Introduction

The Government welcomes the Committee's wide-ranging and detailed report. We have taken careful note of the Committee's conclusions and recommendations and we will take them into account in ongoing and future work around charging for water and future price reviews.

We agree entirely with the Committee that Ofwat, as the independent economic regulator of the water industry, must balance the requirements for sustainable water supplies with bills that are affordable for consumers. The Government also recognises that affordability of water and sewerage services is an issue for some customers. This was a key driver behind the Government's decision to commission an independent review of charging for household water and sewerage services—the Walker Review.

As the Committee is aware, Anna Walker's interim report was published on 29 June. This was after the Committee had completed its oral evidence sessions. The Walker Review is reporting to both Defra and Welsh Assembly Government. In response to the interim report, we have said:

Defra Ministers and Welsh Ministers welcome the publication of the interim report of the independent Review of Charging for Household Water and Sewerage services. We are very grateful for the work that Anna Walker and her team have undertaken to date, including gathering evidence and listening to customers and others. She has raised important questions about the fairness of current charges, and we look forward to publication of the final report in the autumn. We will respond to the Review's recommendations in full when the final report is published.

The timing of this response to the Committee means that we have not yet seen Anna Walker's final recommendations. The interim report invited comments on its recommendations and the review team is currently considering the responses and further evidence submitted by stakeholders. Many of the issues that the Walker Review is looking at are inter-dependent, such as metering, affordability and bad debt. Consequently we are not in a position to pre-empt the final report and thereby provide a definitive response to some of the Committee's individual recommendations.

The Government issued its consultation paper on Martin Cave's proposals on competition and innovation in water markets on 17 September. We agree with the Committee that it is essential to consider the impact of policies on companies ability to raise the funds needed to enable them to continue to invest and to provide water and sewerage services.

Since the Committee published its report, Ofwat has published for comment its draft determination of water price limits for 2010 to 2015. Ofwat published this on 23 July. Under Ofwat's proposals, average water and sewerage bills would go down, before inflation, by an average of £14 from £344 in 2009/10 to £330 in 2014/15. Ofwat will issue its final determination of water price limits in November.

The Government response to these recommendations has been drafted jointly by Defra and Ofwat. Ofwat is accountable to Parliament and may also submit a further response to the Committee on the recommendations that the Committee has made to Ofwat.

Response to conclusions and recommendation

RECOMMENDATIONS ON "KEY CHALLENGES FOR PR 09"

1.  The challenge for Ofwat is to balance the requirement for sustainable water supplies, delivered by water companies able to pay for necessary environmental improvements, with bills that are affordable for consumers. This must be delivered against the background of the current economic recession and the predicted impacts of climate change. (Paragraph 13)

The Government agrees with this recommendation. When Ofwat began the process in 2007 customers were put at the heart of the 2009 price review (PR09)—well before the current economic recession occurred. Ofwat also identified that it would be a priority for the companies to address the potential impacts of climate change.

Ofwat is clear that the price limits it sets should allow companies to supply water and sewerage services and make necessary drinking water quality and environmental improvements. The draft determination does this—the price limits will allow all companies to meet all their obligations in a sustainable way, putting in place more than 99 per cent of the national environment programme, delivering required improvements to drinking water supplies, providing a secure water supply system and maintaining networks in a condition to deliver a quality service now and in the future.

Ofwat's draft determination also contributes to the affordability objective as under its proposals bills will be steady and, in some cases, lower on average across England and Wales by the end of the price review period.

2.  The Government's decisions on implementing the Cave and Walker reviews' recommendations and the content of the Flood and Water Management Bill will still be unresolved when Ofwat comes to make its final determinations for this price review. The uncertainty generated may affect the companies' ability to raise money on the capital markets. Despite the 'change protocol' mechanism, we conclude that Defra should set out the probable timing of its full responses to the Cave and Walker reviews; and to what extent and how the regulation of the water industry will be altered by the Flood and Water Management Bill. (Paragraph 15)

The Government is sympathetic to this recommendation but would note that we have not seen any evidence that uncertainty around the proposals in the Cave and Walker Reviews, or the Flood and Water Management Bill which we have published in draft, are affecting companies' ability to raise money on the capital markets.

Ideally, Ofwat's final determination of water price limits would take full account of the recommendations that the Government proposes to take forward from the Cave and Walker Reviews and the proposals in the Flood and Water Management Bill. However, this is not possible given that Ofwat will issue final determinations in late November.

The Government and Welsh Assembly Government issued a joint consultation paper on the implementation of the Cave Review's recommendations on 17 September. The consultation will run for three months until the end of the year and the Government will then consider the responses received in early 2010, with a view to introducing any necessary reforms into legislation at the earliest opportunity.

The final report of the Walker Review is now expected in November. The Government will consider the timing and process for taking forward its response to the final Walker recommendations once these have been published.

