The Privatised Water Industry
of England and Wales
8. It is important to consider the process and outcome
of the 1999 Periodic Review (PR 99) in the context of the previous
price reviews which have taken place and the evolution of the
water industry following privatisation.
Regulation
9. The current system of regulation of the privatised
water industry in England and Wales was established by the Water
Act 1989. Since privatisation, the industry's fortunes have largely
been dictated by the economic regulation of the industry by Ofwat,
which from August 1989 to July 2000 was headed by Director General
("the Director") Sir Ian Byatt. Mr Philip Fletcher took
over the post in August 2000 and will no doubt be a key influence
on the industry's future fortunes.
10. The Director's duties are set out in Section
2 of the Water Industry Act 1991 and require that the Director
acts in a way which he considers is best calculated to ensure
that:
- the functions of a water and sewerage company
are properly carried out;
- companies are able to finance their functions,
in particular by securing a reasonable rate of return on their
capital
11. The Director also has to ensure, in the interests
of customers, that no undue preference is shown and there is no
undue discrimination in the way in which companies fix and recover
charges.[6]
This means that a customer's bill should, in general terms, reflect
the costs which the customer imposes on the water and sewerage
systems for a supply of clean water, the disposal of dirty water
and the draining of surface water.[7]
12. Other responsibilities include: promoting economy
and efficiency, enforcing the duty placed on water companies by
the Environment Act 1995 to promote the efficient use of water
by customers, facilitating competition between suppliers and potential
suppliers and ensuring that a framework exists in which competition
can develop, enforcing company licences and limiting charges for
water.
13. The Director also has environmental duties (set
out in Section 3 of the Water Industry Act 1991). However, these
are rather narrow, referring mainly to the conservation of: flora
and fauna, natural features, sites, buildings and the protection
of Sites of Special Scientific Interest (SSSIs). Water quality
standards in inland, estuarial and coastal waters are regulated
and enforced by the Environment Agency of England and Wales. Drinking
water quality standards are set by The Secretary of State for
the Environment, Transport and Regions which are enforced by the
Drinking Water Inspectorate (See paragraph 32).
Periodic Reviews—background
14. Sir Ian Byatt chose to give effect to his Director's
duties by setting maximum price limits in the Periodic Review
process in the manner described in paragraphs 37-42. Initially,
company licences required that a major review of price limits
took place after ten years, or after five if the company or the
Director so wished. Both the Secretary of State in 1989 and the
Director in 1994 set price limits for ten years ahead. However,
in practice, Ofwat found that a gap of ten years between reviews
was too long despite the long-term nature of the water industry[8]
and that all the
factors influencing prices needed to be reviewed
every five years in the light of companies' performance.
15. The construction price index is an example of
a key factor which can greatly influence the context in which
the water companies operate. The Government first set price limits
in 1989 when construction prices were at a peak. A later dip meant
that water companies found their investment programmes were costing
less than expected, and indeed than allowed for, in the price
limits. For example, North West Water was estimated to have had
its costs cut by £94 million in this way.[9]
16. Ofwat felt that a five-year time-frame preserved
adequate incentives whilst allowing a swifter distribution of
benefits to customers.[10]
Thus, in 1996 Sir Ian announced that he would be re-setting price
limits for the second five year period in 1999. Water company
licences have since been modified (with effect from April 2000)
so that price reviews now take place automatically at five-yearly
intervals.[11]
Prices for 2000-2005 were set in November 1999, taking effect
in April 2000.
17. Ofwat sets price limits which restrict the amount
of revenue that water companies can raise according to a formula
RPI+K+U. The RPI is the Retail Price Index and accounts for inflation.
U is any underspend carried over from previous years. K is the
amount (positive or negative) by which charges are allowed to
rise each year above inflation (or if negative, must fall below
inflation). The K factors are set individually for each company.
In the interests of their shareholders, companies therefore have
the incentive to reduce costs by providing services to customers
more economically than the Director has assumed would be possible
for them. If they are successful, savings can be passed to customers
at the next price review in the form of lower prices, or a larger
quality/environmental programme, or a mixture of the two. In this
way, the regulatory system is intended to give the water companies
the incentive to be efficient.
18. At privatisation, the then Secretary of State
for the Environment, Nicholas Ridley, had to make assumptions
about the cost of capital, dividend yields and expected costs
and outputs, all based upon the company information made available.
In addition, the Government recognised that a large programme
of investment would be required to meet environmental and water
quality standards, in particular the Urban Waste Water Treatment
Directive, and offered a "green dowry" of £1.1
billion for upgrading the industry's assets and a £5 billion
debt write-off.[12]
With this information, and his own assumptions about future efficiency
gains, the Secretary of State fixed each company's K-values for
a decade ahead. It soon became apparent that the companies were
in better shape than had seemed and, under pressure from Ofwat,
the companies raised prices less than the maximum which the K-values
permitted.
