Why change?

As consumers we are all probably glad that the water industry is very conservative. None of us wants undue risks being taken with public health or with our environment. I accept therefore that those who seek to change the way in which the industry operates or is regulated should explain why they think change is necessary and what the impact of change is likely to be.

Before I make the case for change, I think it is important to recognise the improvements the industry has made in levels of service to customers; in its efficiency; and in improving both water quality and waste water discharges to our environment.

However, this worthy performance in the past is not a sufficient reason to remain with the status quo. Nor does it mean that further improvements could not be made. The current economic regulatory framework imposes a five-year delivery cycle. It is not clear that a project with a positive NPV that pays back in seven years would be pursued by a regulated company. Even if any capital expenditure were included in the RCV, it is far from certain that investors would achieve pay back on their investment – let alone a reasonable return.

The separate regulation of operating costs and capital expenditure may exacerbate the pursuit of the lowest whole life cost solution or satisfactory returns for owners. Asset creation earns a return; any other spending does not. As such it is better to own vehicles than to lease them. It is better to build a reservoir than to buy water from a neighbour. Indeed the current framework may reclaim any extra revenue generated from trading water and regard expenditure on traded water as operating costs and, perhaps, as a source of relative inefficiency!

Allowing the same return on potentially more risky projects that are, in some way, out of the ordinary could similarly limit the benefits that could accrue to customers. For example, the pursuit of a catchment management solution may earn little or no return for a water company. Yes, it is risky but it could likely be much cheaper to customers than the likely alternative: the construction of an asset.

A second example could be where the delivery of a major project represented a significant proportion of a company's RCV. There is a valid question whether the marginal rate of return on a large and potentially risky project should be the same as for a portfolio of already completed assets or even a large portfolio of assets that are in construction using tried and tested methods.

Given these weaknesses in the current regulatory framework, it seems to me difficult to justify the collection of extensive data returns, or indeed lengthy and detailed business plans from Scottish Water. Regulation should be proportionate if it is to be effective and, even more important, legitimate.

One advantage of the substantial information collected was to allow comparisons to be drawn between companies. We made extensive use of such comparisons in our initial challenge to the three authorities and to Scottish Water to improve the efficiency of the industry in Scotland.

But what about customers? What I have described is an extended dialogue, sometimes cordial, sometimes rather adversarial, between the regulated company and the regulator. Both sides, at different times, lay claim to represent the interests of customers best. Even when we each ask customers, it has tended to be adversarial – whose research is better?

And what of those customers who want choice: would they be satisfied with a regulatory solution? Certainly the regulator could set higher and more stringent customer satisfaction benchmarks, but at what cost given the broad agreement that the regulatory burden for companies should be lowered not raised? And to what extent will incrementally increased service levels, which is all a regulatory solution could ever hope to achieve, placate those demanding choice?

Perhaps we need to pause and ask: “Why do we do what we do?” It seems to me that both the regulator and the regulated company should be working in the interests of customers. And if there are opportunities for a management, an owner or, heaven forbid, a regulator to take a short-term approach, should this not be seen as a failure on the part of each participant in the process?

So I rest my case. The compromises inherent in the current regulatory framework are too great and it does not position us well for the new challenges, such as addressing climate change, that lie ahead. Those who may favour the status quo should be able to suggest how the issues I have outlined above are to be addressed. I do not think that this will be an easy case to construct!

In Scotland, we are working with Scottish Water to make the regulatory framework more flexible, to encourage innovation and to welcome any project that could add value, while improving the level of service provided to customers or to the environment. 

Scottish Water and the Commission are also working with Consumer Focus Scotland to establish a Customer Forum. This Forum will represent both household and non-household customers and will be empowered to make the trade-offs that are important to customers within the policy framework set by the Scottish Government. Interestingly, the participation of retailers – with interests in other parts of the country – can ensure that the incumbent wholesaler can be challenged to at least match the performance of its neighbours!

And, of course, the retail competition framework allows those companies or public sector organisations for whom choice is important to choose the service and price offering that best meets their needs. All the while, the wholesaler knows that there will be no detriment to its activities. This certainty should lead to a greater willingness to innovate – especially given the more flexible regulatory framework that we are in the process of establishing.

Could we do better? Without question – but only by talking further. Not by engaging in the polemics that have unfortunately characterised the debate so far!

Regulation: Fit for future purpose

Competition is not an end in itself. It is useful if it increases the chance that customers will be happier with the service they receive or if better outcomes or lower costs can be achieved. It is not easy to introduce a competition framework either for the regulator or the regulated company. And it takes time! But it will be more effective if it is part of a package of measures designed to achieve a more sustainable water industry. This is what we, working with Scottish Water and other stakeholders in Scotland, are seeking to put in place.

What does such a package contain?

