How to weigh the cost of water

The regulator is setting five-year price caps for the water companies. Neil Summertonexplains the la

The regulator is setting five-year price caps for the water companies. Neil Summertonexplains the labyrinthine process

Ian Byatt, the water regulator, will on 27 July announce the maximum levels the water companies in England and Wales are to be allowed to charge customers over the next five years. After about three months' consultation, he will fix final price limits at the end of November, for introduction on 1 April 2000. (The process does not extend to Scotland and Northern Ireland; there, water and waste-water services are still in the public sector.)

The background to the Ofwat price review is a decade of increases. On average prices rose in real terms by 5.5 per cent a year between 1990 and 1995 and by 1.5 per cent a year between 1995 and 2000. The main drivers were the need to improve drinking-water quality and environmental protection in response to European legislation, and the need to eliminate capital maintenance backlogs that had built up before 1989. While the average bill for all households this year is £246, wide regional variations have developed because of the uneven impact of environmental requirements.

The regulator fixes a price-increase cap (known as the K factor) separately for each of the 18 water-only companies and the ten combined water-and-sewerage companies. The K factor tells them the percentage figures by which, in real terms, the companies may raise their prices - or must decrease them - in each of the five years.

For the customer, the K factor is modified by two other factors. First, inflation or (in theory) deflation: for any given year the change in the retail price index is added. Second, there may be changes resulting from the rebalancing of charges between types of customer; for example, between customers who pay on a metered basis and the 82 per cent who still pay on the basis of rateable values from 1973 (see page vi). This factor could be significant, as meter penetration is expected to increase rapidly in the next five years.

The simple, headline K factor masks a good deal of complexity. Ofwat's basic job is to ensure that the companies carry out properly their functions, many of which are laid down in the law. Byatt must ensure that they have sufficient income (and can raise the necessary capital on the market) to deliver appropriate services to customers while also meeting drinking-water quality and environmental obligations - we often forget that our excreta are a major environmental pollutant and that "the polluter pays".

In addition to Ofwat, the companies are regulated separately by the Drinking Water Inspectorate and the Environment Agency, which are responsible, respectively, for enforcing drinking-water standards and environmental requirements. Byatt works closely with these agencies and with the Department of the Environment, Transport and the Regions on policy, as he needs to know how much the companies are obliged to spend to improve drinking-water safety and to protect the environment from pollution and over-abstraction. He must judge what rate of return will persuade private investors that investment in water is worthwhile (this is the "cost of capital") and the related question of to what extent the companies should be borrowing, ie, how far costs are to be met by future customers rather than by present ones. Finally he must decide how much companies need to spend to maintain existing pipes and equipment (in the 1970s and 1980s inadequate maintenance stored up bills for future customers and led to slightly shaky water quality and a lot of illegal pollution).

All these factors tend to push prices up. The scope for efficiency savings, both in operations and capital expenditure, pushes in the other direction. Byatt has to judge two things here: how much more efficient companies can become up to 2005; and how the financial benefits of that efficiency should be divided between customers (in lower prices) and companies (by way of profits).

This last point reflects the only justification of the whole privatised system: companies have an incentive to become more efficient because of the profits that that will generate; and in the longer term, the gains in efficiency will be so much greater than under a publicly operated system that customers also will benefit through lower prices.

Having weighed all these factors, Byatt must make one further key judgement: how keen customers are for cash in their pockets through lower prices, as against a higher (more costly) quality of service, such as better-looking, smelling and tasting water or improved customer service.

The periodic review takes time. The regulator began the current review way back in the autumn of 1996 and soon made his expectations clear. The evidence of 1994-96 was that companies could make much greater efficiency savings than had been previously assumed. And a rebalancing between companies and customers was necessary, by means of a large, immediate price reduction in 2000. Since then the key public debate has been about how much money should be spent on health and environmental improvements. Water and waste-water are subject to demanding mandatory European standards - which some lobbies and the Environment Agency want exceeded. Water scarcity is, additionally, a real problem in some areas.

