Cathryn Ross, chief executive of Ofwat has described the water industry regulator as “slightly nervous” about the requirement in the Water Bill for it to act “in accordance” with the strategic policy steer which Defra is providing.

Cathryn Ross told the House of Commons Public Bill Committee at its first sitting to examine the Bill this week that while Ofwat welcomed the steer itself, the requirement seemed to “go against the thrust of independent economic regulation.”

Ms Ross said Ofwat was also concerned about clause 22 of the Bill which places on Ofwat a duty to ensure resilience of water and sewerage provision, commenting:

“Obviously, it is for Parliament to decide what statutory duties we have, but our concern is that a resilience duty might lead to a conversation concentrating on capital investment and might be seen by the companies in particular as a licence to build, which is precisely what we have been trying to move away from with some of the innovations in our periodic review. “

In response, Rob Wesley, head of policy at Water UK, also appearing as a witness, said the water companies took “a somewhat different view” and described the introduction of the new duty as “one of the most important clauses in the Bill.”

In terms of whether it could be seen as a licence for capital expenditure, Water UK gave credit to the changes that Ofwat had made to the regulatory framework. Reweighting incentives between capital and operating schemes by introducing a new totex—total expenditure—approach bringing capital expenditure and operating expenditure together as a single assessment, together with other changes had led to a more balanced approach. He added:

“We saw the first fruits of that yesterday in companies’ business plans submitted to Ofwat.”

Confidence-boosting measures needed on competition

Much of the Committee’s questioning of a range of witnesses appearing before it centred round the opening up of the non-household sector in England to retail competition in April 2017.

Alan Sutherland, chief executive of the Water Industry Commission for Scotland, called for the inclusion of confidence-boosting measures in order to stimulate the introduction of competition in the water sector, including:

• an absolute requirement for each business to publish a wholesale charges scheme; no negotiation;
• no doubt as to what is on offer for the entrant;
• introduce a statutory commitment to the creation of a level playing field,
• a legal duty for incumbents to behave, consistent with the level playing field, ensured by a suitable governance code;
• and all codes in place to apply equally to all, whether they are an incumbent or a new entrant.

Water Bill “light on the level playing field issue” for competition

Mark Powles, chief executive of Business Stream in Scotland agreed, saying that the Bill was “light on the level playing field issue’ and that it should be strengthened to put more obligations on the incumbents to show no undue preference and to ensure that there is transparency, fairness and openness in the way they deal with new entrants and their incumbent arms.

He also raised the issue of why there was currently no provision for incumbent companies to exit the market, commenting:

“…should incumbent companies be forced to be retailers in a new market? I have never seen someone be successful in a vibrant retail market by being press-ganged into becoming a retailer. The market could become very complex if we have 22 wholesalers and up to 40 retailers fighting for 1.1 million customers.”

Mark Powles warned that the more players there are in the market, the more cost and complexity are built into the model. The more complexity, the higher the cost to serve is for retailers and the benefits that could be shared with customers would be less.

Rob Wesley said that the water companies should have the option to make their own choices about competing in or exiting the market and that an exit mechanism was desirable but not essential for the opening of the competitive retail market. Ofwat had a range of regulatory tools that could be used to ensure that there is a level playing field, and they would be strengthened by the Bill. Mr. Wesley proposed that the question of exiting the market could be returned to at a later date.

Ofwat - lack of exit provision will bake in costs for customers

Cathryn Ross disagreed, saying that in Ofwat’s view retail exit for incumbents was a critically important element of a functioning, effective retail market. If incumbents were not allowed to exit, inefficient retailers were being mandated to remain in the market which would basically bake in avoidable cost that customers would have to pay for.

Alan Sutherland said the lack of a provision was “quite a flaw”, commenting that “whatever the parliamentary intention, the crafty guys in the City will work out a way of disposing of the asset in some shape or form.”

“Once they have done that and once that has happened in a way that takes it somehow to the edge or outside of the regulatory ring fence, enforcing good behaviour by retailers that are on the other side will be incredibly difficult, because the only mechanism would be through the licence.”

He also said that compared with the introduction of competition in Scotland, some lessons had “not been fully learned” one of which was separation. Scottish Water had to separate an entity— functional separation—and it had chosen to go further and separate legally. A no detriment clause was also put in for the wholesaler to ensure that the retailer would not in some way be hindered, hampered or discriminated against by the wholesale business that feared loss of volumes in its business and therefore potential loss of profit. There had also been a clear statutory commitment to creating a level playing field and to ease of entry for potential new entrants – and he was unsure whether the Water Bill went far enough on the issue

Rob Wesley responded that the water companies would absolutely agree with the objective of a level playing field to allow retailers to compete on their merits for customers and that the logic of allowing more flexibility in the structures to allow retail exit and entry would seem to be strong. However, Water UK questioned whether it was essential, at this stage of implementing the new market, for that to happen.

