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Taking a view on price review. A perspective on economic regulation in the water industry.

The end of 1996 was an important milestone in water regulation. We were able to document the water companies' performance during the first year of the price limits set in 1994. This article provides an opportunity to look back at those price limits and, in doing so, to put them into the context of the second Periodic Review to take place in 1999.

Economic and social objectives

As Ofwat's latest reports show, environmental quality is improving and levels of service to customers are rising. Regulation has delivered on the economic virtues.

The price limits set in 1994 allowed, on average, for a modest increase in prices over the next ten years. This increase resulted mainly from the cost of implementing the EC Waste Water Directive. Without new quality obligations, bills would now be falling in real terms.

This is in marked contrast to the experience of the first five years following privatisation. The price limits set by the Secretaries of State in 1989 envisaged an increase in the average annual household bill of [pounds]43 in today's prices. This was made up of an increase of [pounds]32 to finance quality obligations, [pounds]16 to finance enhanced service levels and growth in the capacity of the system, less an efficiency factor of -[pounds]5.

In 1994, the new price limits envisaged an increase in the average annual household bill in the next ten years of [pounds]23. This was made up of a larger quality factor of +[pounds]44, a more modest factor of +[pounds]3 to allow for enhanced levels of service and growth in the capacity of the system and a much bigger efficiency factor of -[pounds]24 to allow for both reduced profitability and greater efficiency.

The benefit to customers in the form of lower bills from the 1994 price limits, compared with those set in 1989, was nearly [pounds]2 billion. With the exception of sewerage customers in some coastal areas, bills are now relatively stable, and in some cases they are falling in real terms despite the fact that the price limits allow for more capital expenditure than in 1989 to improve the quality of water (both drinking water and waste water discharged to rivers and the sea).

Of the regulated utilities, water is the exception to falling bills because of the need to finance investment programmes which have amounted to some 2.5 per cent of total national GDCF - for an industry accounting for only 1 per cent of consumers' expenditure. Investment in the water industry, at [pounds]2.6bn in 1995-96, is much higher than before privatisation.

Costs are now showing more benign trends. The figures for operating costs in 1995-96 show a reduction, in real terms, compared with recent years. As companies respond to incentives, costs are now running below what was allowed for in price limits in 1994 - the amount varying with the company - and the expectation is already building up that price limits can be lowered at the next Review. Last year the cost of delivering water to customers fell in real terms for the first time since privatisation. And sewerage unit costs rose only modestly.

This parallels what happened at the 1994 Review as incentive regulation continues to work. Operating expenditure in 1992-93 was, on average, some 6% below what was anticipated by the Secretary of State in 1989, after adjusting for inflation. This contributed to the negative efficiency factor at the 1994 Review, but was then outweighed by the large positive quality factor.

The companies, rather than concentrating on garnering ever more resources, have used those they have more effectively. Costs have been reduced as a result. This will lead to lower prices at subsequent reviews. It does, however, not preclude additional sharing of benefits between formal price reviews, as some companies have already done. While regulation has clearly delivered in economic terms, there are a number of social issues which have met with varying degrees of success.

Disconnections

The number of households which had their water supply disconnected for non-payment of their bills initially rose sharply following privatisation. But, since 1992, when new guidelines were issued to the companies, the number has fallen to pre-privatisation levels. It was necessary to push the companies into much better procedures and better payment methods for customers who have difficulty in budgeting. The fact remains, however, that there are some customers who cannot afford to pay their bills - and they need a sympathetic approach by the water companies.

Pre-payment devices

One option which has helped customers budget - and which offers an alternative to disconnection - is Budget Payment Units. The number of customers choosing to use these units rose by some 43% in the first six months of 1996. Over 21,000 are now in use. Critics suggest the reduction in disconnections is solely linked to the increased take-up of these units. This is not so. From a social point of view, if customers find the units helpful in paying bills, their choice should not be restricted. But the legality of these units has been challenged and it is now for the High Court to clarify the legal position.

Social issues of metering

The sharp increase in bills was not cushioned by any changes in social security. Some groups - such as low income households with children, who have not enjoyed the general increase in prosperity - have lost out. Where these households were moved into new or refurbished local authority or housing association housing, with compulsory meters, it has led to adverse publicity for metering if their bills subsequently rose. Without supporting universal metering, there is a strong case for the spread of selective metering where it is cheap and economic to do so. The issues make it even more important that companies should offer customers in debt a wide range of easy payment options - and advertise them - to help them budget. Budget Payment Units can play an important role here.

Regional disparity

The price limits set in 1989 led to greater regional disparity in water bills. This was exacerbated by the Government's acceleration of quality improvements to bathing beaches in the South West in 1990. Some of these factors are only now working themselves through, such as the significant price increases on the South Coast as a result of the EC Waste Water Directive.

