I attended the Water UK infrastructure conference this week. As usual the event was well organised and well supported.

There was a lot of talk about how badly the industry procures and delivers capital projects. But before we go criticising others, it seems to me that we, as economic regulator, should think hard about what we can do to facilitate effective asset management. In my view there are five steps that we could take that may help:

• Set prices with a real eye to the very long term.
• Set prices that take account of the annualised resources that are likely to be required to deliver this longer term plan.
• Focus on outcomes and costs for delivery of outcomes rather than an overly prescriptive list of capital projects (thereby encouraging greater innovation and creativity).
• Recognise that optimal capital planning and paybacks do not fit neatly into five-year regulatory price setting cycles and give a regulatory commitment for longer than five years when this could improve the efficiency and effectiveness of asset management.
• Allow flexibility in timing of outcome delivery where this is agreed with customers and regulators.

A longer term approach to asset management is likely to become increasingly important over the coming years. Replacing assets on a like-for-like basis will, almost certainly, become prohibitively expensive. We will need to find more innovative and/or more strategic solutions. Understanding the extent of this capital maintenance challenge will tell us a lot about the improvements in service levels that customers may be able to afford in the future. 

Historically, our approach has been to set prices based on an (overly) defined investment programme to which we have applied challenges both with regard to scope and efficiency. It seems to me that this approach has likely encouraged risk aversion on the part of Scottish Water. Our approach has reinforced the consideration of capital expenditure in a silo when, arguably, alternative approaches were becoming more desirable as we look to reduce carbon footprints, for example.

An alternative would be to adopt a simpler price cap approach, recognising the need for investors to earn a fair return irrespective of how the required outcomes are achieved. Under this model, it would be for Scottish Water to justify to its customers (who could, if they wanted, seek the views of both the regulator and the industry assessor) the outcomes that it would deliver within the resources available. Such an approach would likely also require Scottish Water to be empowered to negotiate with both SEPA and the DWQR about what outcomes they wanted and in what timeframe.

Scottish Water's hand would be strengthened both by the involvement of customers but more particularly by the longer term visibility on resources that is central to this approach. This still allows the space for Ministers to set high-level objectives which set the context for the outcomes to be achieved.

There has been a lot of debate about the length of regulatory control periods. Should they be five years, or perhaps 10 years as originally intended? Ofgem recently opted for eight years but allowed the possibility of a reopening after four years. The pessimists focused on the latter rather than the former!

But are we asking the right question? It is clearly good to give a degree of certainty to a regulated business about the level of resources to which it will have access. This is essential to the effective operational and financial management of the business. But such defined periods are unlikely, it seems to me, to fit neatly with an optimally planned programme of service enhancements.

Would it not be better to have a defined level of resources that takes account of the operating environment that we expect over the next 25 or so years? This would allow the regulated company to plan larger capital interventions as effectively as possible within this framework and allow other initiatives to be phased appropriately, taking full account of the views of customers and other stakeholders, as and when resources are available?

My final thought is that, as regulators, we may have regarded all changes to the sequencing of capital expenditure to be a ‘bad’ thing, worthy of criticism. Clearly, there will have been cases when criticism was probably warranted but there will be others where unexpected bottlenecks may have appeared and some re-jigging was appropriate to deliver the overall programme as timeously and efficiently as possible.

There may be other circumstances where the priorities of customers or the environmental regulators may change and an alteration to the capital programme is appropriate. On reflection, and subject to proper evidencing to the Commission and the Customer Forum, it would seem entirely reasonable that Scottish Water should phase its service improvement expenditure in whichever way it calculates most likely to be best for customers.

If we were to adopt this approach, it would seem to me that capital procurement prices should fall, ceteris paribus, and there should be less need to ‘pad out’ a capital programme (whether by Scottish Water or a quality regulator) and consequently less need for the regulator to feel instinctively that the programme needs cutting back........

My original expectation had been that competition would be about the larger users wanting a little bit extra off their bill. I have already come clean and admitted that I got this wrong. Clearly, there are some customers for whom price is the most important factor – but the most interesting result of offering a choice to non-household customers is the extent to which retailers, including the former Scottish Water, have found the freedom and ability to segment and understand customer needs and subsequently tailor and provide new services. In some cases this is advice on water efficiency, in others it is the management of drainage, in yet others it is dealing with discharges to our environment.