RECOMMENDATIONS ON "TRANSPARENCY AND BURDEN OF PROCESS"

3.  We recognise that economic regulation of a monopoly utility will be complicated and welcome the improvements in transparency in this price review. We commend Ofwat and the companies' determination to place more information in the public domain and recognise that Ofwat will need to publish a series of guidance and information as the process develops through consultation and discussion. Nevertheless, the current regime's complexity risks hampering the regulator's wish to increase transparency. We recommend that Ofwat and Defra seek ways to rationalise, and make more comprehensible, the process to companies. We further recommend that Ofwat and Defra consider what further information relating to the price review can be placed in the public domain, and ensure that such information is comprehensible and comprehensive. The volume of a submission is no substitute for the quality of its content. (Paragraph 20)

The Government agrees with this recommendation. Ofwat is committed to improving the effectiveness and value of price-setting information. Ofwat's formal review of the 2009 price review process will take place sometime in 2010, depending on any appeals to the Competition Commission following final determinations. This review will consider issues around transparency, the provision of information and the comprehensibility of the process. Defra will contribute to this review.

PR09 is the most transparent price review so far. The only information not placed in the public domain is that which relates to national security or to matters that are commercially confidential, such as Ofwat's view on the costs of putting in place solutions to individual and identifiable problems.

RECOMMENDATIONS ON "CONSUMER ENGAGEMENT"

4.  We recommend that Ofwat require companies to demonstrate how consultation with their consumers has informed their business plans. We further recommend that it be a condition for Ofwat's approval of a company's business plan that the company demonstrate that its plan is understood by the majority of its consumers. (Paragraph 22)

The Government agrees with this recommendation. Ofwat expects companies to show clear evidence of having consulted with their customers and taken account of their views in developing business plans.

Ofwat's current approach to price setting is not to approve a business plan as such, but rather to take a view of each company's proposals. Nevertheless, for future price reviews, Ofwat will ask companies to set out how they have consulted with customers and how this has informed their business plans.

Business plans submitted for the purpose of setting price limits necessarily contain complex and sensitive technical material that a typical water customer is unlikely to understand. For this reason, for PR09, Ofwat asked each company to develop and publish a summary of its business plan set out in a way that would allow customers to understand its proposals and their implications. We were pleased that CCWater built on this approach by providing feedback to each company on the public summaries and offering advice on how these could be improved. For the next price review Ofwat will develop this by providing companies with examples of accepted good practice and formalise the role of CCWater, as the customer representative, in providing companies with advice on producing business plan summaries that the majority of customers can understand.

RECOMMENDATIONS ON "A SUSTAINABLE WATER POLICY"

5.  We recommend that Defra sets out how it envisages delivery of Future Water's objectives will impact on the industry and the regulator. Water customers will be part of the delivery mechanism of Future Water, particularly in relation to reducing water demand. Defra should include in its analysis the role played by water customers and the likely impact upon them. (Paragraph 25)

Future Water is a cross-Government strategy that looks ahead to 2030 and we are working closely with our key delivery partners, including Ofwat and the water companies, to take forward the action points set out in the strategy. Implementation of Future Water can be tailored to local circumstances, and can be achieved in many different ways. Innovation and scientific advances over the next two decades are also likely to make new solutions available. Consequently estimating the impact of Future Water on the industry and Ofwat, including how much the strategy will cost or where these costs will fall, would be a premature exercise at this time. However, where policy direction and action are more certain there have been, and will continue to be, relevant individual impact assessments to accompany consultations and announcements. Value for money, affordability and environmental impact are key criteria in choosing suitable implementation.

RECOMMENDATIONS ON "ENVIRONMENTAL IMPROVEMENTS"

6.  We recommend that Defra explore the potential for derogations to implementation of the EU Water Framework Directive's requirements to enable the phasing of environmental improvements and their related costs, where the near-term burden of these on customers would be severe. (Paragraph 33)

The Government agrees with this recommendation. The Environment Agency concluded their six month consultation on the draft River Basin Management Plans on 22 June. The plans were developed in line with Ministerial guidance which supported utilising the three planning periods to achieve the objectives of the Directive, based on extensive cost effective analysis that had been undertaken as a part of the Collaborative Research Programme. Due to the uncertainty associated with classification results, source apportionment and the effectiveness of measures, a longer-term adaptive approach to river basin planning should be more effective and cost effective than an unphased approach, given the current state of knowledge.

The draft plans contained a range of measures that would enable us to work towards our objectives but to do so in a proportionate way. The Environment Agency is currently in the process of preparing the final plans for approval by Ministers.

Ofwat has also been working closely with the Environment Agency on the application of the disproportionate cost assessment under the Water Framework Directive. This work has looked closely at the possibility for deferring schemes which would place a heavy near-term burden on customers with little benefit in return. Final decisions on this will be made by Ministers when the final versions of the River Basin Management Plans are announced later this year. In the meantime Ofwat's draft determinations reflect the joint work with Environment Agency.

7.  We further recommend that Defra provide clear guidance to Ofwat as to the application of cost benefit analysis and Ofwat's guidance to the companies needs to be clear and unambiguous. (Paragraph 34)

Defra sets the policy or regulatory framework for Ofwat, the independent economic regulator for the water and sewerage industry. Like Defra and other Ministerial and non-Ministerial departments, Ofwat is guided by HMT's Green Book on the economic assessment of spending and investment and the application of cost benefit analysis. This sets the general framework for economic analysis within government. Defra does not provide further guidance to Ofwat specifically on cost benefit analysis (CBA) as it is a principle of the framework that those with the responsibility for incurring the expenditure also have the responsibility for appraising it.