19. In the 1994 Periodic Review, Ofwat concluded
that the companies could increase their efficiency at a faster
rate than they had achieved since privatisation and than
they had in the pre-privatisation era. However, even with these
tougher assumptions, Sir Ian told the Committee that it "turned
out that they could do better than that".[13]
They quickly showed out-performance on operating and capital costs
and there was clearly some extra efficiency which could be passed
to customers.
20. After privatisation profits started to soar in
real terms[14]—between
1990/91 and 1997/8 the pre-tax profits of the ten water and sewerage
companies increased by 147% [15]
at a time when customers faced continual price rises. Water and
sewerage prices rose respectively by 36% and 42% from 1988-1998
(in real terms)[16]
with the bulk of the increase occurring in the period up to 1994-1995.[17]
The industry faced a public outcry in relation to high levels
of directors' pay and profits, and Sir Ian came in for some criticism
for being too soft on the industry. However, Sir Ian told the
Committee "I think in the circumstances we made perfectly
good estimates and at the time people did not disagree with those.
It was only when the numbers started to show that the water companies
could do better that I observed then there were some benefits
to be had at the next review, and I believe those benefits arose
because the full power of the incentive regime started to operate
in that period".[18]
21. Sir Ian felt that the figures demonstrated this.
In 1990-95, on average across the companies, prices went up by
5% a year above the rate of inflation and 1.5% from 1995-2000
—much slower but still going up.[19]
These increases did not escape customers' notice—complaints
about charges and billing have dominated and accounted for over
half of all complaints received by Ofwat Customer Service Committees
(CSCs) in the last decade (1990-2000). Not surprisingly, 1999-2000
was the only year in the last decade when the proportion of charging
complaints fell—the year when price cuts were announced.[20]
22. Sir Ian told the Committee that water company
efficiencies had been seen in both operating expenditure and on
capital expenditure.[21]
The main controllable costs for companies are: manpower, energy
and chemicals, and these are where the main efficiencies can be
made.[22]
Sir Ian explained that companies had felt they could operate with
less staff and by giving junior staff much more flexibility in
carrying out their work many operations could be carried out more
cheaply. On the capital side, Sir Ian felt that because of some
innovative solutions and increasingly more effective procurement
and planning, companies were now able to carry out their obligations
with more streamlined methods.[23]
23. PR 99 has assumed that the companies can
continue to increase their efficiency. Ofwat identified past and
future efficiency savings which amount to some £60 per year
per household customer,[24]
allocating £30 towards improvements in drinking water and
environmental quality and £30 to lower bills.[25]
Sir Ian advised the Committee that the efficiencies had come later
in the water industry than the other utilities but that they were
now coming.[26]
The Environment Minister, Mr Meacher, felt that the determinations
of PR 99 were "tight, challenging but realisable".[27]
However, Water UK described PR 99 as a "tough settlement"
and the one-off price cuts as a "short term fix which put
at risk the high level of service which companies currently deliver".[28]
24. Just before the final determinations were published,
Water UK warned that one in four jobs in the water industry could
go (amounting to some 9,000[29])
as a direct result of the draft price proposals. It warned that
companies were being driven towards job losses in order to meet
efficiency targets that were neither realistic nor practical.[30]
So far significant job cuts have been announced by Severn Trent,
Anglian and Yorkshire Water.[31]
Both the Chief Drinking Water Inspector, Mr Michael Rouse and
the Environment Agency have publicly warned companies that reductions
in operational personnel must not result in the "cutting
of corners" in relation to maintaining drinking water quality
or meeting their statutory duties relating to the environment.[32]
The regulators will clearly be watching to ensure that health
and safety, and the quality of monitoring arrangements are not
compromised.
25. Two water-only companies, Mid Kent Water and
Sutton and East Surrey Water, appealed to Ofwat for referral of
their determinations to the Competition Commission. The Competition
Commission has since revised their price limits, resulting in
slightly higher average K-values for 2000-2005 than proposed by
Ofwat but still a far cry from those put forward in the companies'
business plans.[33]
The Commission determined that a number of company-specific factors
affected both the costs allowed by Ofwat and the scope for efficiencies.
In particular, the Commission took a different approach from Ofwat
on: the treatment of depreciation, the scope for efficiencies
in capital programmes, and the number of customers opting for
a meter.[34]
However, the Commission did endorse Ofwat's approach and conclusions
on the cost of capital and Ofwat's assessment of the scope to
make efficiency savings. Ofwat has undertaken to consider the
Competition Commission findings for the 2004 Periodic Review.
