General

The Water Services Regulation Authority (Ofwat) is the economic regulator of the water and sewerage industry in England and Wales. Our main statutory duties are to protect the interests of consumers, wherever appropriate by promoting effective competition, and to enable efficient incumbent water companies to carry out and finance their functions. Our main instrument is to review and set price limits for each regulated company, currently at five-year intervals.

We welcome the timely report of the House of Lords Science and Technology Committee following its inquiry into water management. We agree with the Committee that water resource and management issues are of fundamental importance to society, the environment and the economy at large. We look to work with the other stakeholders in the sector, including the Government, the Consumer Council for Water, the companies engaged in the sector, fellow regulators including the Environment Agency, and others. We seek to ensure that water resource issues are integrated with other requirements to improve the environment and customer service. By incentivising greater efficiency, we look to keep bills to customers no higher than is necessary.

The report suggests (3.106) that 'Ofwat ... focuses too narrowly on keeping water prices down, and insufficiently on security of supply … '. We agree that water is a resource essential to life, environmental health and a successful economy. We seek, working with others, to achieve security of supplies for all essential purposes. Inevitably, this requires judgements to be made. In the 2004 price review we accepted that prices should rise significantly, in spite of continued improvements in efficiency, in order to meet the need for investment in capital maintenance, environmental improvements, and service improvements as well as security of supply. All companies were financed to achieve full security of supply for demand in 2010, with provision for further work to meet future anticipated demand. Going forward we shall continue to seek an appropriate balance, conscious that rising water bills have economic and social costs.

We agree with the emphasis placed by the Committee on the importance of a long-term approach to the regulation of the sector. In particular, our approach must be consistent with long-term strategies that include, for example, the development of new water resources, when necessary, over several decades. We do not, however, consider that it is necessary or practical to set price limits, even on an indicative basis, for very long periods of time (the Committee suggests 24 years) to enable such integrated strategies to be developed and implemented. We are taking an alternative approach to achieve the same goal.

The Committee emphasises the importance of achieving an appropriate balance between resource development and demand management, including the development of metering, the promotion of water efficiency, and the control by the water companies of their resources, including control of leakage. We agree that we must play our full part in developing this integrated approach. As members of the Government's Water Saving Group we shall participate in the development of the unified strategy. We have launched a review of the current approach to leakage control, the economic level of leakage. The concepts underlying our current approach are dynamic and are directed towards ensuring that environmental and social, as well as financial, factors are fully taken into account. However, current public concerns about leakage, especially in water stressed areas affected by drought, and the Committee's findings indicate the need for such a review. We shall complete it in good time before the next review of price limits, which concludes in 2009.

We shall also continue to ensure that the companies carry out their statutory duty to promote water efficiency. We see the extension of metering, especially in water stressed areas, as an important component of efficient use, together with other measures in the Government's control, including the use of building and water fittings regulations. We shall in particular work closely with the Environment Agency on these issues to determine an integrated strategic approach to resource management.

Although we therefore fully support the underlying thrust of the Committee's report, we do not accept all of its detailed recommendations as likely to achieve the end goals. We explain our reasoning in the response below.

Response to individual recommendations

The Regulatory Framework

8.2. Responsibility for water management is dispersed and unclear. We need clearer lines of responsibility, greater accountability and more effective funding procedures. Water management should be a partnership in which the water companies, the regulators, Government and the consumer can all engage in a constructive dialogue. Stakeholder engagement requires transparency, accountability and a mutual respect for the interests of all participants. Our report seeks to demonstrate how more appropriate water management could be established for England and Wales.

We agree that there needs to be constructive dialogue about water management to which all parties with an interest can contribute and influence outcomes.

Ofwat is the economic regulator of the water and sewerage industry in England and Wales and our approach is directed by our statutory duties. On water resource issues we work closely with Defra, the Welsh Assembly Government and the Environment Agency to facilitate a more integrated approach. We are also working with the Department for Communities and Local Government to improve the integration between water resource planning and housing growth and planning. We are all working together with water companies to ensure that the growing population of England and Wales, wherever it is located, has a secure and reliable supply of water.

The Water Act 2003 places a statutory requirement on water companies to produce water resource plans. Water companies will have to consult publicly on these plans. This will improve the transparency of the process enabling all stakeholders, including consumers, to be better informed and to contribute to the water resources planning process.

8.4. We recommend that, in order to synchronise the periodic review cycle and the six-yearly reviews of River Basin Management Plans, Ofwat extends the periodic review cycle to six years.

8.5. We strongly recommend that, in addition to extending the periodic review cycle to six years, Ofwat commits to agreeing indicative prices for the subsequent six years and prospective prices for the 12 years beyond that, as proposed by CIWEM. This would provide water companies with a greater degree of financial and logistical certainty as they plan major resource development projects. We further recommend that these price indications be appropriately aligned with the water companies' long-term water resources plans.