  • A more flexible approach to regulation: this could include treating operating costs and capital expenditure equally; setting upper and lower bounds for the acceptable cash return earned by investors in the industry; allowing for different approaches and returns to be earned in different circumstances; allowing for capital investment planning and delivery over a longer time horizon; and allowing for payback on company initiatives that may stretch beyond a single regulatory control period.
  • Customer involvement: offering household and non-household customers and retailers the opportunity to engage directly with the water company to decide (within the defined policy framework) on key service and price priorities and to influence other key decisions such as how to meet mandatory improvements or on the scope for future efficiency. Involving retailers and household representatives is key – just imagine comparative competition devolved to customer representatives: “They can do it, why can’t you?”
  • Encouraging and rewarding collaboration: trading water, jointly developing resources, working with farmers may all bring about better outcomes for the customers of the companies who pursue such options. Allowing space for experimentation or enhanced rates of return (provided the overall cost to customers is lower) could be a useful step forward. By continuing to improve our dialogue with Scottish Water, I believe that we can create the necessary space.
  • Offering non-household customers the chance to switch supplier: our experience in Scotland is that this can be done in a cost-effective way that reduces total industry costs. Careful joint working with Scottish Water allowed us to develop an effective operational code that has stood up well to two of the most severe winters in recent memory. Avoiding some of the mistakes that we made could mean that the same benefits may be available to companies and customers in England at lower cost.
  • Reducing the bureaucracy of regulation: there is little doubt that the econometric models served customers (and the industry) well – even if there was some temporary pain.... But these models born of a study of detailed costs and drivers triggered further pursuit of new and better information either to substantiate or undermine conclusions.

Business plans got to be so long they were unactionable – and if unactionable, what is their point? Does ever more information really address information asymmetry between companies and their regulators? Or might more frequent, more strategic dialogue be at least as effective? If so, the cost reductions on both sides of the regulatory divide could be substantial!

Customers’ interests are that utility services continue to be provided in an efficient, effective manner, meeting their needs at a price they can afford. Most investors in utilities would take a similar view. Perhaps then we should regulate appropriately, recognising the success that has been achieved but preparing for the new challenges that lie ahead.....

Economies of scope, and the evidence from Scotland

There is much debate about whether, and to what extent, economies of scope exist in a vertically integrated wholesale and retail water and sewerage company. A further question is the extent to which such economies of scope are lost if retail activities are managed separately from the wholesale business. And a further question again as to whether savings resulting from separate operation may offset any demonstrated loss of economies of scope.

I am not convinced that there is a robust, unchallengeable answer to these questions.

What is clear, however, given the evidence from Scotland – both in terms of the level of service provided to non-household businesses and the reductions in costs that have been achieved by Scottish Water and Business Stream since they began to be operated separately – is that there are potential gains (in terms of level of service and cost reductions) that may benefit customers.

A comparison of the retail costs declared by the water and sewerage companies south of the border with those of Business Stream before separation suggests that they are higher. This may reasonably be explained by the better level of service that was provided to non-household customers by the privatised companies in 2006-07. But Business Stream has now reduced its costs by more than £8 million a year and, according to its customers, the level of service now provided compares well with that available elsewhere in Britain.

At the same time Scottish Water has been reducing its costs ahead of its regulatory targets.

This could lead to a conclusion that there is no loss of economies of scope as a result of separating wholesale and retail activities. But it is possible that there have been other effects, not currently observed, which are detrimental and which offset the cost advantages seen in Scotland.

One frequent objection to operating retail and wholesale activities separately is that the industry would be likely to respond less effectively in the event of an emergency. The argument would likely continue that given the importance of an effective response to an emergency, wholesale and retail activities should remain vertically integrated – whatever the potential savings or benefits in terms of customer service or environmental improvement.

But there is evidence on dealing with emergencies available from Scotland. Since separation in 2006-07, there have been two of the coldest winters in recent times. However, both Scottish Water and Business Stream stepped up to meet the challenges presented by such extreme conditions – not least the challenge of dealing with non-household customers during a holiday period when the normal occupier of a premises may not be easily contactable. Certainly their response and those of the other licensed providers would seem to compare favourably with other areas of the country.

Of course, this does not mean that the separated activities will always be able to respond as effectively to every emergency. And while I have no reason to be worried about market participants' understanding of how to deal with emergencies, one of the conclusions of our competition framework review is that we should issue a clear, high level statement of our expectations and the responsibilities set out in the Operational Code.

To conclude, are there economies of scope? Neither I nor anyone else can be sure! But the onus is surely on those who assert their existence to prove it – particularly in the light of the evidence from Scotland.

About Alan

Alan Sutherland

I’ve been Chief Executive of the Water Industry Commission for Scotland since its establishment in July 2005. Prior to that I was the Water Industry Commissioner for Scotland having been appointed to that role by Scottish Ministers in November 1999. In 1998 and 1999 I was a managing director of Wolverine CIS Ltd, a division of Wolverine World Wide. Prior to that I worked in strategic consultancy with Bain and Company and in the investment banking industry with Robert Fleming and Company.