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!

What is the role of the economic regulator?

Until recently, competition has been a small yet discrete team in our office. Increasingly, however, as we look at our reform of how we regulate Scottish Water and the lessons that we have learned from watching retail competition develop, we see that these two work streams are merging.

The retail market ensures that retail activities focus on what customers need and are ultimately accountable (because they can lose customers) for the level of service that they provide. Initially, I had expected competition to be principally about larger customers wanting a reduction in their charges. In actual fact, the market has proven to be about smaller users and owners of larger property networks wanting more tailored services.

In my view three lessons can be drawn from this experience:

  • Regulators may not be best placed to know what customers actually want (accessing the silent majority is far from easy).
  • If there is space to innovate, a commercially minded company will seek to achieve the benefits that are available.
  • Reputation is critical – and managements tend to respond quickly if their reputation is at risk.

These lessons are also fundamental to the changes we are seeking to make in the economic regulation of Scottish Water.

We want to empower Scottish Water and for it to take full ownership of its business plan and its customer service. As such it should be immediately accountable for its performance, and any shortfall in performance would impact on its reputation.

We want to empower customers. We are working with both Scottish Water and Consumer Focus Scotland to establish a Customer Forum. The Forum will be well placed to gather and synthesise the views of customers (of all shapes, sizes and locations) and negotiate the delivery of appropriate levels of service within the policy framework set by the Scottish Government.

So what then is the role of the economic regulator?

  • To work with Scottish Water and other stakeholders to set out, before the business plan drafting process begins, some of the key planning assumptions that we would see as being reasonable. (This may include views on future base operating costs and capital maintenance, reasonable rates of return and other similarly high level, yet fundamental inputs to a business planning process.)
  • To provide an objective view that customers and Scottish Water can draw on in coming to their view of the best combination of price and service.
  • To set prices within the policy framework set by Ministers and the agreements reached between the Customer Forum and Scottish Water.
  • To provide the space for innovation to happen.
  • To facilitate planning for the longer term (for example providing certainty that longer term outcome delivery would be financed).
  • To monitor and comment on the performance of Scottish Water against its regulatory contract.
  • To monitor and comment on the Innovation Report that will be produced periodically by Scottish Water.

As regulator we act as a surrogate for the competitive market. This requires us to enable, be flexible, be adaptive and to encourage. It may also require us to set out areas where we consider performance has fallen short. But in essence the main driver of progress should be Scottish Water's determination to meet its customers' needs (whether that is retail or household customers).

Governance of the proposed Customer Forum

Separating the retail activities of non-households in Scotland has increased the focus on the customer and certainly led to an increase in the tailored service packages being offered to customers. The proposed new Customer Forum will seek to communicate the views of all customers, both household and non-household, and of customers of both retail and wholesale operations.
The forum’s founding members are proposed to be WICS, Scottish Water and Consumer Focus Scotland. These three parties will establish the forum’s remit and the selection process and criteria for its Board. They will also appoint the Chairman.
The forum itself is proposed to be established as a separate entity, with a ring-fenced remit within Consumer Focus Scotland. Once the forum is established, WICS and Scottish Water will play no role in its day-to-day operation.
Membership of the Board is expected to include appointees nominated by Consumer Focus Scotland, licensed providers and a cross-sectoral business organisation. Board members will be appointed provided they meet the Board selection criteria as determined at the outset by the founding members.
The plan is that the Board would establish an engagement team of three people, including the Chair. Having had regard to the expected price and level of baseline services, this team will engage with Scottish Water to determine which discretionary customer service improvements will be delivered. The engagement team will be able to reach agreement with Scottish Water provided its members reach a unanimous decision, and provided the agreement is within the remit given to it by the Board. Otherwise, the engagement team should return to the Board for further guidance and approval. 
In the event that no agreement can be reached, Scottish Water and the Customer Forum would prepare a document that sets out the areas on which they had agreed and any remaining areas of difference. Scottish Water and the forum may choose, either jointly or separately, to set out why they have not been able to agree on a way forward. We would consider this evidence in reaching our initial conclusions in the draft determination.

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.