We agree that the price limits need to be consistent with and support long term planning for water resources and other investment requirements. We have recently consulted stakeholders on the length of the next price review. We are examining the responses and will publish our conclusions later this year. Almost all the respondents considered that five years offers a reasonable price review period that balances the need for a settled future against the difficulty of judging component elements for a long period. This difficulty would in our view make it impractical to set even indicative price limits for 24 years ahead. Very few respondents wanted to see a move even to six-yearly reviews to tie-up with the Water Framework Directive. CIWEM did not respond to our consultation exercise, but we have read their written evidence to the Committee. The main focus of the responses is on developing the way in which long-term projects are handled at price reviews, including those that are identified between price reviews and those, like the building of new resources such as reservoirs, that span several price review periods.

We recognise that we need to do more to encourage long-term planning both by the industry and in the way that we regulate the industry. We are at an early stage with our thinking but we are giving thought to whether twenty-five-year business plans should be prepared at the next price review. This builds on the approach that we already take to certain aspects of each company's investment programmes such as capital maintenance and water resource planning as well as long-term water quality and environmental outputs under the Water Framework Directive.

Resource development

8.6. We urge Ofwat in the strongest possible terms to ensure that it allows sufficient funding—and the required long-term financial assurances—to enable water companies to undertake necessary resource development, and to demonstrate to the Government that it is doing so. Further, Ofwat should work closely with the Environment Agency to ensure that the companies are indeed planning sufficient resource development to maintain security of supply.

We accept the importance of this function and will continue to address it. In their water resource plans water companies forecast the supply of and demand for water and, where there is any imbalance. They also set out their least cost set of measures, taking into account financial, social and environmental costs to redress the balance. Companies must take account of the risks and uncertainties associated with particular schemes when deciding on an optimal plan. Measures are likely to be a combination of reducing leakage to the economic level, enhancing demand management, extending existing resources and commissioning new sources. This approach is twin-track and does not in principle favour either demand management or supply side measures including new resource development.

At the last price review we assumed companies would invest around £3 billion in the period 2005-10 to achieve stable security of supply and eradicate any deficits in supply compared to demand. Where appropriate our approach encourages companies to plan longer-term projects such as reservoirs in the knowledge that, if shown to be needed, they will continue to be supported in future price limits. We assumed the companies would investigate the need for four new reservoirs and raise the level of three other reservoirs. These are all in the South and East of England. Even if the planning process goes smoothly they are unlikely to increase significantly the volume of water available until after 2015.

Water efficiency

8.8. We consider that Ofwat has placed insufficient importance on the promotion of water efficiency by water companies. The new Ofwat board should therefore make it a top priority to provide genuine incentives to encourage water companies to invest more in promoting water efficiency. Equally, during future price reviews, the presumption should be in favour of funding water efficiency initiatives proposed by the companies, unless there is a compelling reason not to do so. We recommend that ministerial guidance to Ofwat be framed accordingly.

8.9. We call on the Environment Agency and Ofwat to work together to ensure that water companies are encouraged to undertake water efficiency initiatives, and that water efficiency is given a higher priority in future price reviews.

We accept the importance of promoting water efficiency as an important component in balancing supply and demand. We will continue to work on this with the Environment Agency and others. Each company must comply with its duty to promote the efficient use of water amongst its customers. This applies regardless of whether it faces an immediate constraint in terms of the balance between supply and demand. We expect all companies to do this as part of their normal interaction with customers. It is part of their normal operating costs and therefore does not require enhanced funding at customers' expense.

However, when setting price limits we make financial provision for identified enhancements to a company's strategy to promote efficient water use by its customers. We require evidence that it will result in a further benefit to customers—by improving the security of supply—and that it is part of the company's least cost water resource plan, taking into account social, financial and environmental costs.

Our responses to 6.19 and 6.20 provide further detail on our thinking.

8.10. We welcome the adoption of the Common Framework for Capital Maintenance and Ofwat's decision to allow a considerable increase in spending on infrastructure improvement in PR04. However, we are seriously concerned that the network replacement rate may still be far too slow and could be storing up problems for the future. In light of the concerns expressed by CIWEM and the Environment Agency, we strongly recommend that Ofwat gives serious consideration to working with the companies to increase the replacement rate.

We accept the importance of this issue. We have at this stage an open mind on whether further increases in prices will be needed for maintenance after the 22% increase in expenditure assumed for 2005-10 as compared with 2000-05. We expect companies to keep their assets in a condition where they are fit for purpose, providing services to consumers and the environment now and in the future. We call this concept serviceability. We expect companies to maintain the serviceability of their assets by carrying out capital maintenance, as well as routine maintenance and repairs, and to do so efficiently.