Benefits of competition could be as much as £750m

Alan Sutherland provided the Committee with some interesting figures with regard to the potential benefit in terms of savings to the taxpayer and businesses could be from retail competition. Having looked at the numbers in Scotland and reading those across to England, he said that the current impact assessment “understates the value of retail competition quite considerably.” Comparison on a like-for-like basis showed there is potentially a net present value of about £750 million, compared with just less than £200 million in the DEFRA impact assessment.

On funding ongoing investment programmes by the water companies, Rob Wesley told the Committee that maintaining investor confidence was crucial to the sector. The water companies would need to continue to invest, to maintain and enhance services, at about the current level of £5 billion a year. Funding that directly from customer bills would need bills to be about a third higher than at present.

However, as concerns about the arrangements in the draft Water Bill had been addressed by changes made, Water UK’s view was that investor confidence could be maintained, provided that the upstream reforms were implemented sensibly.

Ofwat – “upstream reforms will deliver about £2 billion of benefits”

Cathryn Ross told the Committee that the upstream reforms in the Bill are really important - when combined with the retail reforms, the upstream reforms would deliver about £2 billion of benefits.

However, she flagged up what Ofwat sees as “a couple of missed opportunities in the Bill as it stands” which the regulator would like to see changed, commenting:

“First, it envisages what we refer to as a closed market for upstream trading in the sense that incumbent water companies will be able to trade with each other, but not with other potential water providers. Given that, at the moment, water companies extract about 50% of available resources, that is a much smaller market than could be the case. I understand why it is like that, but it is a missed opportunity.”

“Secondly, there is the restriction in the Bill on being able to introduce into the system only the water that you can demonstrate that you will take out of the system. That is an unhelpful restriction, which could constrain companies from dealing with system imbalances that could otherwise be dealt with efficiently through trading”

She also expressed concern that the Bill did not contain provisions for Ofwat to modify water company licences on a collective basis, which would “tie our hands somewhat” in establishing the level playing field. In addition, the restriction to a period of two years after the relevant provision comes into force for making consequential licence modifications did not allow enough time to see how the market was working and to make corrections to establish the level playing field.

In response to a question from Neil Parish MP who asked:

“Some companies act almost as monopolies. Are you worried that you cannot break that?” Cathryn Ross said the question is currently under consideration by Ofwat. at the moment and whether the right conditions were being put in place to succeed, first, so that the existing monopolies could compete with each other and secondly - and crucially, so that challengers would enter the market.

Ofwat - householders will be protected from subsidising competition

Cathryn Ross said Ofwat believed that householders would be sufficiently protected from subsidising competition in the non-household sector through the issuance of ministerial guidance and the price review.

On issues of affordability and social tariffs, Cathryn Ross said there was scope for water companies to do more on social tariffs - the business plans submitted to Ofwat showed that some of them had already done so.

For the water companies, Rob Wesley said that following Government guidance that companies have to follow to have a new social tariff approved by Ofwat, three companies had introduced a new social tariff at the earliest possible opportunity. More would follow next year—subject to regulatory approval-—and in the year after.

In the business plans published this week many companies had set out plans for new social tariffs to come forward in April 2015. The challenge that companies had faced was in developing an approach to social tariffs that had broad support from their hard-pressed customers. Both Cathryn Ross and Rob Wesley agreed that it was not necessary to make a mandatory requirement for social tariffs in the Bill.

Public does "not necessarily trust the water industry" 

In the course of the wide-ranging discussion, comments by Dr Peter Kenway, director of the New Policy Institute and Dame Yve Buckland for the Consumer Council for Water flagged up public perception challenges the water sector is currently facing.

Dr Peter Kenway, director of the New Policy Institute, who also appeared before the committee, made some thought-provoking observations about the Bill, describing it as “curious” and commenting:

“I wonder what problems it answers, and whose interests it serves. I would be suspicious about whether this in fact looks like a Bill by insiders, with an insider interest. I think that one should be very wary if there is any suggestion of that. I cannot give any more specific answer, but this does not look to me like a properly competitive model in which new entrants would necessarily feel very comfortable about coming in.”

“I think the thing has to bend over backwards to reassure people who might want to come in. My suspicion is not out of line. You are facing a very powerful industry, a very mature industry which has had a 25-year relationship with its regulator. Public choice economics tells us very clearly what happens in those circumstances. There are risks of regulatory capture. It is a very settled relationship. I think that there are always grounds for suspicion in these cases. “

In a discussion about the pros and cons of universal water metering, Dame Yve Buckland for the Consumer Council for Water commented:

“Metering alone does not necessarily encourage people to change their behaviour. It is a technical solution to a domestic and behavioural problem….. What we hear in research is that the public do not like compulsion if it is not necessary. It gives them the sense that they are being coerced on to something. They do not necessarily trust the water industry, so although their bills might go down in the short term, they think that they will be stuck in the longer term. That is how it is expressed to us. “