Defra also believes that further generic guidance to Ofwat would not be helpful but the Department stands ready to help Ofwat interpret specific requirements in relation to the implementation of water policies, such as the consideration of the costs of carbon or the environmental benefits of water status improvements. It is recognised that in addition to providing information of the costs and benefits of policies (to develop or aid the implementation of policies) there is a role for CBA in making the costs and benefits of water company investments transparent to customers.

Defra agrees that guidance from Ofwat to companies on CBA should be clear and unambiguous, referencing the Green Book and associated guidance. The large number of water companies and the large number of projects undertaken by companies mean that certain generic guidance is likely to be needed in terms of ensuring a level playing field and for comparative purposes. However, this should not be so specific as to be to the detriment of encouraging innovation nor be counter to arms-length regulation and getting companies to own their plans. Water and sewerage companies should be undertaking CBA to inform their own decision-making and planning. Defra stands ready to assist Ofwat in interpreting how CBA should be applied in individual cases, or over the longer term in relation to specific types of projects.

Ofwat's guidance to companies on the CBA to accompany their business plan proposals was set out in "Setting Price Limits for 2010-15: Framework and Approach" and in the detailed guidance note referred to in that document. Ofwat will review any lessons to be learned from the use of CBA with external stakeholders after final determinations as part of its review of PR09.

8.  Ofwat and Defra have so far failed to make the argument that regional variations in the costs customers must bear for environmental investment are fair and appropriate. We have found it hard to see how alternative charging mechanisms for infrastructure investment could be made to work effectively without significant changes to the current underlying regional charging regime. Defra must therefore examine how changes might be made to the way water industry investment is paid for when it is directly and expressly for the purpose of improving environmental standards for national benefit. (Paragraph 40)

The question of how environmental improvements with national benefits should be paid for is one of the issues being examined in the Walker Review and Defra will subsequently examine and respond to her final recommendations. Defra and Ofwat agree with Anna Walker's view (paragraph 3.3.18) that "the arguments as to whether environmental improvements should be paid for by the local water customer, the national water customer or the taxpayer are complex."

Subject to seeing Anna Walker's final recommendation on this, the Government notes with interest her interim recommendation (paragraph 3.6.2) that "the review team is minded to recommend that, in the long term, the net benefits are likely to be limited of moving to a national or taxpayer charging for some environmental benefits".

RECOMMENDATIONS ON "CLIMATE CHANGE MITIGATION"

9.  Defra should assess the impact of new requirements for water companies to improve water quality and conservation to ensure that only policies with net positive environmental outcomes are adopted. Ofwat should require the water companies to set out the carbon impact of their business plans and the measures they will put in place to mitigate any increases. (Paragraph 42)

The Government supports this recommendation. The Environment Agency has climate proofed the measures that are being proposed in the first River Basin Management Plans to ensure there are no proposals that do not provide positive environmental benefits. The Environment Agency is also engaged in developing European guidance on the integration of climate change considerations throughout the river basin planning process for cycles two and three and this is expected to be published this winter.

As part of PR09, companies were required by Ofwat to set out the carbon implications of their business plans. Operational carbon from companies' day-to-day activities and the embedded carbon resulting from the activities and materials associated with building projects were specified at a project level. This data was applied using the shadow price of carbon (now superseded by the non-traded price of carbon) within CBA to allow carbon to influence investment decisions. This requirement was applied to all new investments and included proposals to reduce emissions.

Since 2007 Ofwat has taken a proactive stance on greenhouse gas accounting. In consultation with the water industry Ofwat has set operational carbon accounting reporting requirements. Ofwat has now collected annual operational carbon emissions data from 2007/08 and 2008/09. Through this process Ofwat has seen a significant increase in the effort and attention that companies pay to carbon accounting. This has helped to set the context for the current price review.

RECOMMENDATION ON "CLIMATE CHANGE ADAPTATION"

10.  Climate change is predicted to have a significant impact on water availability throughout the country. The management of water resources will have to take climate change into consideration. We welcome Defra's proposal that Ofwat and water companies be considered as priorities for early reporting on how they will adapt to climate change. However, Defra should consider if changes are needed to the regulatory regime to ensure that water companies have incentives to take early action to adapt to climate change. We further recommend that the Flood and Water Management Bill should place an explicit requirement on water companies and Ofwat to exercise their functions with regard to the adaptation objectives of the Climate Change Act 2008. (Paragraph 46)

As the Committee notes, climate change is expected to have a significant impact on water resources, and therefore the future availability of water for public supply. That is why the Government used its powers to direct companies to include the best available evidence of climate change on both supply and demand to inform their Water Resources Management Plans, which informs the supply-demand aspect of the price review process. The first set of plans were informed by the UKCIP 2002 scenarios. Future plans, and annual reviews of published plans, will need to be informed by recently published UKCP09 scenarios (or subsequent scenarios in later planning rounds). The Government will be considering whether to require future plans to have a longer planning horizon than the 25 years currently used, and direct companies accordingly for the next set of plans.