We share the Committee's confidence in the common framework. We are seeking to learn and improve upon our process in time for the 2009 price review. In late March 2006 we issued our consultation on assessing capital maintenance requirements which closed at the end of May. The workshop that we held for stakeholders and the responses we received will help us develop our process in the future. We are also taking part in collaborative research through UK Water Industry Research (UKWIR) to review our approach to efficiency, and the process for assessing forward-looking plans. In autumn 2007, we expect to consult on our overall methodology for assessing capital maintenance requirements at the next price review. In the lead up to this we will develop our proposals, informed by open exploration of the issues and options with stakeholders.

Research and development

8.11. We call on Ofwat to address the disincentives in the regulatory system that discourage companies from investing in R&D. We recommend that Ofwat allocates to R&D a certain proportion of companies' turnovers that would be exempt from the efficiency targets, and reconsiders the mandatory return of all efficiency savings resulting from new technology. Any of the money allocated for R&D that is not spent should be returned to customers in the following price review.

We agree that research and development (R&D) is important. We have in place an incentive structure that encourages the regulated water and sewerage companies in England & Wales to deliver their required outputs and outperform price limits. Investing in R&D is one way to achieve sustained outperformance at the same time as delivering regulatory outputs. Companies not undertaking R&D, perhaps for short-term cost cutting reasons, run the risk of not meeting longer-term efficiency assumptions. Our role is to challenge, not manage the companies. It is therefore for regulated companies, just as it is for unregulated companies, to determine the level and nature of their R&D spend.

The Committee notes the level of spending on R&D by the industry is at a relatively low level. UKWIR, which facilitates research on the industry's behalf, has been very effective in undertaking research on behalf of all the companies. Suppliers and contractors within the companies' supply chains have also contributed to developments by the industry. The Committee's report acknowledges the technological advances made in the area of leakage. These have come about as suppliers have competed to win a share of the valuable market created by challenging regulation.

We note the Committee's recommendation that we should address the disincentives in the regulatory system that discourage companies from investing in R&D. We are participating in UKWIR's project to consider barriers to innovation. We will need to consider the outcomes of this project and how we take forward its findings. However, we have reservations about the proposals to increase prices by allocating a proportion of companies' turnover to R&D. This approach may not be in the interests of customers. Allocating specific expenditure to R&D could mean companies pursue poor value schemes in order to spend their allocation. R&D should be focussed on informing and achieving relevant outcomes for either specific companies or the industry. We will however develop our approach to incentives in planning for the periodic review in 2009 and beyond.

8.12. It is clear that something concrete has to be done to address the very high level of unpaid bills, and experience in Melbourne suggests that partial disconnection may be both effective and publicly acceptable. We therefore recommend that the Government examine the evidence from Australia, with a view to introducing more effective strategies for reducing the number of people who can afford to pay their water bills but refuse to do so.

We share the Committee's concerns about the level of unpaid bills and about issues of affordability. The statutory ban on disconnection of domestic customers, and partial disconnection has had a marked effect on the level of bad debt. All customers through their bills pay for the costs of recovering or writing off bad debt. Those on low incomes who try hard to pay their bills will be paying towards those who do not meet their obligations. Customer research shows that customers particularly object to price increases as a result of others' unwillingness to pay. It is therefore essential that companies are able to recover revenue as efficiently and effectively as possible. Our regulatory approach ensures that inefficient companies cannot pass on unnecessary costs to their customers.

As part of the overall strategy for companies to reduce bad debts, we actively encourage them to offer a range of payment methods that enable customers to spread bill payments. We have also issued 'Guidelines on dealing with customers in debt' which sets out our expectations of how water companies should manage their indebted household customers. These guidelines seek to ensure that those customers in real difficulty are treated fairly while allowing companies to collect revenue effectively. We are in the process of consulting on these guidelines to ensure they are still relevant, comprehensive, up-to-date and easy to follow.

Competition

8.14. We welcome the introduction of greater competition to the water industry and look forward to the extension of the new regime to increasing numbers of customers in future. However, when judging licence applications, Ofwat must guard against "cherry-picking" of the easiest opportunities by new water supply companies.

We note the Committee's concerns about "cherry picking" of the easiest opportunities by new water supply licensees.

Our role in the process is limited to granting a water supply licence to a market entrant, and does not extend to guarding against licensees targeting profitable customers. The licence granting process has no provision to protect incumbent water companies or their customers. However, the Water Act 2003, which established the current competition regime and the cost principle on which it is based preserves existing cross subsidies and ensures that all licensees contribute fully to appointed water companies' unavoidable costs. While new licensees will target opportunities that they deem to be in their commercial interest, "cherry picking" that disadvantages the incumbent water company's customers is prevented under the current competition regime.

Competition is not progressing as quickly as we would wish. We are working hard to encourage new entrants into the market. We believe that as this new market develops and matures both companies and customers will recognise and take advantage of the opportunities that exist.

The way forward

8.15. We recommend that long-term integrated water management plans be drawn up by regional boards—one for each River Basin District—comprised of local representatives of Ofwat, the Environment Agency and CCWater. These boards would have a statutory duty to draw up such plans and to advise Ofwat accordingly at the national level in advance of each periodic review process. They would also have a duty to advise Regional Assemblies on Regional Spatial Strategies.

