Response by the Director General of the Office of Water Services to the Government green paper, "A fair deal for consumers: modernising the framework for utility regulation"

Response by the Director General of Water Services to the Government Green Paper
A Fair Deal for Consumers: Modernising the Framework for Utility Regulation

THE DIRECTOR'S RESPONSE TO THE GREEN PAPER

Following its review of utility regulation the Government, on 25 March 1998, published its proposals for change in a Green Paper entitled "A Fair Deal for Consumers." This submission to the President of the Board of Trade sets out the Director's response to those proposals.

The Director welcomes the Green Paper as a whole, in particular its evolutionary approach to the difficult task of regulating important elements of the nation's infrastructure. He is pleased that many of the suggestions made in his submissions to the review, in September 1997, and subsequently, are reflected in the proposals now made.

This submission focuses on those aspects of the Green Paper on which views are specifically sought.

The comments in this submission follow the order of the Green Paper, with reference to the specific proposals summarised on pages 60-65 inclusive.

Ofwat welcomes the proposal (Proposals 2.1) for the Government to issue statutory guidance on social and environmental objectives; and for regulators to be placed under a secondary duty to have regard to such guidance in the exercise of their statutory functions. Ofwat also strongly supports the proposal (Proposal 2.3) that social or environmental measures which have significant financial implications for customers, or for companies, should be decided by Government and implemented through specific legal provision. These proposals reflect recommendations made by the Director in his initial submission to the review.

The Director has already, in respect of the 1999 Periodic Review of price limits, sought ministerial guidance on future water quality and environmental standards to be met by water and sewerage companies, so that there is clarity about the companies' future functions that need to be financed.

The Government's consultation paper on water charging, "Water Charging in England and Wales: A New Approach," covers most of the social issues in the water industry and Ofwat is pleased that it recognises that those proposals with financial implications, and those involving an element of cross subsidy between customers, should be implemented through legislation.

It is important, however, that statutory guidance on social objectives does not extend in scale or scope to matters which should be dealt with through taxation and/or the social security system.

The Director sees advantages in ministerial guidance being issued periodically to link with the five year cycle for reviewing price limits. This would ensure stability and avoid potentially precipitate changes which could affect the cost of capital, and ultimately customers' bills.

The Government seeks views (Proposal 2) on whether the existing duties in respect of social and environmental objectives should be retained, and extended, to align with the scope of ministerial guidance, for example, to cover low income customers. In Ofwat's view the regulators' duties should be aligned in this way, in order to secure clarity, and statutory authority, for the decisions taken by regulators in response to that guidance.

The Director welcomes the proposal (Proposal 3.1) to recast the regulators' duties to give primacy to the protection of customers' interests (which include matters relating to quality of services as well as prices). This is something that he recommended in his initial submission.

The proposal refers to giving due weight "to (customers') longer-and medium- term interests as well as to their immediate or short term interests." The advantage to customers of the incentive based RPI - X form of regulation, which the Government proposes to retain, is essentially a medium term or longer term advantage. Clear recognition of this in the recasting of the regulators' duties is essential to avoid an otherwise short term approach to regulation which could increase the cost of capital and more generally not be in customers' interests.

Ofwat believes that the Director's duty to secure that existing Appointees can finance the proper carrying out of their functions (in particular, by securing reasonable returns on capital) is a key part of the regulatory regime and welcomes the statements in the Green Paper supporting its continuance. To alter it in any fundamental way, other than making it subject to the duty to customers, could, for little gain, create considerable uncertainty in the financial markets. It could be seen as retrospective. It would increase the cost of capital and reduce its availability. Ofwat, however, supports the proposal in paragraph 3.8 to ensure that this duty does not entail support for inefficient companies.

The duty to secure reasonable returns on capital, however, does currently have an unfortunate implication for inset appointments. The nature of these appointments, unique amongst the utilities, is such that the Director's duties apply equally to their holders. Ofwat considers that the Director should not be under any obligation to assess and endorse the financial viability of potential new entrants prior to granting them licences. Such a requirement acts as an effectual constraint on the development of competition in the water industry. Ofwat would like consideration to be given to this issue as part of any proposed revision to the Director's duties.