The Government has recently consulted on its strategy for using the Secretary of State's power under the Climate Change Act 2008 to require public sector organisations to report on the risks to their functions presented by climate change, and their proposals for adapting to those risks. Once reports are received and published organisations are required under the Act to have regard to its findings in exercising their functions. Ofwat and the water companies, being part of our national infrastructure, are identified in the consultation as being priority organisations, and so are likely to be directed to report to the Secretary of State by November 2011. The Government will be laying its final strategy for using the power before Parliament by 26 November this year, including the final list of organisations that will be required to report as a matter of priority.

Ofwat has proposed a notified item to deal with the impact of climate change on water resources. This could lead to an interim determination on companies' price limits before the next price review (PR14), once the implications of UKCP09 are understood.

RECOMMENDATIONS ON "WATER EFFICIENCY"

11.  We recommended in our report on Energy efficiency and fuel poverty published earlier this year that energy efficiency targets be set for existing homes, delivered through an area-based approach, focusing first on the areas of most need. Funding for this would come from Government schemes such as Warm Front as well as the Carbon Emissions Reduction Target (CERT) activity funded by energy supply companies. This is a model whose merits could usefully be considered for the water industry. (Paragraph 55)

The Government agrees that water efficiency can be a useful mechanism to address affordability and that models such as Warm Front and the Carbon Emissions Reduction Target should be considered as possible models for the delivery of water efficiency. The interim Walker Review (chapter 10) makes a series of proposals regarding water efficiency including the introduction of a statutory requirement for all water companies to implement a water efficiency scheme targeted at defined low-income customers and closer alignment with energy schemes. The Walker Review has consulted on these proposals and interim recommendations and, subject to seeing the final report, we are minded to accept this recommendation to consider the merits of these energy models for the water sector.

12.  We are not convinced that the mechanisms in the price review are sufficient to promote the increases in water efficiency necessary to ensure that water demand can continue to be met in periods of water scarcity. We consider that there are models from the energy sector that could usefully be adapted for water supply and Ofwat should assess how best practice in achieving improvements in energy efficiency can be applied to the water sector. We recommend that Ofwat and Defra explore more extensive water efficiency obligations, either by placing limits on volumes sold or a (CERT style) measures based approach. Ofwat should benchmark the performance of the UK industry in delivering sustainable water management on an international basis. (Paragraph 56)

The Government agrees that there are opportunities for water efficiency to play a more prominent role in meeting the supply-demand balance provided it can be delivered in a cost effective way. The interim report of the Walker Review (chapter 10) makes a series of proposals regarding water efficiency including the introduction of a statutory requirement for all water companies to implement a water efficiency scheme targeted at defined low-income customers and closer alignment with energy schemes. Subject to seeing the final report, we are minded to accept the Committee's recommendations to explore alternative water efficiency obligations and international benchmarking of sustainable water management.

There is also a statutory requirement for water companies in England and Wales to prepare Water Resources Management Plans. These contain companies' plans for balancing water supply and demand under both normal and critical period conditions over the period up to 2035. Each company plans to balance water supply and demand such that the risk that it will have to impose restrictions on consumers' water use (such as hosepipe bans) is no greater than the risk stated in its target level of service.

Each company's plan is subject to public consultation. The Secretary of State has powers to order an inquiry or a hearing if he considers that a company has not responded satisfactorily to comments raised during the consultation. He also has powers to direct companies to make changes to their plans. This process is designed to make sure that each company will have sufficient water to meet its customers' demands under its target level of service. Ofwat will make provision in price limits for each company to balance water supply and demand, consistent with its Water Resources Management Plan.

With specific regard to water efficiency, Ofwat is introducing targets for the period 2009/10 to 2014/15. It developed these targets in conjunction with the Ministerial-led Water Saving Group, and it consulted stakeholders before confirming the targets' structure and levels. Ofwat has also introduced a revenue correction mechanism, which provides a modest incentive for water companies to outperform their water efficiency targets, selling less water to their customers than we assumed when setting price limits.

RECOMMENDATIONS ON "PUBLIC FUNDING FOR SUPPORTING WATER CUSTOMERS"

13.  We welcome the contribution that the Walker interim report has made to the debate on how to improve affordability of water bills for all customers and look forward to the Government's response. Central to this response must be adoption of a firm definition of water affordability to be used by all relevant agencies together with strategy for improving the monitoring and reporting of water affordability. (Paragraph 64)

The Government also welcomes Anna Walker's contribution on the important issue of water affordability and looks forward to seeing her final recommendations. However, there are a number of practical difficulties around agreeing any definition of water affordability and the Government is not convinced that the use of a firm definition of water affordability by relevant agencies would be practical or useful.

Unlike the need to maintain a property at a particular temperature, there is no consensus on the volume of water that an individual needs for essential everyday use. Even if there was, it would require near universal metering to enable this to be provided in a way that takes account of income and water use (and most households are currently unmetered and their bills fixed). Further, unlike energy costs, the cost of a block of water varies across the country. In addition, average energy bills are up to three times higher than average water bills and people can have their energy supplies disconnected for non-payment.

Agreeing what measure of household income to use in any affordability measure would also present problems. There are many definitions, including gross income, net or disposable income, and income before or after housing costs. Depending on which measure is used could dramatically alter the number of households that could be identified as having water affordability problems.