Large businesses and the public sector are likely to need help if they are to operate in a more environmentally friendly manner. There is little doubting the commitment of many of our largest businesses, but this just makes it all the more important that they can access the sort of support they might need to achieve their ambitions. Assisting these businesses is proving to be the core competence of the new retailers in any new competition framework. Indeed, if Business Stream’s experience is anything to go by, it could be a potentially meaningful source of the green jobs, for which our politicians aspire.

Business Stream already appears to be able to add meaningfully to its retail gross margin by offering these additional services. And it should not be forgotten how important providing services such as consolidated billing are to the retention of existing customers!

Why is freeing up customer-facing activity so important? There are four reasons that I could suggest:

• It requires the potential conflict between water efficiency and effective asset utilisation to be addressed explicitly.
• The fear of losing or the chance of winning customers strengthens the level of engagement with the customer base, resulting in more innovative service propositions.
• The creation of a profit centre from what was, traditionally, purely a cost centre will likely reduce costs in an area that anything other than very invasive regulation could not reach.
• The marginal extra revenue and profit available from providing these value added services is not likely, at least initially, to be important viewed from the perspective of the vertically integrated utility. However, from the perspective of the retailer, revenue from these sources is likely to be very material – being both a source of growth into the future and a source of much higher margin business than the core activity of water and sewerage retail.

Retail is therefore about the meeting of customers’ needs – needs that customers may not yet have identified for themselves. It should be the goal of the water retailer to find ways that will support water customers in using less water and in being more environmentally- friendly. Such an outcome is likely to be far more important to many businesses and the economy and environment more generally than a small reduction in the tariff.

It is never easy to admit that you got it wrong. But this is what I have had to do when it comes to how retail competition has developed in Scotland. I had expected that the prime movers would be the largest users of water – who often operated in relatively low margin commodity sectors. I reasoned that even a relatively small additional reduction on their bill would be useful. Large users of water had been understandably vocal during each price setting process!

However, it has been instructive to see how the market has developed. What I see is an unexpected – at least by me – demand for something different from a part of the customer base in Scotland that had not previously been all that vocal.

Perhaps the best example of this is from multiple-site customers. A tender by Procurement Scotland placed only a 35% weighting on price – favouring instead value added services such as water efficiency.

Similarly, some of the best known retail names have opted for tailored services. In one case, the customer enjoys substantial savings in their own administration costs because they are billed in a manner that is convenient for them.

There is still more to do in building awareness of the market and the opportunities that could exist for new entrants. Potential returns are attractive but the amount of capital required is relatively low. This may discourage new entrants to the market. It is for this reason that we believe an Anglo-Scottish market could be attractive. Such a market would offer a scale that could be more attractive to both incumbent water companies and, potentially, the large energy retailers. Having said that, I find it interesting that one of the smaller new entrants should see the potential of targeting smaller non-household customers.

However, we must also look closer to home to identify whether there are other bottlenecks that limit the level of competition or the extent of choice available to non-household customers. Our review of market arrangements appears to confirm that potential new entrants were put off by a requirement to serve any customer, anywhere in Scotland at the default tariffs. With 20-20 hindsight, I can certainly see that with no knowledge of customers’ payment histories I was requiring them to take on a potentially significant risk – especially when the incumbent had the best available information on each customer!

Reviewing this experience, I do wonder how well we understand the constraints faced by regulated businesses and how complete our understanding of what customers want actually is. This suggests that better regulation may require two distinct steps:

• involving customers in setting prices; and
• creating a sufficiently flexible framework where innovation and commercial competence can result in a higher return.

It seems to me that involving customers may begin to reveal that the actual priorities and trade-offs that customers would make are quite different from those that we might make on their behalves. And at the same time there may be a difference between the constraints that we, as regulators, may regard as most significant and the actual experience of market participants. The same is likely to be true of incentives devised, somewhat artificially, by regulators!