8.16. This would enable all three components of sustainable development—economic, environmental and social—to be factored into the price-setting process far more effectively, whilst also ensuring that security of supply is maintained in a way that best suits the needs and pressures of each individual region.

We acknowledge the value of an integrated approach and wider stakeholder engagement, particularly at the regional and local level. But we consider that the specific proposal for statutory regional Boards would confuse accountability.

We are committed to working with others and developing the forums that already operate at the regional and local level. For example, we are active members of the EA-chaired Water resources in the South East (WRSE) drought group, which has representatives from companies and CCWater. The remit of this group is to consider resource issues in the south east and to co-ordinate water resource planning and management of the current drought. This group also sponsors a technical sub-group—water resources in the south east—that aims to introduce greater cohesion and integration in water resources planning within the region. The River Basin Liaison Panels, the Regional Environmental Protection Advisory Committees (Repacs), and CCWater also operate at the local level.

Water resource plans are already drawn up at a regional and national level by companies in collaboration with the Environment Agency and Ofwat. The requirement to draw up and regularly review the content of water resource plans is now a statutory duty. Water companies will also have to consult publicly on their new statutory water resources plans, which also allows regional stakeholders to contribute to the process.

Before each price review we consult on how we will work with all stakeholders including customers. While we accept there is a greater need for stakeholder engagement, roles and responsibilities are clear. Our duty is to determine price limits at a level that allows companies to carry out their functions, including the paramount importance of the supply of safe drinking water and removal of wastewater. We are concerned that the introduction of new regional boards would result in a blurring of roles and responsibilities.

Demand for water

Demographic and social factors

8.17. We are concerned by the impact that population growth, decreasing average household size and increasing per capita water use will have upon domestic demand for water. The only one of these factors that can be directly addressed by the industry and regulators is the growth in per capita water use. It is vital that the growing emphasis on water efficiency amongst the key stakeholders is communicated effectively to the public at large as rapidly as possible.

We are also concerned about the impact of per capita growth in water use. We are actively involved in a number of water efficiency initiatives that can impact on growth in per capita water use. We have discussed in our response to 3.54 and 3.56 our role in the Water Saving Group. We are also represented on the board of Waterwise. Waterwise aims 'to develop a model framework for sustained water efficiency in the UK for all use of mains water and to reverse the upward trend in per capita consumption by 2010, underpinned by the robust evidence base demonstrating the social, economic and environmental benefits of water efficiency'.

In order to generate a strong response to efficiency measures it is important that using water efficiency is made easy for consumers. In our response to the consultation on the Code for Sustainable Homes we recommended that a minimum level of water efficiency should be made mandatory in all new developments.

Water supply

Climate change

8.24. We have seen insufficient evidence to convince us that the potential consequences of climate change are being adequately factored into long-term planning for water management, with due regard being paid to the inherent uncertainties. We therefore recommend that both Ofwat and the Environment Agency take steps to make the process whereby such issues are addressed within long-term planning more transparent and open to scrutiny.

We recognise that climate change is a major issue and expect it to impact on the provision of water and sewerage services and the environment in the future. We expect companies to set out the actions they are taking to deal with issues arising from climate change. In the last price review, in general, companies' plans did not seek significant precautionary expenditure, but did confirm that climate change is a growing issue and gave some indication of the possible implications for their water supply and sewerage networks.

As robust evidence emerges about the impact on companies' resource positions we will take it into account at price reviews. We are currently exploring the possibility of using future UK Climate Impacts Programme (UKCIP) climate change scenarios. Companies plan their infrastructure based on the climate and weather patterns. Having a better idea of what is most likely to happen will help companies to develop robust plans that factor in the effects of climate change.

We will work with the Environment Agency to include guidance on climate change as part of the water resource plan guidance for future price reviews, as we did for the 2004 review. In all instances, we will take account of the latest and best evidence as it develops.

8.25. We believe that the construction of new reservoirs, and the enlargement of existing ones, for the purposes of public water supply are likely to be necessary in order to meet long-term water demand. However, the development of such new resources should be treated as only one part of the twin-track approach, and the required water must be supplied as sustainably as possible.

We agree with the Committee that the construction of reservoirs and the enlargement of existing ones are likely to be necessary to meet long-term water demand. At the last price review in 2004 we allowed funding within price limits for expenditure to enable the companies to investigate the need for four new reservoirs and raising three existing reservoirs.

We also support a twin-track approach (employing both demand side and supply side measures) to manage water resources effectively. We agree that the development of new resources should be treated as only one part of this twin track approach. We expect companies to set out the least cost set of measures to balance supply and demand, taking into account financial, social and environmental costs. All measures used to meet the supply demand balance should be carried out as sustainably as possible, taking account of new evidence and technologies as they develop. We plan to continue to ensure the industry adopts best practices as these change over time.