The Government agrees that improved arrangements for monitoring and reporting water affordability are needed. Subject to seeing Anna Walker's final report, we are minded to accept her recommendation (paragraph 8.25.3) that "the review team feels that a requirement on Ofwat, working with CCWater, to publish an annual report on affordability and debt will stimulate innovation in companies and could set benchmarks for assistance schemes and levels. Where it is not clear that it is possible to solve the affordability problems within the current regulatory framework, Ofwat should provide advice to the Secretary of State for Environment, Food and Rural Affairs and Welsh Ministers on what action is necessary and why."

RECOMMENDATIONS ON "ADDRESSING AFFORDABILITY THROUGH TARIFF STRUCTURES"

14  Ofwat argues that it has gone as far as it is prepared to go without Parliament sanctioning the further use of cross-subsidies to support customers struggling to pay water bills. Ofwat's remit should be strengthened to enable it to require water companies to adopt more progressive methods of tackling water affordability for all customers. Defra needs to set out how Ofwat can be equipped with the necessary tools to implement this. (Paragraph 68)

The Government's response to this recommendation is partly covered in its response to recommendation 33 on the role and remit of Ofwat.

Government policy is that poverty is tackled through the general tax and benefits system, and not targeted on particular bills. The role of benefits and tax credits is to provide support and protection for people unable to work (either temporarily or permanently) or retired. Cost of living expenses within benefit rates take account of a wide spectrum of household outgoings, including water costs, and are increased annually by the rate of inflation.

15.  There is a need for innovative solutions and the water sector can learn from the energy sector on how to support vulnerable customers. In particular water companies need to be far more pro-active in disseminating information on the availability of support schemes for vulnerable customers and in providing advice on water efficiency. (Paragraph 69)

The Government agrees with this recommendation. All water companies distribute information on water efficiency to their customers, usually with their bills. Defra and Ofwat also expect companies to promote the assistance available to vulnerable customers. The interim Walker Review (paragraph 11.8.2) makes proposals for other information that should be provided to customers, either through bills or by other means. This includes information on tariff choices, availability of assistance and eligibility for WaterSure and guidance on where to find further information. The Walker Review is inviting views on this interim recommendation which, subject to seeing the final recommendation, the Government is minded to accept. We are also minded to support the emerging recommendation (paragraph 11.8.3) that "companies assess and improve their communications with harder-to-reach customers to ensure that essential information is available to all, and that Ofwat reports on this activity."

16.  We endorse policies which encourage the greater use of sustainable drainage since this can have both environmental and economic benefits. Customers who install such drainage systems should share the benefits, through lower tariffs, of reduced costs from lower volumes of surface water run-off generated. We recommend that Defra explores how individual households can be informed about sustainable drainage systems and encouraged to install them. The costs for highway drainage, that water customers currently bear, should be shared with local taxpayers who benefit from the service. (Paragraph 71)

The Government strongly agrees that customers and companies should be encouraged to behave sustainably. Reducing rainwater run-off to public sewers will reduce the risks of surface water flooding and sewer flooding.

There is already an incentive to household customers to make arrangements so that no surface water from their property drains to the sewerage system: each sewerage company offers a rebate of surface water drainage charges to any customers who can show their house is not connected to a public sewer.

Further incentives to household customers to reduce rainwater run-off (so that only part of the property drains to the sewer) may be problematic. Four companies have introduced charges for surface water drainage for non-household customers based on site area. Under this system customers are incentivised to reduce the area of their property that drains to the sewerage system as the charge they pay is calculated based on the size of that area. This encourages the use of permeable surfaces and technologies such as sustainable urban drainage systems or soakaways. This type of system would be more difficult to implement for households, as the size of household premises does not vary widely and it would be difficult to show how the costs vary for individual households which partially drain to the sewer.

Annual highway drainage charges total around £700 million and currently account for about £25 of each household bill in England and Wales. We recognise that there is currently no incentive for highway authorities to install sustainable drainage systems because the cost of highway drainage is met by water customers. The Walker Review is considering whether it would be more in line with the "polluter pays" principle if highway drainage charges were paid by highway authorities. However, the cost of highway drainage would still have to be met and any transfer of highway drainage charges to highway authorities would place a cost on local authorities. The Government will consider this further in light of Anna Walker's final recommendation on this issue.

RECOMMENDATIONS ON "METERING"

17.  Given the stage we are currently at in the price review timetable, it is frustrating that, despite clear support in Anna Walker's interim report for charging based on volume, the Government's initial response on metering may not appear until the autumn. (Paragraph 79)

The Government said in Future Water that we believe that near universal metering will be needed in areas of water stress by 2030. Currently around 36 per cent of household in England and Wales are metered. Ofwat's draft determinations of water price limits provide for household meter penetration to increase to 49 per cent by 2014/15, or to 56 per cent in water scarce areas.

The interim Walker Review has said (paragraph 5.7.2) that it believes that compulsory metering is justified and should be actively encouraged by the regulator for high discretionary water use, where the true value of water is high and where levels of metering are already high (and is inviting views on what percentage of metering should trigger compulsory metering). The Government will issue a full response to Anna Walker's recommendations once her final report is published.