Fat cats, dividends and share options

There has been constant criticism of salaries, dividends and share options. This is not an area for regulators - it is for shareholders to ensure their executives do a good job and give value for money. Share options have probably made the biggest headlines, although it is worth remembering that for the last four years the water sector has performed in line with the market; the big gains were in the years 1989-92. The salaries point may have been overdone - but it has stuck. This is not an area for regulators. The regulatory cure may be worse than the disease. It is for shareholders to ensure that they get value for money from their managers, looking at the long-run position of the company, not simply at present profitability. Shareholders, including institutional investors, are encouraged to consider the special position of regulated water utilities. Like all companies, they will only thrive if they look after their customers, albeit in the absence of short-term financial advantage. Some of them are in danger of appearing 'plus capitaliste que les capitalistes.'

Where the sphere of activity in the regulated water business is very different from that of the plc, as in the case of the multi-utilities (United Utilities/North West Water, Hyder/Dwr Cymru and Scottish Power/Southern Water) there is a strong case for separate listing of the water business, or for the issue of targetted stock. This would institutionalise them as free standing bodies and would ensure independence for the Board, as well as providing stock market information for the regulator. We intend to pursue this issue at an industry level.

Stopping the price escalator

We have been living with rising prices for a long time. At one stage it looked like an endless escalator. This was slowed down at the last price review, with help from the government in reining back on new quality obligations. There needs to be continuing co-operation in this area, where co-operation means controlling environmental and quality ambitions.

An important lesson - for companies as well as governments - is that these social matters do not go away on privatisation. For the companies, they are not just another plc; they have to learn to accept social responsibilities and to present themselves as responsible bodies. For governments, they have to be clear and explicit about non-economic factors - such as quality obligations in water. Otherwise the responsibility placed on regulators, who have largely economic objectives, is too great.

Unless government is explicit about social responsibilities and is to be accountable for them, the independence of regulators can be compromised. As far as water quality and environmental obligations are concerned, the division of responsibility has worked well. Ofwat asked Ministers to address the cost of quality in 1993. This was done and decisions made which enabled us to do the economic and financial analysis to set price limits in 1994.

Independent regulators

This independence is at the heart of arrangements. Regulators are accountable for carrying out their statutory duties. These are mainly about economic efficiency (return on capital, productivity assessments, undue discrimination, competition, etc) the elements of the situation where, to quote Nigel Lawson, 'the government of business is not the business of government'.

The next periodic review

In October 1996 Ofwat announced that all price limits would be reviewed in 1999. The new price limits will take effect from 1 April 2000.

Trends over the last five years in all aspects of company performance will be looked at and full account will be taken of the very encouraging efficiency savings made by the companies, which will then be shared with customers. The evidence is that price limits could come down.

Five years is a reasonable time period for a review of price limits. The companies' licence allows for this to happen. While there are new obligations on the horizon, a ten year review is too long. At the same time more frequent adjustments would have considerable disadvantages in this long-term industry, and would damage the incentive of price cap regulation to reduce costs and bring about efficiency savings.

The companies must deliver the legal obligations allowed for in existing price limits, and the levels of service their customers expect. If any company fails to deliver, then it will be penalised. Ofwat will be working closely with the quality regulators, whose job it is to police the companies' progress against their obligations, to address the issues. During the 1995 drought one company came very close to failing in its duty to supply customers with water, and many failed adequately to manage the demand upon their resources. This influenced the decision to take the earliest opportunity to review price limits.

The announcement of the next review was timed to allow for full and effective planning of the process of the review, including full consultation with the public and to remove speculation and regulatory uncertainty relating to it. We want to stimulate informed debate on the issues.

Ofwat will publish a periodic review schedule, including plans for consultation, early in 1997. In the meantime, in the context of the 1999 review, it is useful to look again at some of the economic issues handled at the last review.

Economic factors

In a capital intensive industry, where the regulator is statutorily enjoined to secure that companies get a reasonable return on capital, there are issues relating to the capital base and the real rate of return on that base. Quantitatively, the first is more important than the second.

On the capital base, Ofwat rejected the replacement costs of assets ([pounds]120bn) and indicative value calculated by the Secretary of State at privatisation ([pounds]16bn). We opted instead for the market value at flotation, less the cash injection (Green Dowry) to the former authorities and plus an estimate of a comparable valuation for the water only companies (the statutory water companies) ([pounds]7bn). To this we added subsequent net investment - gross investment less depreciation charges.

For the rate of return, it seemed that companies could finance their functions at a lower rate of return. There was scope for a reduction in prices as a result of the convergence of the return on new capital to 5-6% post business taxes, and interest cover (on unfavourable scenarios) of no lower than two.

