Ofwat Chief Executive Cathryn Ross has flagged up the need for to find ways of driving more market testing of significant new infrastructure - and creating scope for this to be provided not by existing water companies but by others, if they can do it more efficiently. 

Speaking at the annual Beesley Lectures in London last week analysing regulated industries,  Ross raised a number of wide-ranging issues and provided a useful insight into the challenges now facing the water sector, which she described as “more complex and more dynamic” than at any point since privatisation. 

Ofwat’s Chief Executive set the scene by outlining three essential characteristics of economic regulation:

• economic regulation which seeks to influence behaviour through the use of incentives  which come from the allocation of risk, including  financial, reputational  and procedural  risks
• economic regulation uses incentives to align the interests of capital with those of customers. 
• economic regulators exist in relation to markets. 

Ross said that taken against the policy goals of privatisation, the regulatory model worked well to date with more than £120bn of privately financed investment in the sector from privatisation until 2014.  The sector was more than a third more efficient as a result of economic regulation, with bills a third lower than they would otherwise have been.

Although it was “fair to say that bills did rise by 40% in the period from privatisation to 2014”,  the principal beneficiary of the gap between rising bills and more efficient costs was the environment, she added. Investors had also done well too with equity returns that had “significantly outstripped  the FTSE100 over the same period.”

Commenting on its efficiency challenge to date, Ross said:

“In PR14 we moved to a benchmark based on historic upper quartile efficiency.  But, frankly, that isn’t a great reflection of what you would find in a competitive market.  In what competitive market do you see customers saying to a company ‘I know you are high cost and have higher prices  than the other guy, so I am going to give you 5 years to get your price down to 30% more than his’?!”

Now “utterly compelling reasons for change”

According to Ross, there are now “utterly compelling reasons for change”, with changes bringing the challenges that would define Ofwat’s regulation of the sector in the run up to PR19 and beyond falling into 4 categories:

Supply-demand balance – where unevenly distributed population growth will have a big impact on already water-stressed areas and also have an impact on surface water run off –  more development, especially on flood plains, will exacerbate flooding. More pollution incidents would also be seen where drainage and sewerage is combined (as in London).

Technological changes.  While it is “probably true that the water sector has not been at the forefront of technological change” this is now changing. Sensing capability is a major change – the ability to gather real time data on network performance, flow and quality is improving rapidly.  Technology is also enabling huge changes in how customers are able to interact with service providers and what they expect

Cultural and social changes.  Some customers are looking for more information about and more control over their interaction with service providers, and technology is enabling this. Other change in this category is the increasing concern of customers and society more widely not only with what they get, or with how they interact with service providers, but how they feel about those interactions. 

Financial changes – including changes in the financial climate facing companies and the affordability challenge, which has been a bigger issue over the last 5 years than at any point since privatisation. According to Ross, what happens on affordability over the next few years is really a function of whether the rise in housing costs will outstrip the growth in incomes.   

Challenges mean “we need to rethink the role of markets in the sector”

The challenges mean that “we need to rethink the role of markets in the sector”, Ross said, commenting:

“The sector will not continue to deliver a reliable supply of wholesome drinking water from the tap, it will not continue effectively to take waste water away and return it safely to the environment in the face of population change and climate change, and within the constraints of affordability if it does not find ways of doing more with less. This is something I firmly believe markets can help with.”

Ross defined ‘markets’ as “places where buyers meet sellers and where transactions take place”, saying she was not using the term ‘markets’ synonymously with ‘competition’. Markets may or may not be competitive and may or may not be capable of being competitive, she added. 