26. Both Ofwat and the Environment Agency took the
view that as only two out of the 23 water companies had appealed
to the Competition Commission the inference was that other companies
believed they were adequately financed to discharge their functions.[35]
It is interesting to note that when the 1994 price limits were
announced one commentator noted that "the meek acceptance
of the regulator's decision by all the water companies but one
[South West Water] should encourage outsiders to smell a rat".[36]
27. However, Water UK told the Committee that for
many companies the decision not to go to the Competition Commission
had not been clear cut—a number had taken the view that
the alternatives of actually getting on with the job and concentrating
on trying to deliver was a better use of their management resources.[37]
In addition, companies are required to refer the whole determination,
they cannot pick out certain elements of the package which they
are unhappy with. Thus, they have to weigh up whether their concerns
warrant an investigation of the whole determination especially
as industry-wide issues such as the cost of capital can only be
looked at on a specific company basis, not as a single issue across
the companies. Ofwat fully endorses this approach maintaining
that the Competition Commission has to review its entire determination
under the same legal duties as the regulator and therefore has
to take into account the same range of factors.[38]
28. The industry now finds itself with increased
risk, fluctuating share prices and in some cases companies whose
value on the Stock Exchange is now less than the sum of their
individual assets.[39]
In the face of ever more restrictive economic regulation, the
industry has been exploring new avenues for restructuring. A recent
example was the proposal by Kelda to become a mutual—separating
asset ownership from operations. As yet no such scheme has been
endorsed by Ofwat which, like the DETR and DWI, remains concerned
that such proposals to date have not made clear how statutory
responsibilities and liabilities would be distributed between
the mutual and the operating company. Ofwat has made it clear
that it will be looking
for any restructuring proposal to offer benefits
to customers and maintain incentives for efficiency.[40]
The 1999 Periodic
Review Process
Roles and responsibilities
Ministers
29. The role of Ministers is to set the policy
framework within which the Periodic Review takes place.[41]
This framework is soon to be revised by the forthcoming Water
Bill which is expected to implement new measures agreed as
part of the Government's Utilities Review.[42]
On the advice of the Environment Agency and the DWI, Ministers
set the size and range of the environmental and drinking water
quality improvement programmes that the industry will have to
deliver over the Review's five year period. The National Assembly
for Wales (NAW) is responsible for setting the environmental programme
for the Welsh water companies, D_r Cymru and Dee Valley Water
Ltd, and has an interest in the Welsh operations of Severn Trent
plc. The NAW was created towards the end of the PR 99 process
in May 1999. During the Review, the DETR operated in close liaison
with officials from the Welsh Office and thereafter with the (same)
officials serving the National Assembly for Wales.[43]
Ofwat
30. Once Ministers have determined their policy
objectives, it is a matter for the Director of Ofwat to decide
the economic conditions, ie the price limits which need to be
set in order to achieve them bearing in mind the full range of
his own statutory duties (see paras 10-13). Sir Ian told us that
in fulfilling his duty to protect customers and to promote economy
and efficiency, Ofwat draws Ministers' attention to the implications
for customers' bills of the proposed environmental and quality
programmes.[44]
The process of conducting the Periodic Review is also a matter
for the Director.
The Environment Agency for England and Wales
31. The Environment Agency has a wide range
of statutory duties relating to the environment but those most
relevant to the periodic review process are to: prevent or minimise
or remedy and mitigate the effects of environmental pollution,
secure the proper use of water resources (ie to achieve an appropriate
balance between the population's needs and the environment[45])
to promote conservation and water-related recreation. The Agency
sees its role in the Review as identifying the "environmental
problems" caused by water companies and advising Ministers
on the relative priority of solving the problems.[46]
The Drinking Water Inspectorate (DWI)
32. The Drinking Water Inspectorate (DWI) enforces
drinking water standards. In administrative and financial terms
the DWI is a division within the DETR but it operates as an independent
inspectorate. The Secretary of State's and National Assembly for
Wales' powers of enforcement and prosecution have been delegated
to the Inspectorate.[47]
The Companies
33. Water companies must properly carry out
their functions and deliver the environmental and quality programmes
within the price limits set by the Director.
The Quadripartite process
34. For the 1994 review the DETR set up an informal
"quadripartite process" which was used again in the
1999 review. This process seeks to support the Periodic Review
process by facilitating the timely flow of information between
the various regulators and the industry.[48]
Quadripartite meetings are chaired by DETR officials and the participants
are: Ofwat, the Environment Agency, Water UK representing the
water companies, and the Drinking Water Inspectorate. The DETR
admitted that the setting up of such a quadripartite group was
"intended to help ensure the inevitable tensions involved
were creative and constructive".[49]
35. In 1998, after some pressure, DETR also invited
English Nature to join the quadripartite discussions in recognition
of English Nature's statutory duties relating to the protection
and management of SSSIs. Designated wildlife sites such as SSSIs
can be damaged by water company abstractions and sewage discharges
and both water companies and the Director have statutory duties
relating to nature conservation. English Nature's equivalent in
Wales, the Countryside Council for Wales, was established mid-way
during the review process and did not directly input to the quadripartite
discussions.