So, on both rate of return and capital base there was a considerable tightening - resulting in substantial reductions in prices by the end of the ten year price setting period. As returns in 1992-3, measured in this way, were well above 5-6%, Ofwat applied the 5-6% to new assets and phased out the 'excess' return on capital over ten years (although most of the convergence took place in the first five years). The judgement on the speed of this transfer from shareholders to customers was taken both to preserve incentives, which might be damaged by an instant movement to a lower rate of return, and to respect some privatisation expectations. In the cases of South West Water and Portsmouth Water, which appealed against Ofwat's decisions, the Monopolies and Mergers Commission used a five year phase out - which, on reflection, is a better solution. But they allowed for rather more capital expenditure than Ofwat had done, resulting in virtually the same price limits as Ofwat had set.

Levels of expenditure to be allowed for in price limits were dealt with

* by dividing expenditure into purpose categories, provision of base service levels (existing outputs, including maintenance of existing capital stock), enhanced levels of service to customers (better pressure, quicker response to complaints, etc), additions to the stock or other policies to achieve the right supply/demand balance and enhanced quantity (to deal with new EC and national obligations);

* by looking at different levels of operating expenditure in different companies, relating them to differences in operating environment and assuming efficiency targets based in part on general improvements in efficiency and in part in convergence towards the more efficient companies;

* by allowing for capital expenditure on new quality obligations after going through a rigorous process with Government (involving the Treasury) and not allowing in price limits for most claims for other capital expenditure said to be necessary to improve services for customers;

* allowing for continued expenditure on capital maintenance, to maintain the serviceability trends of the past - after adjusting for efficiency assumptions. Companies should link measures of serviceability to customers with the condition of their assets. The companies' Strategic Business Plans at the last Periodic Review indicated that 91% of the potable water pipes and between 88 and 90% of the sewers were in satisfactory condition. It is scarcely necessary to replace assets that are working satisfactorily;

* allowing for increased demand by a combination of finance for meters and a relatively low national yardstick for expansion of capacity.

Increases in demand can be met by reducing leakage and installing meters, with expensive reservoir construction as the last measure. Selective metering is an essential element in developing a proper relationship between supply and demand. There are economic and political constraints on how rapidly it will develop. But without progress towards a greater penetration of metering it will prove increasingly difficult to meet economic and environmental objectives.

Elements in the K Factor

At the 1994 Review, Ofwat decomposed decisions on the price limits, breaking down the price limit, or K factor into -X (the efficiency factor) and +Q (the quality factor). In 1999, additional elements need to go into the picture.

It is useful to distinguish between an element in the K factor to allow for past achievements in reducing costs below what the regulator had allowed for at the previous Review. Some commentators assume that this [P.sub.o] adjustment would take place quickly.

That would leave a separate element - perhaps best described as a grouping of elements - in the K factor which is addressing the future rather than the past - setting out expectations for the subsequent years of the price limits rather than correcting the past difference between expectations and outcomes.

This grouping of elements in the forward looking K factor could comprise:

X The efficiency/resource allocation factor which relates to efficiency and return on capital.

Q The quality of water factor - drinking water and waste water.

S The levels of service factor which governs the extent to which improved levels of service are reflected in price levels as opposed to being financed through greater efficiency. Last time the S factor was quite small.

V A factor relating to supply and demand for the quantity of water. This may be negative if a company has water to sell, or zero if new resources or, more generally expansion in the capacity of the system, are financed out of higher payments for additional supplies of water, ie through metering, or positive, if bills have to rise in advance of new supplies becoming available.

It is important to think of the elements as components in a group. We do not intend to determine separate price limits for each. Customers may feel that if the [P.sub.o] adjustment is negative - reducing bills in real terms - it would be perverse for the combination of the X, S, V and Q factors to reverse this. Trade-offs between those factors would need to be considered, while maintaining an overall limit on prices.

The output principle

Although price limits must allow for the justifiable costs of the necessary inputs, the regime should focus on outputs - what customers and the environment are receiving. This starts by discovering what customers want - and are prepared to pay for - and establishing environmental obligations. When price limits are set, the regulator is then concerned to ensure that companies deliver their outputs.

This involves continuing work with the quality regulators (the Environment Agency and the Drinking Water Inspectorate) to ensure that legally enforceable quality obligations are met and collecting company information on customer service - both measured indicators such as water pressure and qualitative information on customer care. Ofwat has worked with the quality regulators to develop milestones for the delivery of the major compliance programmes and with the companies and the Drinking Water Inspectorate on an audit of distribution undertakings. Ofwat has developed measures of serviceability to customers to ensure that the infrastructure of the companies is kept in reasonable condition. The results are published annually and, if companies are not performing adequately, we will investigate and, if necessary, take enforcement action at the review or earlier.