Leakage reduction

8.28. Given that the development of technologies for leakage detection and repair continues unabated, we believe that leakage levels in England and Wales should be reduced further. We recommend that Ofwat replaces ELL with a broader concept of "sustainable level of leakage". This would encompass economic impacts, but would also take greater account of the environmental and social implications—in each water company's area—of providing additional supply instead of reducing leakage further. The sustainable level of leakage for each company should be determined in conjunction with the regional boards, as outlined in Chapter 3, taking full account of environmental impact assessments and agreed social priorities, balanced with the cost-effectiveness of resource development.

8.29. Setting a "sustainable level of leakage" would, by factoring in environmental considerations, lead to more stringent leakage targets for companies and therefore offset some of the need for new resource development. We believe that it would also help to increase consumers' trust in the water companies and reduce their resentment at being told to save water when so many water utilities are still losing such a large amount through leakage.

We agree with the Committee that the ELL should incorporate economic, environmental and social aspects of leakage reduction. Although the name may suggest otherwise, the ELL already takes account of these factors. Our 2002 tripartite report, which we undertook jointly with the Environment Agency and Defra, identified ELL as the most appropriate way of setting leakage targets. Since then companies have undertaken a fully integrated appraisal of the financial, social and environmental aspects of their leakage reduction and other operations to ensure efficient use of water resources now and in the future. However, we are now reviewing the concepts in the light of the Committee's report to ensure that these aspects are fully addressed.

The water companies in England and Wales manage water distribution networks with a total length of approximately 335,000 km—enough to go around the equator eight times. In addition, there are almost 24 million connections to properties and associated customer supply pipes, which all have the capacity to leak. Eliminating leakage would be virtually impossible and enormously expensive. It would have a significant impact on customers' bills and raise further issues of affordability. But equally leakage cannot be allowed to go unchecked. A balance must be struck in setting targets for leakage that take account of the needs of customers and the environment, and how these change over time. This is what the ELL was designed to do, and it has led to a reduction in leakage of around (30%) in a decade. In 2005-06 the overall level of leakage in England and Wales was close to 3,600 Ml/d, compared to nearly 5,000 Ml/d just a decade earlier.

ELL is a dynamic concept that should be seen as a profile over a number of years rather than a single spot figure. The level depends on a wide range of factors that will vary between companies and over time. For example the cost of detecting and repairing leaks will fall as new technology is introduced. This may cause the ELL to fall or at least allow companies to maintain current levels of leakage at lower cost. Equally during a drought the value of water rises, making leakage reduction cheaper to undertake relative to other conservation measures and therefore lowering the ELL. It is also important that companies should show a clear lead to customers who are being asked to conserve water.

Where companies fail to properly manage their leakage, we are ready to take stringent enforcement action. The statutory undertaking recently required of Thames Water is a case in point. It will now spend an extra £150 million to replace additional leaking water mains to the benefit of its customers, but at the expense of its shareholders.

While we have confidence in our current approach to leakage, we also firmly believe that we need to build on it going forward. We have accepted the need to review our approach to ensure it reflects a sustainable level of leakage. We aim to produce conclusions that are meaningful to all stakeholders as well as revisiting the guidance on defining and using social and environmental costs. We have also identified further issues that would benefit from review, such as how companies manage leakage in response to short-term and unexpected environmental changes and how our advice on leakage supports our work to meet our sustainability duty. Initially, we are seeking stakeholders' views so that we have a full appraisal of the issues involved. The new approach will inform the forthcoming review of price limits in 2009.

Water transfer

8.30. We have concluded that a national water grid is not currently feasible. However, we recommend that both Ofwat and the Environment Agency encourage and support greater connectivity between neighbouring water companies, particularly in the south and east of England. This would allow a more rapid and flexible response to localised supply/demand deficits.

We agree with the Committee's conclusion that a national water grid is not currently feasible. Such a scheme would have a number of drawbacks including significant financial and environmental impacts.

We welcome the Committee's recommendation that we encourage and support greater connectivity between neighbouring water companies. We expect water companies to consider transfers of water from neighbouring companies as part of their least cost water resource plans. Bulk supplies can be an efficient way of meeting growing demand or restoring security of supply. At the last price review in 2004 we implemented incentives to encourage companies with spare capacity to make this available for bulk supplies. A number of companies will also undertake work during 2005-10 to improve the connectivity between their own water supply resource zones in order to minimise localised supply demand deficits. We have also worked closely with the Environment Agency in the context of improving regional planning and improving efficient cross-company use of water. This involved bringing together eight companies to consider greater integration of their plans.

We have powers under section 40 of the Water Industry Act 1991 to require a water undertaker to provide a bulk supply of water to another when it is expedient for the purpose of securing the efficient use of water resources, or the efficient supply of water. We can also determine the terms and conditions of a bulk supply to assist in expediting such an arrangement. For example, in June 2006 we determined the terms and conditions of a bulk supply from Southern Water to South East Water. We use these powers where appropriate.

