There was an interesting meeting of the European Policy Forum last evening. Perhaps it was inevitable on a day that a drought was announced in the South East of England, but rather than focus on the substantive issues that will empower customers (choice and incentives to reduce costs to supply), most of the discussion surrounded increasing upstream competition or debating whether collaboration becomes impossible when competition is introduced.

There are three things that strike me from this debate on upstream reform.

First, we may have surveyed or consulted customers – but we have never truly empowered them to make decisions. Certainly, in Scotland, our understanding of what customers want from their water industry is now quite different to the period before the market opened. Their actual choices appear to be different from the conclusions of surveys. Customers are keen to work with their retailers to reduce their environmental footprint and would be open to more innovative and cheaper solutions. Experience shows, however, that such initiatives take time to progress.  How do we ensure that upstream reform is consistent with the expectations of customers? We should always remember who pays the bills.

Secondly, is water trading (or the agreeing of bulk supplies at it used to be called) competition? There were some who appeared to argue that it was. Could it not, however, be the result of a collaborative approach and the conclusion of a mutually beneficial agreement between two water companies? It would seem to me that the latter approach does not risk becoming a zero-sum game. A more adversarial approach would offer no such guarantee.

Thirdly, it is unhelpful to think of water resources in a vacuum. The management of drainage and waste water has to be considered. Waste water not only contains potentially valuable heat and minerals – it could also relieve pressure on raw water sources.

There is clearly a need for better definition of the issues. We all agree about the importance of resilience and affordability – the themes of the Government's White Paper –
but we will best achieve these aims by working collaboratively.

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!

I am quite often asked whether, with the benefit of hindsight, we would have done much differently in opening the retail market in Scotland. My answer is “no”. I appreciate that this answer may sound a bit arrogant. It is certainly not meant to imply that:

• We did not make mistakes in opening the market (we did!).
• We have not made changes to the operation of the market in the light of the operating experience of retailers and the wholesaler, and the service experience of customers. In fact, we have made many such changes and have actually just finished a review of the operation of the various codes that underpin the market.
• We do not think that there will need to be further changes if there is not to be an Anglo-Scottish retail market.

Looking back the most obvious mistake that we made was not to ensure that names, addresses and contact details were included in the central registration and settlement systems. But it was also unfortunate that we set an expectation that new entrants should take any customer, anywhere in Scotland, before having reached a critical mass. And no doubt we could have made it easier for a retailer to provide a different guarantee that it would meet its obligations more quickly (other than pre-payment) than we did!

I am however pleased that we got the big process issues right:

• We worked closely with Scottish Water, prospective retailers and customers in developing the market framework.
• We set a clear deadline for opening the market some four plus years into the future (and only just made it with a lot of help from both Scottish Water and Business Stream).
• We recognised that all stakeholders had to see benefits or at least no downside to the new market arrangements and that this involved not touching the RCV or the allowed for return, and ensuring that the wholesaler was pre-paid. It also involved rewarding the retailer with a modestly higher return in return for assuming all the bad debt risk.
• We responded flexibly when an element of the market framework was not leading to better outcomes for customers.
• The market participants and not the regulator are responsible for the day-to-day operation of the framework.
• The creation of retailers allows for more robust dialogue between the customer and asset-facing activities within the water industry, preparing the ground for greater innovation.

No doubt I should be more nuanced in my response about changing things but my defence is that the focus should be on the big strategic issues – not the detail of the framework.

My next blog will be on all the things that have changed since we first opened the market. Even a cursory review should make it clear that we are in a far different place today from where we were three and a half years ago!