Our approach is to develop a framework of rewards and penalties. There should not be large unexplained differences between bids for expenditure allowed for in price limits and outturns.

Communication is the key

The regulatory process is critical. There are several key elements in the process of communications which will be taken forward to the next review. For the 1994 review we consulted widely - and not only with experts - on technical matters (such as the return on capital, financing of growth and financing of quality) and on customers' wishes and expectations. Ofwat's own organisation which, we are glad to say, includes the Customer Service Committees, provided the channel for the latter. The companies were also encouraged to produce market plans in advance of the price review where they set out options for customers, the services which they thought they should supply and the price tags which they thought should be attached to them.

A second important element is the need to be ready to explain the situation to politicians of all parties and the media (as a means of reaching the public), and to lay out the options and the way ahead recommended by the regulator. There is bound to be scope for more, but the contrast with the nationalised days is very striking.

Thirdly, it is necessary to establish a system of communication with the companies aimed at action rather than confrontation. This does not avoid disagreement, but emphasises progress towards defined objectives and, wherever possible, agreement. This is often done quite openly - through MD letters (formal letters from Ofwat to managing directors of water companies) which are publicly available, consultation papers, and through public conferences. There are also privileged discussions in working parties, and one to one meetings with individual companies. Finally a timetable, information requirements and all the proposed processes to be followed in the price review will be set out in advance, involving fairness to companies and participation (usually through representatives) for customers.

All of these processes are designed to produce greater openness and understanding and greater opportunity for all the participants to express their views - taking account of information as well as preferences. It could well involve public hearings. But exercises in consultation must be kept relatively simple if they are to reach the people concerned. The UK should not import US style openness, with endless rate hearings, armies of lawyers and stacks of computer paper without thinking very carefully what we want the participatory process to achieve. In using this we should take full account of our own style and institutions.

What of regulatory reform?

There is much discussion of the differences between regulators and the importance of the personalities and policies of individual regulators. There are large costs to change - many of which will be visited on regulators through loss of expertise and information. Reform should be based on a very careful consideration of objectives - not driven by one perceived problem - and must recognise that alternative arrangements will also have disadvantages as well as advantages. This is all very obvious, but worth repeating. As far as water is concerned, we are dealing with a very different industry and legislation from the other utilities. The existing arrangements have great merits and, not surprisingly, evolutionary changes are to be preferred to revolutionary ones. Many of the problems arose from the original privatisation.

There was great uncertainty about prospects for efficiency in operating costs and, more importantly, in the use of the capital stock, when companies left the traditional public sector environment. And there was uncertainty about how quickly this efficiency would become evident. Hence the importance of a regulatory regime which preserves incentives rather than trying to get everything precisely right.

The low gearing of privatised companies had a number of consequences. Stock market prices have been more volatile, disturbing the public and exacerbating the share option issue. It has led to dividends well above what is justified to meet the cost of capital and reward efficiency. It has led to takeovers whose operating benefits are no more than modest. There is the obvious difficulty in judging 'optimal' gearing. But it makes a lot of sense to inject debt at privatisation - and may not affect the share price as much as the City advisers often claim. Some problems have been easier to handle. At all privatisations the X factors have been too small. But they have successively tightened as evidence of greater efficiency, resulting from incentives, has provided the evidence for this.

There are three modest reforms which seem desirable. First, experimentation with informal benefit sharing mechanisms when companies significantly outperform the expectations of regulators when they set price limits. Second, tighter ring fencing of the regulated utility - linked by changes in corporate governance to keep it close to its customers and require it to act as if it were a separate plc, and, possibly, to develop these characteristics which are not simply these of 'another plc'. The idea of a customer corporation, development of mutuality, some elements of US 'private not for profit' all need to be discussed - although they may pose some threats to incentives and efficiency. Finally, on organisational matters, we are in favour of retaining sectoral regulators, strengthening the links, perhaps bringing them together as a college, with the Director General of Fair Trading in the Chair, to ensure consistency on process and common issues such as the cost of capital and developments of RPI-X.

In conclusion, the regulatory system is a good one and has worked well. Our companies deliver very high quality drinking water with 99.5 per cent of tests showing compliance with standards. At the same time price rises have been reined back. The incentives of price cap regulation are working and we must be cautious about damaging those incentives. But, looking ahead, the system will and must evolve.

Ian Byatt, Director General of Water Services, looks at some of the recent issues and achievements of regulation in the water and sewerage industry. And against the background of the price limits he set in 1994, he looks ahead to his second price review which will set price limits from the year 2000.
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Author:Byatt, Ian
Publication:National Institute Economic Review
Date:Jan 1, 1997
Words:4147
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