18.  We consider that metering can have an impact on water demand, but it should not be adopted as a substitute for a robust water efficiency policy. Before investment is diverted to metering there must be a robust empirical case to demonstrate that the costs do not outweigh the benefits and that demand especially in water-stressed areas cannot be reduced more cost effectively through sustainable water use management. We recommend that the Government set out at the earliest opportunity (ie before Walker produces her final report in the autumn) the evidence that metering reduces consumption in the long term; and reduces consumption by a sufficient amount to offset the additional costs associated with having a meter. (Paragraph 80)

The Government agrees that metering is not a panacea but should be seen as part of a programme of measures designed to reduce demand for water where water is scarce, alongside a robust water efficiency policy. We also agree with the need for robust cost-benefit analysis to demonstrate that the benefits of metering outweigh the costs.

Defra does not collect evidence on the costs and benefits of metering. The interim report of the Walker review has collated available evidence on the costs and benefits of metering, including the effects of metering on the demand for water. This is set out in Chapter 5 and Annex E of the report. The interim report has asked respondents for any further evidence for consideration for the final report. The interim report concludes that the evidence points to a demand reduction of around 10 per cent from the introduction of measured charging and notes that there is uncertainty around these estimates.

The evidence is therefore not totally conclusive on the effect of metering on demand for water. However, the interim report also points out the importance of ensuring that any cost benefit analysis takes into account all the costs and benefits including, but not limited to, the potential impacts on reduced demand for water.

RECOMMENDATIONS ON "BAD DEBT"

19.  A more accurate picture is needed of which customers are in debt to enable differentiation between those who can't pay and those who won't pay. (Paragraph 86)

The Government agrees that further information is needed in order to understand which customers genuinely struggle to pay their bills ("can't pays") and which are choosing not to pay even though they could afford to do so ("won't pays"). It is important to balance a firm approach to deliberate "won't pay" customers against a supportive stance to the "can't pays". However, the distinction between the two groups is not always clear as there is often also a "struggling to pay therefore prioritising debt" category in which "can't pays" and "won't pays" are the same.

There are currently various limitations on companies which make such differentiation very difficult. For example, water companies are legally required to supply all household customers. They cannot choose who to supply, introduce contracts which can then be terminated, or impose terms and conditions on which supply is dependent.

Companies are beginning to collect more information on their customer base (for example, by purchasing data from credit reference agencies and by individual home visits), so they can better understand their individual debtor's circumstances.

20.  We recommend that Ofwat require water companies to disclose more information on bad debts levels, such as where debt is attached to vacant properties. We recommend a mechanism whereby property owners have to inform water companies on vacating a property so that the standing charge is no longer applied. (Paragraph 87)

Ofwat already collects detailed information from companies on bad debt levels including the amount of debt written off and the costs associated with collecting debt. Ofwat plans to review the range of information it collects and publishes following the 2009 price review. Information from the companies suggests that debt attached to tenanted properties is a more significant problem, particularly short-term lets where occupancy frequently changes.

We agree that property owners should inform water companies on vacating a property in order to ensure that companies have accurate and up-to-date billing information. Ofwat set out its recommendations to companies on how best to charge for vacant properties in 2006. In many cases the standing charge will still be applied, particularly for measured customers, for example to reflect the surface water and highway drainage service which is still being provided.

21.  We support a named person being identified as responsible for a property's water charges, so that legal redress can more easily be sought for outstanding debt. (Paragraph 88)

We agree that a named person responsible for a property's water charges would allow more effective recovery of charges, including the use of the court system to recover outstanding debts from customers that are able to pay. Companies have told Ofwat that billing in the name of "the occupier" is rarely successful. A named person would allow companies to obtain accurate occupancy information and would enable them to recover a higher proportion of charges and make it easier to pursue the named person in the event of non-payment of a water bill. This would help to reduce costs overall to other bill-paying customers.

Anna Walker's interim recommendation (paragraph 9.9.1) proposes that "as a priority, the Water Industry Act 1991 should be amended to clarify and widen the definition of who is responsible for paying the water bill, through a definition of 'liable person' along the lines of that used in Council Tax legislation; and ensure that water companies have named customers." Subject to seeing the final recommendations of the Walker Review, the Government is minded to accept this recommendation.

22.  Companies should look at billing schemes which suit low income customers, for example to enable payments to be spread evenly over a year. (Paragraph 89)

The Government agrees with this recommendation. When Ofwat approves companies' schemes of charges each year, it makes sure that all companies offer a reasonable range of payment options, which must include the option to pay in accessible locations, at frequent intervals for no additional charge.

All companies offer a variety of payment frequencies to make sure that customers, including low income customers, can find a payment method which suits them. The exact range will vary between companies, although will typically include paying the bill in instalments such as monthly, fortnightly or weekly, or in full at the beginning of the charging year. Many companies will also consider special arrangements at the request of the individual customer.

More innovative billing schemes could help low income customers to budget better in order to pay their bills. The Walker Review is looking at whether more needs to be done.