8.31. We recommend that the Government, the Environment Agency and Ofwat encourage and support schemes for the planned indirect re-use of treated wastewater by water companies, especially in the driest areas. We also believe that there is scope for greater industrial use of wastewater that has been treated to a sub-potable standard, and we recommend that the Government explore means by which such schemes could also be encouraged.

We expect water companies to consider all options for meeting the supply-demand balance as part of their least cost water resource plan, this may include the re-use of treated water where this offers best value to customers. As an example, we included funding in current and previous price limits for the Langford re-cycling scheme operated by Essex & Suffolk Water.

Water efficiency

Promotion of water efficiency

8.34 Water companies need to be more energetic and imaginative in promoting water efficiency, and we urge Ofwat to look favourably upon the funding of such activities. However, there also needs to be an alternative, independent source of advice and support to both domestic and business consumers.

8.35 We agree with the Government that a water saving trust is not on balance desirable at this time—as long as other bodies are mandated to take responsibility for promoting water efficiency. We therefore strongly recommend that the Government extend the remits of both the Energy Saving Trust and the Carbon Trust to cover water efficiency. We welcome the proposed establishment of Environment Direct, which will help to address the institutional fragmentation in the promotion of water efficiency, and look forward to rapid progress on this initiative.

We agree that we all need to use water efficiently and that more needs to be done to inform consumers about use of a precious resource. We report annually on companies' activity in our security of supply report, naming and shaming those that have done less than we expect. We expect a basic minimum level of activity from all companies. However, where water supplies are under stress a more active approach is necessary. We consider this when assessing companies' progress.

At the 2004 price review we allowed specific funding for water efficiency against seven projects put forward by six companies. We agreed these schemes on the basis that an estimate of water saving was associated with these schemes within companies' business plans. Where companies put forward water efficiency projects, but did not quantify the savings expected, we did not allow specific funding. Allowing water efficiency schemes that exceed the cost of other schemes and deliver questionable water savings would interfere with companies' efficient planning to balance supply and demand. It would also have a direct impact on customers' bills, which is likely to have an impact upon affordability and the level of bad debt.

We have a duty to protect customers' interests and therefore require clear evidence of benefits to customers whether short or long term before allowing their bills to rise. In funding additional water efficiency measures our approach is to fund investment where the value of the resources saved will outweigh the costs of delivering those savings. Any new measures should be economically, as well as environmentally and socially, sustainable. Properly balancing the social, environmental and financial costs and benefits of water efficiency measures will ensure that bills are no higher than they need to be. A lack of robust evidence on the water savings available from water efficiency initiatives has been a barrier to raising customers' bills to fund additional water efficiency activity. We are working with Waterwise and the Water Saving Group to develop a good practice register to collect, evaluate and enhance the evidence base for water efficiency measures. We expect this to help companies to access "off the shelf" expertise on water efficiency measures that will deliver quantifiable savings for a given level of activity. After we have received feedback from companies we intend to publish a draft register in the autumn alongside our security of supply report.

Ofwat and other stakeholders, including the Environment Agency, are giving further consideration to positive incentives to increase water efficiency. All stakeholders have a role to play in helping to use water efficiently. We are part of the new Government-led Water Saving Group which will define, monitor, carry out and review projects and workstreams dealing with targets, the evidence base, best practice, education and policy. We are leading the work on water efficiency incentives where we are looking at how we can encourage developers and water companies, particularly in water stressed areas, to improve the promotion of water efficiency and deliver security of supply with best value for consumers.

We will consider the implications of the Institute for Public Policy Research (IPPR) report, Every drop counts—Achieving greater water efficiency when it is published.

Metering

8.38.The general consensus amongst experts is that household metering is of value in reducing consumption, and we endorse this view. However, if metering is to make a long-term difference, it must be accompanied by a programme of awareness-raising about the importance of water efficiency.

We expect 35% of households in England and Wales will be metered by 2009-10, with meter penetration expected to be higher in most companies' areas in the south-east region. Metering is the fairest way of charging and we believe that customers should pay for the water they use. In addition, when targeted at resource constrained areas, metering should be a key element of any wider strategy on demand management. When customers are metered they become more conscious of their water use, especially if this is accompanied by a programme to raise their awareness about water efficiency. This will make water efficiency activity far more effective. We therefore support moves to make it easier for companies to introduce compulsory metering in water stressed areas.

8.39 We draw the attention of the Government and Ofwat to the smart water bill reproduced in this report, and recommend that they consider the adoption of a design modelled on it for metered customers in England and Wales.

We agree with the Committee that providing customers with reliable and timely information about their household's water use may well encourage customers to use water more wisely. However, for such information to be of value to customers, it also needs to be based on more frequent actual meter readings than companies currently undertake. Changing meter reading frequency would either cost more in meter readers, or infrastructure required for automated reading. This may only be economic where a significant proportion of a company's customer base is metered. Also, changing bill format has associated "start-up" costs, both in technology and in the increased customer contact rate that typically follows a change in bill design.