36. Michael Meacher told the Committee that he expected
that the new independent consumer council for water, which the
Government has proposed, would, in the future, join the quadripartite
process.[50]
The timetable and inputs
37. Both the 1994 and 1999 Periodic Reviews were
conducted over a period of three years. The timetable of key stages
for PR 99 is set out in Figure 1 overleaf.
38. The Director consulted on the timetable for the
1999 Periodic Review process in February 1997 by means of a letter
to Managing Directors (MD 124). The DETR however, did not put
forward proposals on how the quadripartite process should be handled
until July 1997, after Ofwat had completed its consultation on
the timetable.[51]
Water UK was concerned that "Ofwat set the timetable and
others had difficulty keeping up".[52]
However, the industry body did accept that in principle the timetable
seemed reasonable. Sir Ian's view was that as the "water
companies did not like the answers [so] perhaps, that is why they
say they did not like the process".[53]
39. The Periodic Review is a complex and necessarily
iterative process which needs to be efficiently planned and managed.
It is therefore important that the Director establishes a clear
forward programme with sufficient consultation. The Committee
believes that this was achieved in the 1999 Periodic Review, despite
Water UK's concerns, and that all relevant parties were given
the opportunity to make the case for an alternative timetable
if necessary.
40. From early 1997 to late 1998 Ofwat issued consultation
papers on a number of topics to establish a framework for the
review and to highlight key financial, procedural and technical
issues. At the same time Ofwat embarked on a major information
collection exercise and companies were required to make a number
of submissions on quality costing, supply and demand forecasts,
asset condition and unit costs. Ofwat then looked at costed options
and published Prospects for Prices in October 1998 which
set out in quantitative terms what the options were and identified
the key areas where guidance from the DETR and Environment Agency
was needed.
41. Ministers set out their decisions on the environment
and quality programme in their guidance to the Director in Raising
the Quality (September 1998). This guidance was based on advice
from the Environment Agency and Drinking Water Inspectorate and
in the light of the Director's estimates of the potential impacts
on customer's bills.[54]
The companies submitted their final business plans to Ofwat in
April 1999. Ofwat then consulted on draft price limits in July
1999 and issued the final determinations in November 1999.
42. The process is necessarily iterative because
the companies cannot estimate costs nor Ofwat determine the necessary
impact on bills until there is some certainty about the environment
and quality obligations which need to be delivered. In turn, the
Government is not in a position to confirm the scope of this programme
until it has an idea of the costs involved, and thus the possible
implications for prices.
Assessing customer needs
43. One of the Director's roles is to protect and
represent the interests of customers. He therefore needs to have
a good idea of what the customer wants. During the course of the
review Ofwat and other interested parties carried out a variety
of customer surveys. Although these differed widely in their approach
they generally sought to investigate customer attitudes and preferences
for improvements to drinking water and the water environment,
and the extent to which they would be willing to pay more or forgo
savings in the annual bills to fund improvements in services.
44. Water UK told the Committee that it had commissioned
the largest surveys in its history and had sought to agree individual
questions with Ofwat Customer Service Committees and the Environment
Agency so that the main parties would accept the findings.[55]
The industry's research indicated that customers' priorities for
improvements were: reducing leakage beyond current target levels,
minimising the risk of foul water flooding and investing to increase
supply reliability. Customers were asked to indicate whether they
would like varying efficiency savings eg £5, £10, £20
to come to them as a bill reduction or to have it spent on some
service improvement. As the amount of money increased people increasingly
opted for the 50/50 option which split savings equally between
a bill reduction and service improvement.
45. Each survey came up with slightly differing rankings
of customers' priorities. The Environment Agency's survey found
that 69% of respondents were willing to pay more for cleaner rivers,
coastal waters and to ensure an adequate supply of water whilst
the DWI's research indicated that ensuring safe, clean drinking
water was the greatest priority for customers (79%), compared
with improving the reliability of supply (14%) and reducing levels
of river pollution (6%). The DETR found that ensuring a reliable
supply of water had highest priority for consumers and more than
half (53%) of respondents were prepared to pay more for their
priority improvements. However this "willingness-to-pay"
varied according to income and the level of the current water
bill.
46. Overall it can be said that the DETR, DWI, water
companies and the Environment Agency all found that customers
were not looking exclusively for the maximum possible reduction
in water prices if the implication was that important environmental
and quality benefits could not be secured. In Raising the Quality,
the DETR concluded that in general most customers would probably
prefer lower bills in real terms and for water quality and environmental
improvements to be funded from efficiency savings by the water
companies and a lower rate of return on capital.[56]
Figure 1: Milestones in the 1999 Periodic Review
Process
