This blog first appeared as a guest blog for Utility Week on 13 May 2013.

The speculation can finally end - the Queen's Speech confirms that there will be a Water Bill. But wait! Am I being too hasty? As always, the devil is in the detail: will the Water Bill facilitate competition or will it reinforce opportunities for cherry-picking?

From a Scottish perspective, my worry is about unintended consequences in England spilling over and changing the nature of our market. Our mantra when we implemented a competitive retail framework in Scotland was to "think big, but act small". It seems to me that, given the potential additional complexity of dealing with multiple vertically integrated companies, such an approach may also be appropriate in England.

If we are to maximize benefits to all customers on both sides of the border (in line with the policy direction set in the Water White Paper), there are four changes that we would like to see in an amended Water Bill. These suggestions are consistent with the EFRA Select Committee's detailed critique of the draft Water Bill.

1. Rule out de-averaging

We are concerned that de-averaging could materially disadvantage businesses (and, potentially, households) that are located in more rural areas. It also seems likely that it would disadvantage smaller businesses. We are sceptical too that the suggested benefits (ie that improved location signals will be offered to intensive water-using businesses) could outweigh these disadvantages. In our view, the costs of raw water are unlikely ever to be a major element of total water supply costs - especially given the capital intensity of water supply and waste water collection assets.

We have asked Oxera to carry out a detailed analysis of the potential impact of de-averaging in Scotland, and Scottish Water has agreed to make all of the necessary data available. We are hoping that Oxera's work will be reviewed, as it progresses, by a steering group that will comment on both the approach and conclusions. We will publish the results of this work and the method used on our website.

Although we are opposed to de-averaging, we do believe that it is important that Scottish Water understands its local costs of supply. This information would be helpful when considering the procurement of incremental capacity. It would also help Scottish Water to develop a clearer understanding of the circumstances in which it is beneficial to adopt innovative approaches where these are put forward by customers and suppliers. Which brings me to the next point...

2. Rule in incentives for innovation

Innovation could sensibly be encouraged by allowing customers to benefit from discounts if they have taken some action that reduces the water company's overall costs (the Section 29E procedure in Scotland). It also requires an acceptance by the regulator that the traditional regulatory framework has limited the scope for innovation and that, at least in theory, an innovation could merit (and be rewarded with) a higher return and still end up being beneficial overall for customers.

In Scotland, we are seeking to make such opportunities attractive both to Scottish Water and to its partners.

3. Rule in a level playing field

In Scotland, the 2005 Act redefined Scottish Water's non-household retail activities as 'non-core' and, therefore, not subject to regulation. Scottish Water had to separate these activities although the choice of a legal subsidiary was one of many options it could have chosen. Legal separation certainly made it easier for the Commission to ensure that there was a level playing field, although neither incumbent nor new entrant were probably happy with the decisions taken.

Ensuring that there are clear and effective governance rules will be even more important as there is no sign that the Government will allow water businesses voluntarily to separate their retail businesses.

While these measures are essential if we are to facilitate entry by new market participants (on the assumption that Government does not decide to allow for voluntary legal separation), they are, in my view, likely to require quite invasive governance codes. The codes would need to cover, inter alia, the handling of money, communication between the wholesale and retail functions (IT, human resources, data sharing etc) and the provision and cost of central (ie group) services.

Ironically, such robust governance arrangements (and their policing) are likely to add costs and could make the market opportunities less attractive both to new entrants and to end customers. It will also make it more difficult to gain market share (acquisition of customers would be problematical) and limit losses in the event that a vertically integrated retailer proved to be less effective than its rivals.

Clearly, the best option would be to allow for voluntary separation. Although problematical, the next best solution would be to put robust governance rules in place. If neither is done, the new market arrangements are unlikely to bring the desired benefits.

4. Rule in favour of a 'for the market' approach to upstream reform as opposed to an 'in the market' approach

Issues such as the minimum levels of resilience that should be maintained by water companies are, quite clearly, political decisions. It is then for the regulator, working with the regulated company, to establish the most cost-effective way of delivering these policy objectives.

In our view, the most effective way of delivering such incremental capacity to the water and waste water system is to place an efficient procurement obligation on the local monopoly company.

It is also desirable to ensure that the regulatory regime has no inherent features that might mitigate against the selection of the most effective and efficient outcome (either in the way capital expenditure and operating costs are treated or in the handling of appropriate returns). Such an approach should ensure that new entry is possible and that the most efficient solution - irrespective of who provides it - is delivered. This approach would benefit both customers and our environment.

These suggestions effectively strengthen the policy direction from Government, move the industry away from a common carriage model, focus competition on retail services and ensure that new capacity is procured as efficiently as possible. They would also make it much easier for the small player to make water resources or other skills available to the industry without having to go head to head with the incumbent monopoly.

A Bill that delivers these opportunities would be a major step forward for the industry, for customers and for our environment. It would also be consistent with the policy direction set out in the Government's White Paper. Intriguingly, it requires only relatively modest changes from the draft Bill that was critiqued earlier this year by the EFRA Select Committee.

Anyone for reform?

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.

The wholesale water business of Scottish Water should be a lower risk activity than the currently vertically integrated water utility. But I, for one, have no ambition to cut its allowed for cost of capital – my focus is on ensuring that customers benefit in the form of lower bills and better, more sustainable services. What matters is the outcome for customers – not the means by which that outcome is delivered.

So, if it is cheaper for a relatively low return to be earned on building an asset then Scottish Water should choose that option. If an alternative solution exists that is cheaper overall – although perhaps more risky to implement and requiring a higher return – then Scottish Water, in the interests of customers, should opt for this solution.

In looking forward to the next regulatory control period, I see no reason to adjust ex ante the return that we have allowed for historically. But we should respond positively to proposals from Scottish Water that would lower costs to customers in the short, medium or long runs. To do otherwise would run a risk of disempowering Scottish Water and any such loss would not be in customers’ interests.

Two particular thoughts come to mind:

• I would like to see Scottish Water become more innovative in pursuing the outcomes that are agreed with Government and with the Customer Forum.
• A business that is truly focussed should potentially opt for different solutions – perhaps with a greater reliance on operating costs, perhaps on collaboration through trading or asset development with a neighbour, perhaps on longer term structural initiatives such as asset rationalisation.

Our approach will be to allow Scottish Water the flexibility to operate within a range of indicators of financial strength. This range would take account of any proposed solutions that are more risky or more innovative. It would be for Scottish Water to set out in its Business Plan the benefits to customers that could accrue from, for example, innovation or asset rationalisation. If the NPV is positive and customers’ bills will be lower over time, we would be pleased to see any such initiatives – provided, of course, that the Customer Forum regards Scottish Water’s suggested approach as reasonable.

As regulator we need to avoid, intentionally or otherwise, appearing to favour one approach over another. To do so would be to step away from regulation of outcomes, which, it seems to me, is most likely to deliver the sort of value for money that customers want. The management of Scottish Water should choose the option that is likely to deliver the best possible value for money to customers – in some cases that will be the tried and tested, in others it may be something rather different.

My commitment is that there will no longer be any bias in favour of capital expenditure and that we are prepared to discuss longer term ring financing of initiatives that will deliver value for money to customers. We recognise that Scottish Water is accountable to its customers first and last. If it does well and delivers in line with its contract with customers, it will be well on its way to achieving its ambition of becoming Scotland’s most trusted and valued business!