RECOMMENDATIONS ON "SURFACE WATER DRAINAGE CHARGING"

23.  The level of anger surrounding this issue illustrates the importance of companies having sufficient information about their customers and taking account of their needs when implementing changes in charging policy. This will be something companies need to take more account of in future as changes to implement recommendations made by the Cave and Walker reviews will need to be clearly explained to consumers and their implementation undertaken carefully. (Paragraph 95)

24.  We consider that Ofwat should have intervened earlier and harder on this issue. It is not sufficient for the regulator to lay the blame with a company for poor communication while not attempting to help clarify action that water companies needed to take. (Paragraph 96)

25.  Ofwat must now develop a clear protocol to guide all water companies to ensure that a fair and affordable charging regime can be introduced throughout England which properly reflects community based organisations' ability to pay for water services. (Paragraph 97)

Ofwat agrees that companies implementing new charging systems should take account of the impact on their customers and manage that impact appropriately. This did not happen in the case of one water company—United Utilities—and this led to the high level of public anger seen over the last year.

Each company is responsible for how it deals with its own customers, and for proposing its own charges. Ofwat has worked hard with United Utilities this year to ensure that the affected customers have seen less of an impact while the issue is resolved. Ofwat looks forward to receiving the company's proposals for charging next year, which are expected to be more acceptable to customers and to take better account of the impact on customers with large site areas but small rateable values.

Ofwat approve charges in line with its duties and having regard to the Secretary of State's guidance. Ofwat do not consider that allowing a tariff that takes account of organisations' ability to pay to be in line with its duties.

There have been problems for churches, community amateur sports clubs and other voluntary groups following the switch to site area charging for surface water drainage. The Secretary of State announced on 28 September that the Government will legislate to allow water companies to operate concessionary schemes for these groups.

RECOMMENDATIONS ON "FINANCING"

26.  The regulatory regime, and prospective changes in the regime, contributes to the cost of capital for water companies because it influences lenders' assessment of regulatory risk, which in turn might affect lenders' assessment of the financial risk implicit in the companies' gearing. For the period covered by PR 09, the regulatory risk may be rising due to uncertainties due to the outcome of the Cave and Walker reviews, and the content of the draft Flood and Water Management Bill. (Paragraph 107)

The Government recognises that the regulatory regime, and prospective changes to the regime, can affect the risk associated with water companies. As previously mentioned, we have not seen any evidence that uncertainty around the proposals in the Cave and Walker Reviews, and the Flood and Water Management Bill, are affecting companies' ability to raise money on the capital markets and impacting negatively on companies gearing.

However, we recognise the Committee's concern and will be keeping issues around water company financeability under review. On 3 September, Defra and HMT agreed with Ofwat that a group consisting of Defra, Welsh Assembly Government. Ofwat, Water UK, and a number of water and sewerage companies (a mix of highly geared, publically listed companies plus a water only company including Welsh Water) should be established to discuss implementation of the recommendations in the Cave Review and possible impacts on financeability.

RECOMMENDATIONS ON "PROTECTION OF CRITICAL INFRASTRUCTURE"

27.  The protection of critical infrastructure has different beneficiaries and the costs should be distributed according to those who stand to benefit. Some protection clearly provides an improved service to water customers, who should bear the cost. Other measures, though, are intended to allow water companies to continue to meet their service delivery obligations, and thereby benefit the companies. In practice the distinction might be a difficult one to make. Nevertheless, Ofwat should critically assess what measures it allows companies to pass on to their customers, to ensure that the companies bear the costs of those investments which are essentially part of 'doing business'. (Paragraph 110)

Ofwat requires that investments in the protection of infrastructure result in a measurable step-change in levels of service delivered to consumers. Ofwat's guidance to companies on resilience, published in June 2008, sets out the basis for justifying projects on cost benefit grounds. It requires that "the decisive factor in company decision making should be the effect of societal and environmental impacts on water consumers".

As a result companies cannot make the case for increased resilience, financed by water customers, based primarily on private costs. This approach prevents companies from unjustifiably de-risking their activities at consumers' expense.

Ofwat will review its approach to resilience, as part of its overall consideration of climate change, and develop it further in collaboration with the Environment Agency and other key stakeholders. Infrastructure resilience is an important part of long-term service sustainability and, as such, will be considered in the context of a changing climate and other long-term drivers.

RECOMMENDATIONS ON "COMPETITION"

28.  The Government response to the Cave Review, published in the Budget 2009 provided little information about the Government's views. The Government needs to provide a full response to the Cave report which explains: (Paragraph 128)

• What forms of competition are being considered, for which sectors and to what timetable;
• The potential risks of introducing each form of competition and how those risks will be managed;
• How Professor Cave's 'trust and verify' approach will work and what the Government's measure of success will be (before moving to the next stage of competition);
• What procedures will be used to reverse competition should the approach fail to achieve the required benefits;
• How competition will affect regional differences in water pricing and investment;
• The Government's view on how different forms of competition will influence the cost of capital for companies, and
• How the approach to competition promotes sustainable water management.

The Government has recently issued a consultation paper on the implementation of the reforms recommended in the Cave Review, which also provides a response on each of the recommendations. A copy is available via the Defra web site: www.defra.gov.uk/corporate/consult/cave-review/.

It identifies which forms of competition are being considered for which sectors and also discusses the potential risks and issues associated with each of the reforms and how these will be managed, including the risk on financing.

The Cave Review proposed a step-by-step approach to reform. The Government proposes to follow this approach in implementing Cave's recommendations. A phased approach is also necessary because most of the recommendations made by Cave are likely to require new primary legislation. This phased approach will follow the Cave Review's "trust and verify" principles by ensuring that the benefits outweigh the costs.

