NAO review of water sector economic regulation

Roger and I were recently contacted by the National Audit Office to give evidence into a review of Economic regulation of the water sector. We didn’t actually know this review was underway but were happy to be involved, given we’ve drawn on NAO’s scrutiny work in the past, particularly when talking about the (hidden) costs of the privatisation of the England and Wales water industry in 1989.

Shortly after NAO got in touch and we agreed a date to talk, I started searching around to find out what the NAO has been looking at related to the water sector in recent years. This turned up some interesting material, like the June 2014 NAO early review report on potential risks to value for money of the controversial £4.2bn (2011 prices) Thames Tideway Tunnel project in London. I also found the NAO’s November 2013 report on the impact on consumer bills of infrastructure investment that took a combined look at ‘energy, water and, to a lesser extent, telecoms sectors‘.

I saw the NAO has work on Strategic Management of Flood Risk scheduled for Late Autumn 2014, in the wake of the UK’s 2013/14 ‘wettest winter since records began‘ with ‘[e]xtensive and continuous rainfall [that] resulted in widespread flooding with large parts of the country under water for sustained periods‘. The NAO hopes to ‘use the winter floods to illustrate the importance of effective strategic management of flood risk in England‘ and ‘look at whether strategic decision-making in the allocation of funds to both capital and revenue flood management projects is sound, and based on best available evidence; whether current funding arrangements are sustainable given longer term uncertainties and risks; and how decision-making on flood defence fits into the overall system for managing and supporting UK infrastructure‘. Timely and important work, in my view.

Interestingly, given my last post about Regina Finn’s recent guest lecture for our Manchester/UNC-CH class searching for ‘NAO’ and ‘water sector’ also turned up a news story that I’d missed earlier this year. This was on Ofwat’sunforeseen- financial overspend of £5.6 million‘ in 2013/14 due to ‘significant failings in Ofwat’s own internal processes and financial management‘ (see Water Briefing 27 June 2014). This had also been reviewed in Ofwat’s last annual report and was highlighted earlier in the year by a story in Utility Week (24 January 2014) explaining the overspend came from a ‘a special licence fee on companies of £3.2 million‘ and £2.4 million from Ofwat’s reserves as it realised it did not have the internal programme management capacity to complete PR14.

I’ll return to this Ofwat news in another post. Suffice to say I’m intrigued by the tone of the news reporting. Regulatory innovation (major change) will by definition require dabbling in ‘unknowns’ and will entail uncertainty over capacity, budgets and timing (especially when budgets have to be set years in advance of the as-yet-not-finalised regulatory framework changes). So ‘oversights’ could easily be reported instead as ‘somewhat inevitable degrees of risk’ depending on one’s point of view…

Anyway… having looked at this news I wasn’t sure if it had motivated the review of economic regulation by the NAO. However before our conference call it was made clear that NAO was interested to talk to us about ‘the system of economic regulation in water as a whole (i.e. not just Ofwat’s role)‘. They also wanted to talk to us mainly about the first two of these three questions:

  1. Are the ‘right’ outcomes being commissioned, and what assurance is there that companies are delivering?
  2. Are customers being charged a fair price, whilst allowing companies to finance their functions?
  3. Do highly geared structures represent a risk to customers and/or the taxpayer, and is the mitigation which is in place appropriate?
Photo: Roger and Duncan talking with NAO for its review of economic regulation in the water sector.
Photo: Roger and Duncan talking with NAO for its review of economic regulation in the water sector.

In the end our conversation was quite wide-ranging and not limited to these questions. As a rough idea of what we said, we made the following general points:

  • If the England and Wales water companies have ‘world-leading’ performance, why are they not world-leading developers/users of technology for the benefit of customers, e.g. better value-for-money, pioneering more water saving by customers?
  • Ofwat could use more standard global benchmarks of water sector performance to make it easier to see how England and Wales compare to other water sector best practices around the world (current comparisons are mainly qualitative).
  • If the main focus is on value-for-money, why don’t the water companies do more to deal with issues like (huge, spiralling?) customer bad debt?
  • Why is the water sector so proud of spending so much CAPEX? Does it disregard economy/efficiency?
  • From our experience, water companies routinely ‘game’ regulators and policymakers (regulatory optimisation, not illegal, we did stress!); performance indicators get ‘captured’ and have diminishing value for benchmarking performance over time. Company ‘evidence’ submissions need to be viewed in light of this behaviour/strategy.
  • Due to indicator/regulatory-capture, evolution of indicators and regulatory frameworks over time should be seen as ‘normal’, rather than something to oppose (necessarily).
  • Ofwat can be quite short‐termist in some cases, e.g. Roger gave an example of pipe coating instead of pipe bursting with new plastic pipes.
  • The water sector could do more to proactively survey the state of its assets. Otherwise when things go wrong suddenly, it can be expensive and highly disruptive. (We had the current Manchester city centre sewer collapse example on our doorstep here!)
  • Not to be entirely negative, attracting over £115 billion capital investment since privatisation in 1989 has been no mean feat, and bucks the general trend around the world of water utilities’ struggling to attract investment. (Of course whether returns on investment have been fair or ‘sweetened’ to attract this investment is another matter here!)

Overall it was great to be invited to give some input, and our thanks go out to the NAO. We think NAO has got quite a broad remit with this particular review. It’s not going to be easy to summarise key findings! NAO aims to publish its report(s) next February. Once they do, we’ll post up about it here.

Duncan Thomas

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