unreasonable delay and lack of transparency in providing information – and the terms of access for common carriage, such as the basis for an access price. We have told the companies that they risk infringing the Act if they do not offer reasonable terms for access, or cannot explain objectively why access is not practicable.

Ofwat will be consulting on best and reasonable practice for common carriage. We will draw out examples of good practice in companies' codes and Ofwat's experience of managing common carriage cases. This is not intended to replace any company's access code, or act as a single code for all companies. Instead, we will publish a set of criteria which companies should adopt if they want to minimise the risk of their access codes breaching the Competition Act. If you like, it will be a rule of thumb for the likely ways in which Ofwat might determine common carriage disputes and guidance for aspirant entrants to the water market, as well as to the industry itself.

My first nine months have been anything but a gentle settling in period. And the water industry has had a lot more to cope with than Ofwat, including problems with fuel, floods, freezes and now foot and mouth. I have no doubt that we will continue to have some interesting times ahead over the next few years, and some difficult moments. I wish the industry continuing success in its drive for a better deal for customer, investor and environment alike. You can expect the regulator to be there encouraging you forward, and sometimes perhaps pushing you rather faster than you would ideally like to go.