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!

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!

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.....