Smart meters, as the Committee notes elsewhere in its report, are a further way for customers to receive information about the water they are using. They offer advantages to customers in allowing them to monitor and improve their personal water efficiency. A number of benefits would also be available to water companies. For example, smart meters that are read remotely could increase their ability to monitor their networks. However, smart meters also have disadvantages. They are much more expensive than conventional "dumb" meters and may require updated billing systems.

Ultimately implementing smart bills and/or smart meters would involve companies, and therefore customers, in additional expense. The benefits in sustained water savings would need to outweigh the costs. We therefore expect companies to make the case if they wish to move to smart water bills and introduce smart meters. This may be on the grounds of operational efficiencies, in order to charge by a peak demand related tariff or to provide more accessible customer information. Any company wishing to pursue this should set out the costs and benefits case supporting changes in their approach. One company (Mid Kent Water) made the case for smart meters at the last price review in 2004, which was a continuation of their policy in the previous period. We accepted this policy and allowed funding for smart (touch-read) meters.

Going forward, we are aware that Ofgem is studying the case for smart meters. We will examine its findings once they are available. We will also consider companies' proposals for both smart bills and smart meters where they make the case for them.

8.40. We urge the Government to consider rising block tariffs as part of their current study of tariff structures. We recommend that the use of such tariffs be made obligatory for companies granted permission to impose universal metering under the water scarcity status provisions.

Following the 2004 report on affordability, we are working with Defra, UKWIR and CCWater on a review of charging methods. This review will examine the likely incidence effects of a range of tariff options, including rising block tariffs. It may be that rising block tariffs could help to address affordability concerns, although there may be some practical difficulties with implementing them. We note the Committee's view that such tariffs can only be introduced fairly in universally metered areas. We would expect the review of charging methods to consider the effects of introducing these and other tariffs at various levels of meter penetration.

Water and the environment

Water Framework Directive

8.52. We welcome the Water Framework Directive, particularly its emphasis in river basin planning. However, it is essential that the Environment Agency should clarify the precise meaning of "good ecological status" as soon as possible if there is to be any hope of complying with the proposed timescales. In addition, the Agency must ensure that the new Liaison Panels represent a true cross-section of all stakeholders in each River Basin District.

We also welcome the Water Framework Directive and, as the economic regulator, its emphasis on incorporating economic analysis into integrated river basin planning. We are playing an active role in the implementation of the Water Framework Directive, participating in the Defra-led stakeholder and implementation groups and also in the Defra-led Collaborative Research Programme on developing economic analysis. We too understand the need for there to be clear goals on environmental objectives, which are consistent with good status on ecological, chemical and quantity parameters. In view of the potential costs of complying and meeting all the requirements of the Water Framework Directive, it is essential that there should be sound scientific evidence backed up with relevant economic analysis to justify what could be substantial work programmes with consequent incidence effects for a number of sectors.

We agree the new River Basin Liaison Panels should represent a cross-section of all stakeholders. We welcome CCWater's inclusion on these panels, as we believe it has a key role to play representing water customers. They are key stakeholders in the river basins.

8.53. It is apparent that the biggest challenge in terms of tackling diffuse pollution comes from agriculture. We welcome Defra's Catchment Sensitive Farming Delivery Initiative to help farmers tackle water pollution, but it will only be successful if farmers and advisers work together in an open and positive spirit. Moreover, the Environment Agency must not place unrealistic or excessively rigid demands on farmers when formulating River Basin Management Plans. However, at the same time, the water industry must not be seen as a soft target for tackling diffuse pollution when compared to agriculture. We recommend that the Government give further consideration to how the Single Payment Scheme and cross compliance requirements could be used to help tackle agricultural diffuse pollution in a flexible manner.

We welcome the Committee's acknowledgement that water consumers should not be seen as a soft target for tackling diffuse pollution. We also recognise that all sectors contributing to point and diffuse pollution need to play their role in meeting the environmental objectives in the Water Framework Directive. We look for recognition and application of the polluter-pays-principle in tackling pollution. Customers of water companies should pay their fair share, but no more, of dealing with their proportion of the adverse impacts on water bodies. The water industry has invested more than £17 billion on improvements to the sewerage system since 1989, which has contributed to major improvements in both inland estuarial and coastal waters.

Priority Substances Directive

8.54.  The lack of de minimis levels in the proposed Priority Substances Directive is extremely worrying, making it difficult—if not impossible—to comply with the Directive's requirements. Moreover, it is most unlikely that a Directive without realistic target levels—taking into account background levels of these substances—could be justified in terms of the potential costs. We strongly recommend that the Government work towards the inclusion of appropriate, science-based de minimis levels in the Directive.