29.  The first stage of competition will apply to business customers, as in Scotland. As the domestic consumer will not gain from retail competition, they should not be expected to contribute towards the higher cost of capital that will result from non-domestic retail competition. (Paragraph 129)

The extent to which regulatory and/or legislative changes contribute to a higher cost of capital for companies will depend on whether these changes materially impact on the creditworthiness of companies. Whether such reforms have a material impact on creditworthiness will, amongst other things, depend on the consequential risk to revenues and the proportion of revenues at increased risk.

Water companies' retail activities represent a relatively small proportion of assets and revenues. Collectively they are estimated to account for around 11 to 14 per cent of a company's value chain. Due to the small proportion of revenues associated with non-household retail competition, the Government does not believe that retail competition reforms, including retail separation, would result in material increases in the cost of capital for the industry and customers, be they household or non-household customers.

The Government fully recognises that household customers must be protected from additional costs resulting from the creation of an effective retail market for non-household customers. Our recent consultation on the implementation of the Cave recommendations seeks views on how the Government can continue to ensure that customers remain adequately protected following these reforms. The Government will continue to engage with the Consumer Council for Water (CCWater) and other consumer groups as it develops its proposals.

30.  We recommend that Defra and Ofwat fully involve consumers (through CC Water and others) in the discussion around the introduction of competition. Before such a major change is introduced consumers should be fully aware of the possible risks and the hoped for benefits. (Paragraph 130)

A key priority for the Government is the protection of consumers. Competition is not an end in itself but a means to secure a better deal for consumers and the environment than could be offered through existing purely regulatory approaches. CCWater and other consumer groups have provided important input into the Cave Review and the development of its recommendations and their input will be an important part of the current consultation on implementation. The Government will continue to work with CCWater in discussions around the development of competition in the water sector to ensure that consumers are fully aware of the risks and benefits.

31.  Defra should consider how competition can be introduced in different regions, including taking into account Welsh consumers apparent contentment with the Welsh Water model. Ofwat should not impose competition on Welsh Water if this goes against the wishes of consumers. (Paragraph 131)

The Government agrees with this recommendation. We recognise that competition could take different forms in different geographic areas. This was also noted in the Cave Review. Water policy in Wales is devolved and the Government would not want to impose competition on consumers against their will, either in England or in Wales. As the Cave Review notes, there is not presently a strong case at present for extending retail competition to household customers and Cave therefore recommends that competition only be extended to non-household customers.

RECOMMENDATIONS ON "INNOVATION"

32.  We welcome Professor Cave's suggestions for promoting innovation, although it is not clear to us that competition will be the route to greater innovation in areas such as sustainable water management. (Paragraph 137)

The Government agrees with the Cave Review's assessment that more successful innovation outcomes in the water sector would be beneficial, which may require more spending on Research and Development activity. The Government also supports the Cave Review's wider diagnosis of the barriers to innovation such as fragmented spending, lack of co-ordination and a shared long term vision.

Competition and market mechanisms can play an important role in encouraging innovation throughout the value chain. However, there will be some activities or segments of the value chain where competition and market mechanisms can be expected to have a lesser effect on innovation outcomes, for example because of the natural monopoly nature of the activity and the particular reforms proposed. This is part of the justification for a mix of recommendations from the Cave Review, including the creation of a new water Research and Development fund.

RECOMMENDATIONS ON "CONCLUSION"

33.  We recommend that Defra undertake a fundamental review of Ofwat's role and remit to enable it to effectively regulate a future water industry where the value of water and waste water will have a crucial role in determining water companies' charging regimes. If competition is going to be introduced and water efficiency and water demand management are going to become more important, the regulatory regime should be amended. We recommend that Defra set out a timetable for review of the current regulatory approach in relation to those parts of the industry that are likely to be affected first by the introduction of competition. The timetable should allow any recommended changes to be introduced before the next price review. (Paragraph 144)

34.  Providing households with water and waste water services is likely to remain a monopoly activity for the foreseeable future and it is essential that the current mechanism works robustly for millions of customers. The review should therefore consider how the regulatory regime accommodates both competitive and non-competitive parts of the industry operating in tandem. (Paragraph 145)

35.  We recommend that the regulatory review examines how lessons from energy sector regulation can be applied to the water sector, so that a framework that incentivises companies to encourage their customers to be more water efficient can be adopted. (Paragraph 146)

The principle of independent economic regulation was established for most utilities at the time of privatisation (in 1989 in the case of the water industry). For monopoly providers in particular, the case for regulation is clear: the absence of competition will lead to excess profits and drive up prices. It has been calculated by Ofwat that economic regulation saves water bill payers £110 per annum.

The Government recognises that there is a question about whether a system of economic regulation that was set up to extract maximum efficiencies post privatisation is appropriate in the more complex world of today, with social and environmental issues assuming a greater profile, and fundamental challenges about the fitness for purpose and quality of infrastructure, particularly in the face of climate change.

We will keep the issue of Ofwat's role and responsibilities under review and in light of wider Government consideration of the role and responsibilities of economic regulators.

Department for Environment, Food and Rural Affairs

October 2009