This could mean a number of things in practice, including:

• water trading – with water companies looking beyond their boundaries and beyond the water sector and bringing new sources into the public water supply. 
• more extensive use of catchment management schemes e.g. like South West Water contracting with farmers not to put nitrates on the land at certain times, Wessex Water contracting with land owners to flood fields because this is a more efficient way of attenuating flood water than building big tanks.
• water companies participating in energy generation - by using sludge to generate energy that can be sold into the grid and also see them using their sludge treatment and disposal assets to deal with sludge from other companies – bringing in revenue, and potentially also generating economies of scale. 
• water companies realising that others – that some of the smaller so-called ‘new appointees’ are better placed to do genuinely innovative service delivery and working with them to enable that, rather than resisting it. 

Ross said the key lay in the ability of markets to open up new possibilities, enable new choices and reveal information which would in itself “enable efficiency, the creation of value that can then be shared between investors, customers and the environment.”  

Ofwat will get more involved in ‘level playing field’ casework

Looking ahead, Ross said Ofwat would be putting more emphasis on understanding the system operation functions that companies perform and taking steps to ensure that they are both more transparent and enabling of efficient transactions. 

In future Ofwat is planning to get more involved in ‘level playing field’ casework – in the context of market development ,casework becomes a very important tool, she added.

Sector needs to rethink role of customer in the value chain – further step change needed for PR19

Ross said the sector now needed to rethink the role of the customer, whichwas“just as profound” as the need to rethink markets. Both the sector and Ofwat needed to stop thinking about customers as passive receivers of services and as existing at the end of the value chain, and recognise the role they can play throughout the value chain. 

On customer engagement, she commented:

“As we move towards PR19 it should be no surprise that we want to see a further step change in customer engagement. “

Even in the water and waste water value chain in its conventional sense, the customer is right in the middle of it, Ross said. The customer determines how much clean water is needed; the customers’ behaviour determines how much water is returned through the drains and sewers and the state of it.  Customers – in all their forms – are integral to the value chain.

Describing water as “quintessentially local in nature”, Ross said community solutions seem intuitively more likely to make sense and it should be easier to harness the energy of local communities to bring them about. 

However, she warned that in general this is so far from where the sector is today, expressing her concern that “the regulatory zeitgeist may be moving in the opposite direction.” 

She referred to some recent developments that suggested an emerging school of thought that “customers are not sufficiently interested/financially aware/possessed of enough time to bother with utilities.” 

She also ruled out the possibility of negotiated settlements around Price Reviews, commenting:

“I do not see us following some of the examples of ‘negotiated settlements’ that are out there.  Given the importance of companies owning and improving the relationship with their customers, I am very uneasy about a regulatory process that inserts a third party – even if that third party is a customer representative body – into that relationship. “

“A legitimacy crisis would not be helpful in making the sector attractive to investors”

Ross also highlighted the importance of legitimacy in the context of economic regulation, saying that many of the things that drive legitimacy are very closely aligned to the interests of consumers. “I don’t think a legitimacy crisis would be very helpful in making the sector attractive to investors.” she added.

According to Ross, loss of legitimacy would mean a loss of trust and trust is essential if markets are to function. Legitimacy means Ofwat needs to look beyond the traditional regulatory tool-kit and put itself in the position of being able to spot issues or risks early, and raise them with specific services providers or with the sector early, "quite possibly in ways that do not involve the formal regulatory tool kit." 

This means Ofwat needs to be better informed – and the regulator would be putting “considerable work in over the next couple of years” to develop its horizon scanning capability and the visibility of both lagging and leading indicators of risk.  

Ofwat would need to know not only that it had taken steps to support the development of markets, but how they are working and what they are delivering. 

Referring to the Water Act 2014, which envisages water trading and abstraction reform by 2022, Ross said Ofwat needs “ to do the leg work on how we enable this now.”

The regulator is also looking at where in the value chain markets could add most value – with sewage sludge and water resources as prime candidates.

"We need to find ways of driving more market testing of significant new infrastructure, and creating scope for this to be provided not by existing water companies but by others, if they can do it more efficiently," she added. 

Ross concluded by saying that Ofwat would still be using incentives to align the interest of capital and company management with those of customers but the nature of those incentives will change. 

Click here to read Cathryn Ross’ speech in full