I attended the Water UK infrastructure conference this week. As usual the event was well organised and well supported.
There was a lot of talk about how badly the industry procures and delivers capital projects. But before we go criticising others, it seems to me that we, as economic regulator, should think hard about what we can do to facilitate effective asset management. In my view there are five steps that we could take that may help:
- Set prices with a real eye to the very long term.
- Set prices that take account of the annualised resources that are likely to be required to deliver this longer term plan.
- Focus on outcomes and costs for delivery of outcomes rather than an overly prescriptive list of capital projects (thereby encouraging greater innovation and creativity).
- Recognise that optimal capital planning and paybacks do not fit neatly into five-year regulatory price setting cycles and give a regulatory commitment for longer than five years when this could improve the efficiency and effectiveness of asset management.
- Allow flexibility in timing of outcome delivery where this is agreed with customers and regulators.
A longer term approach to asset management is likely to become increasingly important over the coming years. Replacing assets on a like-for-like basis will, almost certainly, become prohibitively expensive. We will need to find more innovative and/or more strategic solutions. Understanding the extent of this capital maintenance challenge will tell us a lot about the improvements in service levels that customers may be able to afford in the future.
Historically, our approach has been to set prices based on an (overly) defined investment programme to which we have applied challenges both with regard to scope and efficiency. It seems to me that this approach has likely encouraged risk aversion on the part of Scottish Water. Our approach has reinforced the consideration of capital expenditure in a silo when, arguably, alternative approaches were becoming more desirable as we look to reduce carbon footprints, for example.
An alternative would be to adopt a simpler price cap approach, recognising the need for investors to earn a fair return irrespective of how the required outcomes are achieved. Under this model, it would be for Scottish Water to justify to its customers (who could, if they wanted, seek the views of both the regulator and the industry assessor) the outcomes that it would deliver within the resources available. Such an approach would likely also require Scottish Water to be empowered to negotiate with both SEPA and the DWQR about what outcomes they wanted and in what timeframe.
Scottish Water's hand would be strengthened both by the involvement of customers but more particularly by the longer term visibility on resources that is central to this approach. This still allows the space for Ministers to set high-level objectives which set the context for the outcomes to be achieved.
There has been a lot of debate about the length of regulatory control periods. Should they be five years, or perhaps 10 years as originally intended? Ofgem recently opted for eight years but allowed the possibility of a reopening after four years. The pessimists focused on the latter rather than the former!
But are we asking the right question? It is clearly good to give a degree of certainty to a regulated business about the level of resources to which it will have access. This is essential to the effective operational and financial management of the business. But such defined periods are unlikely, it seems to me, to fit neatly with an optimally planned programme of service enhancements.
Would it not be better to have a defined level of resources that takes account of the operating environment that we expect over the next 25 or so years? This would allow the regulated company to plan larger capital interventions as effectively as possible within this framework and allow other initiatives to be phased appropriately, taking full account of the views of customers and other stakeholders, as and when resources are available?
My final thought is that, as regulators, we may have regarded all changes to the sequencing of capital expenditure to be a ‘bad’ thing, worthy of criticism. Clearly, there will have been cases when criticism was probably warranted but there will be others where unexpected bottlenecks may have appeared and some re-jigging was appropriate to deliver the overall programme as timeously and efficiently as possible.
There may be other circumstances where the priorities of customers or the environmental regulators may change and an alteration to the capital programme is appropriate. On reflection, and subject to proper evidencing to the Commission and the Customer Forum, it would seem entirely reasonable that Scottish Water should phase its service improvement expenditure in whichever way it calculates most likely to be best for customers.
If we were to adopt this approach, it would seem to me that capital procurement prices should fall, ceteris paribus, and there should be less need to ‘pad out’ a capital programme (whether by Scottish Water or a quality regulator) and consequently less need for the regulator to feel instinctively that the programme needs cutting back........