Byatt has always held that health and environmental improvement are political matters and that it is for ministers, not him, to say how much is necessary. Moreover he is sceptical about the value-for-money of much of it. So he has always tried to bring this part of the equation under public scrutiny, as the dispensable element by which prices can be reduced. DETR ministers have decreed that the regulator should allow for £8.2 billion of such spending in the next five years in the programmes that customers must finance (not much higher than in 1995 to 2000). And they have upped the political pressure (questionably) on Byatt by saying that this health and environmental spending can be done alongside an immediate price cut of 10 per cent.

In the undergrowth a hand-to-hand battle has been going on over a number of technical issues that will have a crucial effect on the K factor. First, the cost of capital. Byatt has become increasingly tough about the rate of return he will assume in making his decision, given the low-risk nature of the water business. He has proposed something in the range of 4 per cent to 5.5 per cent and, despite howls from the companies, seems likely to stick to this.

Second, efficiency. Byatt believes improvements of 3 to 4 per cent a year are feasible between 2000 and 2005, with all the benefit enjoyed in the form of lower prices. The companies blanch at this. The sleep of the other water regulators (and water company directors) is disturbed by anxiety about safety and the environment, if Byatt has seriously over-estimated the scope for efficiency savings.

The third issue is maintenance and replacement of networks and equipment. Byatt believes existing levels of expenditure are sufficient to preserve the status quo. Some companies' assessments (verified by the regulator's own technical assessors) indicate that higher rates of capital maintenance and infrastructure renewals are needed to prevent a return to the deterioration of the 1970s and 1980s.

Fourth is comparative quality of service. Egged on by John Prescott and Michael Meacher, the regulator proposes to reward the most effective companies by giving them more scope to increase their prices and, conversely, to penalise the least effective with less scope. The principle is to try to ape a competitive market in which profits gravitate to the companies that customers perceive to be offering the best value for money. The "least effective" companies argue that the regulator's ways of measuring quality of service are too blunt for the job.

Fifth, this time round, efforts to establish customers' views and to consult interest groups have been much more extensive. But there is a question of whether the regulator prefers the views of the Ofwat Customer Service Committees - which he appoints - to market-research evidence that customers would be content with a smaller price cut or stable prices, as long as the extra income is spent on service and environmental improvements.

Finally there is the interaction between metering and company income. This government has decided to make water meters voluntary and to prohibit disconnection as the ultimate deterrent against "won't pays". Metering is likely to be most popular with low-level water users in high rateable-value properties, so the regulator proposes that companies should "manage" the rate of take-up. He certainly does not want them to rush to implement the new statutory duty: a more rapid take-up of metering than he estimates could produce a shortfall in their revenues, forcing him to agree to raise maximum price levels mid-term.

The bottom line for this review, however, is simple. Both the regulator and the government correctly perceive that customers (voters) really want to have their cake and eat it, which means a one-off cut in prices and a large slug of safety and environmental improvements. That is what the draft review's decisions will imply.

If any company objects to the regulator's final pronouncement in November, it has only one course of action: to appeal to the Competition Commission - even if the purpose is only to get a technical issue reviewed. This is a very costly and time-consuming weapon, with a low chance of success and potentially heavy public relations consequences for the company.

How healthy is this system after nearly ten years of operation? The public is probably as wary of privatisation as it was in 1989, and companies' naivety about salaries and dividends has sustained that. But the arrangements have delivered better drinking water and environmental improvements, and prices are lower than they otherwise would have been.

There could be further improvements to the regulatory system, including replacing a sole regulator with a commission, to render the decisions more consistent over time; defining the primary duties of the regulator to customers and companies much more coherently in statute; and giving the government a more transparent responsibility to meet the needs of poor customers, rather than relying on the many hidden cross-subsidies of the present charging system.

In the end though, no degree of regulation, however skilful, can match genuine competition. In the next few years expect to see far greater effort and imagination going into how to introduce real competition in certain aspects of the water industry.

Neil Summerton was director, water and then director, water and land in the Department of the Environment, 1991-97. He is now director of the Oxford Centre for the Environment, Ethics and Society at Mansfield College, Oxford, director of the Oxford Centre for Water Research, a non-executive director of two small water-only companies and an adviser to General Utilities