I am struck that there is so little focus on the opportunities that could arise from innovation in the water industry relative to what is being discussed in energy. At a recent investor conference, there appeared to be considerable interest in new initiatives that had an energy focus but far less on those suggesting new innovative approaches that could benefit either the water undertaker or its customers. Given that so much of our energy consumption goes to heating water for one purpose or another, such a skewed focus may be to the detriment of both the investor and the end water customer.

The introduction of retail competition has resulted in a much greater focus on meeting the needs of customers and tailoring a package of service appropriate to the individual user. The Section 29E provision, which allows the customer and its retailer to benefit from any initiative that reduces Scottish Water's costs, has not yet been triggered although several market participants are beginning to consider opportunities. In my view, there is a real opportunity for Scottish Water, as the wholesaler, to use the creativity of the retailers and their strengthened relationship with customers to identify opportunities to reduce costs.

Opportunities have been created by the introduction of the retail competition framework but it is now up to market participants to realise the potential. As industry regulator, we will stand ready to make whatever changes are required to ensure that the framework works in the best interests of customers and does not do detriment to Scottish Water’s core business.

Turning to the upstream activities of Scottish Water, our I-cubed initiative is targeted at removing or, at least, reducing regulatory barriers to innovation. This is why we will regulate on a cash, total expenditure basis rather than assess operating costs and capital expenditure separately. It also explains why we will focus on ex-post returns earned rather than setting an ex-ante cost of capital. We also stand ready to work with Scottish Water and its customers to ensure that NPV positive projects with an extended pay-back can be encouraged and appropriately rewarded.

Even a cursory review of some of the innovative approaches being adopted in other parts of Europe would suggest that there is considerable scope for value to be realised from what could be seen (wrongly it seems) as a staid, boring industry. Recovering minerals from sewage, capturing the heat differential between the effluent discharge and the ambient water course, and recycling sewage to create slow-release fertilisers are all examples of initiatives that may prove beneficial both to the water undertaker and to society more broadly.

The onus is on all of us to work together to realise the potential of the water industry.

I am encouraged by the reactions of Scottish Water, the Scottish Government and other stakeholders in Scotland to our I3 (or ‘I cubed’) initiative.
This seeks to involve customers more extensively in the entire price setting process but most particularly in developing the priorities for improvements in broadly defined customer service issues – everything from security of supply to resolving water pressure or malodour problems.
The initiative also seeks to correct some of the perverse features of the current regulatory framework that can limit the opportunity for a regulated company to pursue NPV positive initiatives whose payback is greater than five years, or to favour capital expenditure solutions when other approaches may be economically more efficient. I am also keen that Scottish Water is encouraged to be innovative.
This will require a quite different approach from us as economic regulator. It will be a case of ‘away with the black box’. We will work with Scottish Water to identify and agree some of the key inputs to the price review – such as the level of ongoing operating costs, capital maintenance and the appropriate financial strength of the company. We will also encourage Scottish Water to take a longer term view of its strategy and to engage with customers on their priorities.
After the initial business plan is published we will facilitate meetings between a new Customer Forum, the quality regulators and Scottish Water and will publish our views on Scottish Water’s business plan for discussion. Hopefully this will ensure that our draft determination reflects our considered views. There should be no surprises. As such, we would hope that the final determination is much more similar to the draft than has, perhaps, historically been the case. The goal of reduced regulatory risk and greater upside for good management may be within our grasp!

One of the early challenges to our ‘I³ Project’ (short for Incentives, Innovation and Involvement) was on the need for change. Why was this upheaval necessary when the level of service and value for money provided by the Scottish water industry to its customers has substantially improved over recent years (as our recently published Performance Report highlights)?

In large part our regulatory approach relied on robust comparisons with the performance improvements already achieved by the companies in England and Wales. This benchmarking enabled us to challenge Scottish Water to improve its performance to match that of the leading companies – a challenge to which it has responded well.

There are three reasons for change.

• This benchmarking has run its course.
• It is now clear that investment to improve the quality of drinking water and the water environment is an ongoing requirement; as such it is important that customers understand and are willing to pay for further improvements.
• The reduction in our own budget means we need to find a way to identify and understand customers’ priorities in order to focus resources where they add value.

The scale of Scottish Water’s improvement means we can no longer rely on benchmarking comparisons – the gaps are just too small to draw definitive conclusions. There now has to be a question over the extent of information that the regulator collects. If, for example, Scottish Water finds 40% of the typical regulatory return to be useful in managing its business, should the regulator need any more than 50% of this subset – if his purpose is to regulate rather than to run the business? These proportions are probably both too high – but even they imply a reduction in the information collected of 80%. But in making a reduction (and ours will be of the order of 90%+) we have to ensure that we understand the hows, whys and wherefores of what Scottish Water wants to tell us....

We are moving to the Cold War End Game – a case of trust but verify. This explains our change to the role of the Reporter. Here we seek to replace an engineering review of regulatory information with targeted scrutiny of issues that Scottish Water, the Customer Forum or the Commission considers could be useful. The Industry Assessor – as the new role will be known –is likely to be an experienced industry leader supported by a multi-disciplinary team that could examine any aspect of Scottish Water’s performance.

In considering the future of the regulatory framework, Scottish Water and WICS concluded that there are three critical issues:

• how best to encourage innovation;
• the use of new incentives to encourage further efficiency and more sustainable outcomes; and
• involving customers in decision-making, particularly in determining how and where service should be improved.

All three will be crucial to keeping bills down, minimising borrowing needs and delivering the services and value for money that customers want. The onus will now be on Scottish Water to identify projects that are positive NPV and increase the scope for innovation – and if they feel a higher return is necessary to pursue these projects to explain why. This forms the basis of our I³ project.