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?
This blog first appeared as a guest blog for Utility Week on 10 May 2013.
As any Monopoly aficionado knows, the Water Works is not Mayfair. It is low return and relatively unexciting. In the water industry, we need to ensure that investors in the Water Works earn appropriate returns for the risks they run and are not earning Mayfair returns for Water Works risks.
It seems to me that one of the issues that needs to be considered is the use of a weighted average cost of capital (or WACC). The level that the regulator fixes for the WACC has probably the single biggest influence on the prices customers pay. Understandably, therefore, it is debated long and hard, with learned treatises exchanged as to why it should be higher or lower. But the issue is much more complicated than simply the level at which the WACC is set.
Equity is accumulated when a company retains after-tax profits rather than distributing them in the form of dividends. Companies can also raise new equity by issuing shares.
Equity is designed to be the first port of call for any costs that might arise from shocks to the business. As such it insulates debt providers from the losses that could arise as a direct consequence of the crystallisation of operational or other risks. Given its additional exposure to risk, equity is therefore more expensive (both to raise and to retain) than debt.
Debt is typically issued for a relatively long time period and changes in the company's leverage (essentially the amount of debt the company holds relative to its regulatory capital value) can be to the benefit, or detriment, of the equity owner. Whether the change is to the benefit or detriment of the equity holder may also be a function of time. It may be beneficial in the short run and detrimental in the longer run. Equity investors' views may therefore be quite different based on the time horizon of their investment and their expectations as to their exit price.
By definition, the regulator has to look at equity in the round and allow for a return consistent with the systematic risks of the water industry and not the specific risks of individual water companies. Even this is a difficult judgement for the regulator - and quite different answers could be justified by using or reviewing the data in different ways (how otherwise could the Competition Commission ever come to a different view than the regulator?). But it is at the level of the individual company that the more problematical issues can arise.
Since an individual company's return is controlled (by the regulator) through the WACC, if a company can substitute a pound of debt finance for a pound of equity finance, this will increase the returns available for the equity holder (because debt is 'cheaper' than equity and is an allowable expense in calculating the level of corporate tax payable).
As has been well documented by numerous commentators, many water companies have increased their leverage and reduced their equity buffer as a direct result. Ironically, the principal exception to this is the first debt funded company, Welsh Water. This company has recently substantially reduced its level of leverage and is now one of the financially strongest in the industry.
The key concern for customers (and debt holders) is that sufficient equity remains in the business to absorb the impact of any shocks. In setting an appropriate equity return, the regulator's allowance includes an element for risks that might arise in the company's operations (and which are outside the control of management). If not paid out in dividends, cash balances would grow; the increase is likely to be very significant because these risks crystallize only rarely but tend to have quite an impact when they do.
Given this, there is the potential for dividends to be paid allowing the current shareholder to benefit, but, in so doing, potentially increasing the risks borne by future shareholders. Examples could include making future capital expenditure more difficult to finance or making it more difficult to respond to an operational shock.
There is no easy way to ensure the sustainable financing of a utility where returns are set through a WACC (with a balance between a return on equity and a return on debt, weighted on an appropriate capital structure). Alternatives could include controls on dividends or the creation of risk reserves. But these options are further complicated if we are seeking to encourage innovation where the profile of risks, rewards and appropriate returns are likely to be different.
In Scotland, we have moved away from the WACC and are looking at an ex-post measure of returns that focuses on ensuring that returns are appropriate for the risks that are run. There is also a clear mechanism for outperformance to be shared with customers. We have called this mechanism our 'financial tramlines'. The way these financial tramlines work is outlined in detail in our methodology document, which we will publish shortly.
This blog first appeared as a guest blog for Utility Week on 3 May 2013.
No doubt it is a sign of the times in which we live. Just last week we saw two reports 'We Deserve Better' by John Penrose MP and 'The Water Industry: A Case to Answer' by the New Policy Institute for Unison.
The level of water bills has now been making headlines for a good few weeks. Such headlines may not be too unusual, but they do seem to be happening much earlier than they have in recent regulatory cycles. Both our and Ofwat's initial decisions are still a year or so into the future. And these decisions will only take effect from April 2015!
The New Policy Institute report draws attention to the level of profit earned by the water industry and compares it to the bills paid by customers. But we do need to recognise that continuing investment in improving our environment, the quality of our drinking water and the level of service we receive requires water companies to earn a profit. It is the division of that profit between investment for the future and the remuneration of the shareholder that is the key issue.
There is increasing evidence that the returns earned by shareholders have been very high. They have been high relative to other asset classes and they have been high relative to the risks of what is, at its core, a regulated industry. Shareholders have certainly benefitted from the substitution of debt for equity in the financing of new investment. Recent transactions would suggest that the returns expected by investors are now much lower than previously - unless, of course, they have wholly unrealistic expectations of the cost of capital that will likely be allowed for.
It is for good reason that the Water Works is one of the cheaper and lower return properties on the Monopoly board. While it may be irritating to pay your opponent (especially if you have just rolled a double six!), it is highly unlikely to bankrupt you (just compare the impact of landing on a hotel on Mayfair). Quite reasonably, the investor has not invested too much either (a mere £300 if they have maximised their potential return by also buying the Electric Company).
So what should we learn from this comparison? Shareholder returns may be irksome but they are necessary if we are to enjoy continuing improvements in our environment and adapt to the potential challenges of a changing climate. It is, however, vital that they are reasonable (the bankrupting Mayfair hotel requires more than ten times the upfront investment!). Equity returns paid out in dividends, which are several times the rate we pay on a mortgage, cannot be classed as reasonable. Should we cap dividends? Should we continue to use a WACC? No doubt there are many different approaches, but the key is that we find a way of sharing benefits more effectively with customers.