In the interests of water consumers we share the Committee's concern regarding the lack of de minimis levels and the need for a science based approach in the proposed Priority Substances Directive. For instance, some of these substances are present in household chemicals and residues can be detected in sewage. Many, particularly metals, are also present at background levels both from natural sources and from historical use. The costs of removing, reducing or eliminating any of these substances could well be very substantial. Other impacts on the environment arising from removal processes for example from excessive energy or other chemical use could also be damaging.

Before decisions on legal and desirable levels are made, it is essential to have sound evidence on both the environmental and the health benefits of reducing or eliminating further discharges of the substances set against the full financial, environmental and social costs of meeting new standards.

Sustainable drainage systems

8.55.  We strongly recommend that the Government give urgent consideration to ways in which the financial, legislative and regulatory barriers to the wider use and adoption of sustainable drainage systems can be removed. However, we are of the opinion that operational and maintenance responsibilities should not be entrusted to individual property owners due to the high risk that they will not be carried out satisfactorily. We suggest that the Government consider alternative arrangements such as those in Victoria, Australia and in the United States of America, which have facilitated the widespread utilisation of sustainable drainage systems.

8.56. We were highly impressed by the use of Water Sensitive Urban Design in Melbourne. We commend such projects to the attention of the Government, and recommend that they give active consideration to ways in which the reuse of stormwater for irrigation of urban parks might be facilitated in England and Wales.

8.57. We welcome the integrated approach to water management being pursued in Ashford, which is a positive step forward. In order to mitigate the need for significant expenditure to meet the requirements of environmental legislation in the water environment around new developments, we recommend that an integrated approach be taken—together with appropriate funding for supporting studies—wherever a large new development is planned.

Ofwat is an active member of the Environment Agency-chaired National Sustainable Urban Drainage Working Group exploring the potential use and costs of SUDS. We support the development of sustainable urban drainage systems where they represent the most sustainable means of dealing with particular environmental problems. However, it is important to note that they may not be suitable in all locations. For example, it may be impractical, disruptive and highly expensive to retrofit such systems in highly confined, built-up urban areas. As we explain elsewhere in this response, any new measures should balance the financial, environmental and social costs and benefits. However, we do envisage that such systems will have a far greater role in the future, particularly in areas of new development.

We believe that one of the main barriers to consideration and in some cases the construction of the SUDS is the current Water Industry Act section 106. This requires sewerage undertakers to accept surface water discharged to combined sewers and also to foul sewers if no surface water or combined sewer is conveniently located. In discussions on the Water Bill in 2003, we jointly supported an amendment with the Environment Agency and Water UK on requiring consideration to be given to other options of dealing with surface water, such as the use of SUDS before sewerage companies were obliged to accept surface water into the sewerage system. We were disappointed that this amendment was not accepted. However, we will continue to work with the Working Group to explore the financial, legislative and regulatory barriers to the wider use and adoption of sustainable drainage systems.

Water resources

8.58. We recommend that the Office of Science and Innovation and the Research Councils give urgent consideration to ways in which the need for additional research into the water resource requirements of freshwater ecosystems can be met. We also call on the Natural Environment Research Council to fulfil its commitment to maintain and strengthen the research in key areas at the Centre for Ecology and Hydrology, particularly with regard to freshwater ecology research. We shall keep this issue under review.

We believe it is essential to have good quality research on freshwater ecosystems, particularly now the focus is in this area for defining environmental objectives for the Water Framework Directive. Substantial investment will be needed to meet environmental objectives and this must be justified by sufficient sound evidence.

8.59.  We welcome the introduction of Catchment Abstraction Management Strategies, but the Environment Agency must ensure that an appropriate balance is struck between the needs of water users and those of the environment, factoring in the potential change in climate. We also recommend that the Agency consider the water quality implications of each CAMS plan and assess how this might tie in with the requirements of the Water Framework Directive.

We hope that the River Basin Liaison Panels will encourage all stakeholders to review all the existing plans affecting the river basin and how they interact. We fully support the requirement that the river basin plans will require a strategic environmental assessment which we hope will address issues such as the interrelationship between quality and quantity of water and the possible impact of climate change.

8.60. The Environment Agency is required to take a precautionary approach to reviewing abstraction licences under the Habitats Directive, but at the same time adequate consideration must be given to security of supply. Moreover, abstraction licences must be judged on the basis of site-specific information, not generic data alone, and we welcome the Government's assurance to this effect.

We agree with the Committee's recommendation that changes to abstraction licences must be judged on the basis of site specific information.

Historically, we have encouraged a thorough investigation of individual sites before significant changes are required to abstraction licences requiring considerable investment. The level of investigation, and the outcome, must be in line with the potential investment. This can be a complex area with many different abstractions, flows and weather conditions affecting ecosystems. When we last set price limits in 2004 we assumed that more than 150 site-specific investigations would be carried out to investigate the environmental impact of water abstracted for the public water supply.

5 September 2006