Ofwat shares the ONCC's disappointment at the Government's proposal (Proposal 3.2) to alter the present arrangements for customer representation by setting up new councils with independent statutory status. In Ofwat's view the proposal to make protection of customers' interests the regulators' primary duty weakens the case for change. The Director recognises the case for strengthening the representational role of the existing ONCC and believes that the suggestions made in his submission to the review are worthy of reconsideration. In the meantime he will continue to treat the ONCC, and the Customer Service Committees (CSCs), as independent representatives of customers' interests.

Quite apart from losing the advantage of integrated operational working, Ofwat is concerned at the potential, albeit temporary, loss of effectiveness due to the inevitable upheaval and uncertainty inherent in such a change. Ofwat agrees, therefore, with the ONCC that the changes proposed in the Green Paper should not be implemented until completion of the 1999 Periodic Review, and would welcome a clear statement to that effect.

Ofwat agrees broadly with the scope of the responsibilities envisaged for the new councils as set out in paragraph 3.11 of the Green Paper. The key criterion is that the responsibilities of the new councils should complement, rather than duplicate those of the regulators. Separation inevitably carries the risk of the latter, however carefully the statutory responsibilities of each are defined. This points to the importance of the regulator and the new councils consulting with each other on their forward work programmes.

The Director agrees that regulators should have a specific duty to consult the new consumer councils in reaching key decisions. This reflects his current practice. He questions, however, whether the suggestion, in paragraph 3.13, for a special entitlement for a unique right to extra consultation on price limits and exchange of correspondence is necessary given the proposed changes to his statutory duties and the proposed requirement to give reasons for decisions. The Director agrees with the suggestion regarding access to information set out in paragraph 3.12.

On a practical note, and in the interests of continuity, efficiency and economy the Director recommends that:-

The existing statutory arrangements give the regulator responsibility for certain complaints, including those in respect of which he has powers to make binding decisions. These arrangements, including customers' right to complain to the regulator about inadequate investigation by CSCs, have worked well and reflect the proper balance of responsibility, proposed in the Green Paper, as between the regulator and the proposed councils. These arrangements should be retained.

Ofwat welcomes the conclusion (paragraph 3.28) to retain RPI – X as the best basic system for price regulation, provided regulators judge that this provides the best deal for customers – and the Director does.

The Director welcomes the support for a regulatory regime which allows companies to benefit from their own efforts as this provides a crucial incentive for companies to become more efficient. Gains in efficiency benefit both customers and shareholders. At periodic reviews, regulators have considerable discretion, under RPI-X, in determining the customers' share of benefits through the frequency of the reviews and the treatment of efficiency gains. In the recent publication, Setting price limits for water and sewerage services, the Director announced his intention to reduce the period between reviews to five years and to pass on past efficiency gains to customers through an initial price cut. Both have the effect of increasing the customers' share of benefits.

There are, however, more detailed considerations. It is of cardinal importance to keep down the cost of capital for the regulatory utilities. To that end, the form of regulation, including any Error Correction Mechanism, should have regard to the criteria of certainty, simplicity and symmetry.

To preserve incentives, there should be the minimum of uncertainty about the returns that companies will be able to retain. The Director therefore welcomes the suggestion that any Error Correction Mechanism supplementing RPI-X, should be a "clear and in-built" means of sharing benefits. In his view, there should be a minimum number of pre-defined specific factors (for example, unexpected changes in forecast capital price inflation) against which outcomes would be measured, as well as an explicit and pre-determined mechanism for calculating any adjustments.

RPI-X is simple and now well understood. Adding to the complexity of the regime by the introduction of new and opaque correction mechanisms will result in the industry being less well understood by the financial markets. Lack of understanding increases costs.

Any Error Correction Mechanism, which might be implemented between reviews, should also be symmetrical. A system under which customers receive the benefit of unexpected changes to specific factors outside the companies' control, yet shareholders bear any losses would result in a disproportionate increase in the cost of capital which would result in higher bills for customers.

The issue is fundamentally about who should bear business risk, customers or shareholders. The Director believes that it most naturally lies with shareholders. At the time of privatisation, the water companies' licences contained a number of provisions which allowed certain specified costs or benefits to be passed through to customers between reviews, thereby leaving them open to the associated risks. The Director has been gradually reducing the number of such items, in order to place such risks on shareholders. For example, only four out of the original 28 companies still retain a provision in their licences relating to unexpected changes in construction price inflation (COPI). For these companies, therefore, an Error Correction Mechanism already exists for this exogenous factor. It may well be the only pure example of such a factor likely materially to affect the water industry.

The Director would support the use of a mechanism in cases where a company had been found to have willfully misled the regulator. It should be recognised, however, that such instances would be rare and would probably require third-party adjudication.

In summary, the Director considers that the RPI – X regime as currently implemented secures the transfer of benefits to customers, at the next review, while maintaining sufficient incentives on companies to create those benefits. He does not believe that Error Correction Mechanisms would add significantly to the benefits for customers. Nevertheless, to avoid adding to costs for customers, and damaging incentives, any Error Correction Mechanism should be symmetrical as between customers and shareholders, simple to understand and certain as to the factors which may result in the adjustments, and the precise mechanics of any such adjustments.

Proposal 3.6 seeks views on how a closer link might be achieved between Directors' remuneration and the achievement of rigorous customer service standards.

Supervision of boardroom pay is a matter for shareholders and not regulators. Nevertheless, the Director supports the Government's view that all utility companies should adopt best corporate practice in setting arrangements for determining boardroom pay.

He also believes that shareholders will have appropriate incentives to influence boardroom pay, through the normal corporate governance avenues, if regulators explicitly and transparently take account of companies' overall service standards in setting price limits. The Director has recently announced proposals to do this at the 1999 Periodic Review.

Ofwat agrees with the proposal (Proposal 3.7) that regulators should use their powers to impose service standards "to ensure that the consumer is provided with a high quality, value for money service." Setting service standards is not, however, the only mechanism, and moreover is a mechanism that has limitations, especially for some aspects of service in the water industry. There are other mechanisms, such as taking account of past performance when setting price limits which the Director proposes to use in the forthcoming Periodic Review, and the regulator should have discretion to determine the best mix of measures to ensure the desired outcome.

The Director welcomes the proposal (Proposal 3.8) to give regulators the power to impose fines for breach of overall performance standards. This is particularly relevant to service failures that cannot readily be covered by guaranteed service standard schemes. He questions, whether fines for breaches of individual service standards is necessary, or desirable.

Section 4.16 of the paper states that the Government is currently considering how to take forward the proposals made with respect to developing competition in the water industry in the publication Water – increasing customer choice (published in April 1996 by the then Department of the Environment and the Welsh Office). The Director at the time supported these proposals and believes the Government should seriously consider actively taking them forward, particular with regard to common carriage. The Competition Bill currently before Parliament will provide increased powers to deal with abuses of a dominant position and anti-competitive behaviour. This is likely to mean new powers to deal with predatory pricing and potentially open up the market to common carriage. The Director, however, believes that it would in any case be sensible to legislate specifically for common carriage in the water industry rather than rely entirely upon provisions within the Competition Bill.

Paragraph 4.16 of the paper also states that the Government is considering the possibility of changes to water abstraction licensing, to provide greater scope for new entrants in water supply. The Director supports this and believes that this issue should be tackled in the DETR's Review of Abstraction Licensing. In particular, the Director would like to see proposals for the greater use of economic instruments (eg changes to the structure of abstraction charges) and the need for a simple mechanism for the revocation and compensation of abstraction licences.

The Green Paper suggests that there are insufficient checks and balances on individual regulators and invites views on whether they should be supported by a statutory advisory group and/or replaced by a small executive board or commission.

This is an issue on which there are likely to be many and different views. There is no obviously right answer; and outcomes will always be influenced by the individuals involved whatever the institutional arrangements. In the Director's view choices should be judged against basic principles.

First, there should be clear accountability for the decisions taken. This is most easily achieved by the single regulator. The idea of a statutory advisory board, however, would not meet this criteria. The advisory members, if appointed by the Secretary of State rather than the regulator would have significant independent power but little or no accountability to anyone. There would be confusion and uncertainty about responsibility.

Second, those responsible for decisions should be closely attached to, and have responsibility for leading the regulatory office. A commission with part-time members is likely to become detached from the office.

Third, there should be the ability to act quickly when circumstances require, and experience to date has shown this to be sometimes necessary.

In the Director's view the fundamental choice is between a single regulator and a commission or executive board.

A number of the proposals in the Green Paper would in themselves minimise "the risk of unpredictable and unaccountable decision making." These, which include the proposals for a social and environmental framework, a requirement to take account of the views of the consumer councils, consistency between regulators, a strengthened MMC and proposals regarding transparency and predictability, lessen, in Ofwat's view, the need for change.

Ofwat welcomes the commitment (Proposal 7.2) to ensuring sufficient resources available to regulators. The resources need to reflect the growing complexity of regulation (for example, the changes in the structure of the industries and the rise of the multi-utilities) as well as the proposals for transparency and predictability which, though welcome, do have resource implications.

Ofwat agrees with all the proposals for improving transparency and predictability:

A Code of Practice governing Ofwat's consultation and decision making process is being developed to formalise current practices, and this will be the subject of consultation with other regulators. Ofwat has already published a detailed programme for the forthcoming 1999 Periodic Review, following public consultation. This sets out the procedures to be followed for involving others in the decisions that have to be taken.

Ofwat has published a summary of its business plan for 1998-99 but recognises that this will need to be developed in future years to meet the full intent of Proposal 7.4.

As the Green Paper acknowledges, the Directors General of Oftel, Ofwat, Offer, Ofgas, meet regularly, with the Directors General for Electricity Supply in Northern Ireland and the Rail Regulator, to review issues of relevance to all sectoral regulators. The Public Accounts Committee, in 1997, examined the issue of consistency between regulators and recommended developing the contacts between individual offices, but recognised that many of the apparent differences between regulators stem from the nature of their respective industries, and differences in the evolution of competition, rather than overly individualistic regulators.

Ofwat agrees that the existing arrangements could be developed and strengthened to ensure that regulatory decisions are consistent and to provide a wider basis for debate about regulatory principles and processes which are of general relevance.

The Green Paper presents two options for achieving this. Ofwat does not support the concept of a Technical Advisory Committee established on a statutory basis. Although the Government states that the role of the Committee should be advisory rather than binding it would nevertheless be a new regulatory body which will confuse the independence and accountability of individual regulators. Inevitably it will create uncertainty and add to costs. The Green Paper does not explain how such a body would interface with the MMC's role, even though the latter, as the main appellate body for regulatory decisions, should surely play an important role in securing consistency on key regulatory principles.

Ofwat strongly prefers the second option. However, rather than placing regulators under a duty to consult on matters of common interest, regulators should be under a duty to consider collectively such matters, and to report periodically on this work. Ofwat also sees advantage in the suggestion that regulators should be required to review collectively specific issues when requested to do so by the President of the Board of Trade. Indeed, the request to report on the issues posed by multi-utilities (Proposal 7.9) is a timely example of this.

In general, the Director supports the proposal (Proposal 7.13) to make the MMC's procedures more open. Hearings might usefully be made open to the main parties. It would, however, still be necessary to make provision for the submission and discussion of confidential information. The question of confidentiality should, however, be tested against clear and predefined criteria such as in the Freedom of Information proposals.

The Green Paper invites views (Proposal 7.14) on options for redefining regulators' discretion in determining licence modifications following references to the MMC. The Director strongly believes that it would significantly reduce uncertainty, for companies, customers and in the financial markets, as well as the duration and cost of appeals, if the MMC were to be as far as possible the body of final appeal. This would mean reducing regulators' discretion to a minimum in implementing MMC conclusions.

It is valuable to distinguish between the MMC's role in price limit determinations and other licence modifications. In the case of the former for water, the MMC is required to redetermine the price limits, and, as the paper states, its conclusions are final. This should be extended to other sectors for price limit determinations.

For other licence modifications, matters are more complicated. On balance, the Director prefers the approach of paragraph 7.59 under which the regulator would be required to consult with the MMC on terms of the proposed modification prior to the statutory consultation. This would have the effect of limiting the regulator's discretion, without unduly lengthening the process - which could happen if the regulator were subject to a further duty to refer his or her proposals back to the MMC for final endorsement. This could prove unnecessarily protracted and bureaucratic.

The Director strongly endorses the Government's preference (paragraph 7.69) for a single cross-utilities panel. He believes that this change would increase the consistency and efficiency of MMC investigations, both in licence modification and merger references.

Finally, the Director welcomes the suggestion (Proposal 7.16) to consider introducing a procedure for the collective modification of licences, provided a blocking minority did not object. This would have merit in the water sector.