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Tearing up the rulebook

The water industry’s 20-year-old regulatory system is set to be reviewed by the government. Water experts tell Jo Stimpson what changes need to be made.

On 26 August the Department for Environment Food and Rural Affairs (Defra) announced that it was reviewing water regulator Ofwat to ensure it is “fit for future challenges”.

“The process will examine how the industry regulator works, whether it offers good value for money and if it is delivering what the government and customers expect,” said Defra.

The move was an acknowledgement by the government of what has long been said within the industry: that, in fact, Ofwat - and the wider system of regulation that includes the Environment Agency and the Drinking Water Inspectorate - may not be fit for purpose any more.

Water privatisation

Ofwat’s current system of regulation, with its five-year asset management plans (AMPs) punctuated by price reviews, was established after water and sewage companies were privatised in 1989. Then, the main concerns were protecting water quality, stimulating capital investment and ensuring accountability and transparency. All of these points have been much improved, says built asset consultancy EC Harris partner Greg Bradley.
Indeed, each of the water experts who offered their opinions to NCE is keen to emphasise that Ofwat has been a success. “It has driven lots of good capital investment - £85bn of investment from private money has gone in over the last 20 years,” says ICE water panel chairman David Nickols.

“You don’t know which services your clients want to buy. You can lose your whole business overnight”

Greg Bradley, EC Harris

 

But what is equally widely agreed is that the issues facing water companies have changed significantly since 1989, with the spectres of climate change and population growth now looming large - and that Ofwat is just not geared to address those problems well enough. “There comes a point in time where there’s only so much more benefit that can be achieved,” says Bradley. “The big ‘macro’ drivers don’t appear to be well catered for,” agrees Nickols.

In addition, water companies’ carbon footprints have grown significantly due to “new [treatment] processes that are inherently more carbon intensive than previous ones”, says Black & Veatch managing director Chris Scott.

“We have got to balance the environmental improvements required with the environmental impacts of the solution. I’m not sure we’ve found that balance yet - that’s something they need to find going forward.”

“Ofwat should be changed”

The Environmental Industries Commission (EIC) - which has long lobbied for changes to water industry regulation - told the coalition government earlier this year that Ofwat’s duties should be changed to include promoting the sustainable management and use of water and promoting innovation in treatment processes and energy efficiency.

But tackling as long-term a problem as climate change is made difficult by the fact that the regulatory set-up seems to inherently encourage short-term thinking. Water companies’ business plans are subject to approval by Ofwat so frequently that a project’s future can only be guaranteed for five years.

“The financial reliability for a project longer than five years is very uncertain,” says Nickols. “You don’t know that Ofwat will approve it a second time.” Bradley adds that the system causes work to be broken up into shorter contracts, which means more re-tendering - an expensive and time-consuming process, which can lead to a jarring change in workload if a contractor fails to win its re-bid.

Furthermore, the five-year AMP cycles create a severe “feast and famine” environment, as work dries up immediately before a price review and does not gear up again for a couple of years afterwards. “You end up with two years of intense work and two or three years of no work,” says Nickols. Bradley says preparing for Ofwat’s determinations can also be a management distraction. “In the last 12 to 18 months there’s been a lot of uncertainty around getting organised for price reviews.” He says the amount of time and money water companies spend on complying with price reviews leads to inefficiencies that are passed on to customers.

Uncertainty

This all creates more uncertainty in the supply chain. “It’s very difficult for [contractors and professional service providers] to know what to invest in,” says Bradley. “You don’t know which services your clients want to buy.

You can lose your whole business overnight.” A sad consequence of this is the migration of skilled engineers to more stable sectors or countries where job security is better, leaving the UK water sector facing a severe and worsening skills shortage.

Water trade association British Water is currently tackling the issue with ongoing research showing that companies in the water industry supply chain have cut staff numbers by an average of 32.3% since the beginning of AMP4, adding up to a potential 29,000 jobs “in flux”. Companies are likely to be wasting money on making these redundancies only to recruit for the same roles two years later. (NCE 15 July).

At least there are plenty of ideas around as to what reforms could improve things. A popular possibility is to change the timescale of the AMPs. Bradley suggests lengthening them to seven years. “Better still would be to stagger them,” he says. “It would avoid the major shocks to the supply chain every five years.”

He suggests another possibility of extending AMPs according to how well water companies perform. Ofwat currently assigns Asset Management Assessment (AMA) and Service Incentive Mechanism (SIM) scores to water companies. If they were ranked by these combined scores, the top two or three could be rewarded with an extension, says Bradley. The opportunity to postpone the disruption of a price review would encourage better performance. “They need to continue to reward water companies that invest in improvements and innovation,” he says. He cites Ofgem’s £500M Low Carbon Networks Fund, which sponsors innovation, as a good model of how to do this.

Staggered AMPs

But staggered AMPs would arguably make it more difficult for the regulator to compare like-with-like. The way to further instil a longer term view could lie in the 25-year plans for managing water supplies that Ofwat required water companies to produce before the most recent price review, known as PR09. If these plans could be connected to the companies’ five-year AMPs, says Nickols, investment horizons could be better stretched.

Nickols says what’s needed is a “major strategic operational change” in the things water companies are required to do, rather than just changing areas of investment. Water companies have to find ways to supply less water and treat less wastewater, he says, and there should be elements built into the regulatory framework to bring that into effect. That could mean raising prices to drive behavioural change. If this does not happen, he says, water companies “will struggle to supply some water stressed areas” in
the future.

“The financial reliability for a project longer than five years is very uncertain. You don’t know that Ofwat will approve it a second time”

David Nickols, ICE

 

Alternatively, MWH Europe-Africa strategy director David Smith says a new approach could minimise the treatment needed, through measures like pesticide control agreements with landowners, and storm water storage solutions for households to reduce wastewater. This could “offset the need for advanced carbon hungry treatment systems,” he says. “This needs to be incentivised in the right way.”
Meanwhile, Smith advocates a more common environmental strategy between Defra, Ofwat and the Environment Agency. There should be “a more joined-up approach right through from policy level to economic regulation and environmental regulation”, he says. The three bodies should work together to bring forward creative solutions such as hydropower. “We don’t want regulation to be a blockage to that, we want it to be supportive,” he says.

Skills stragegy

In the meantime, the EIC would like to see Ofwat tackle skills problems by establishing a skills strategy and by annually reporting to the government on employment in the sector and the supply chain.
However, Nickols says that while he welcomes Defra’s announced review, it does not include the Environment Agency, the Drinking Water Inspectorate (DWI) and Northern Ireland Water and Scottish Water, which are not regulated by Ofwat. “The entire framework needs to be reviewed, not just Ofwat,” he says.
Scott agrees. He says: “I’m struggling to see how you’re going to get a complete review. In looking at the economics of the industry you need to look at what you’re asking the industry to do - it would make sense to include the Environment Agency and DWI.”

The consequences of an ineffective review are unappealing. Scott argues that water companies - which were privatised with no debt but which now borrow heavily - are working to a flawed business model. “We’re going to see a fairly significant increase in prices,” he says.

“Debt per customer is increasing more quickly than prices. That’s inherently unsustainable. The cost of finance will go up if we keep doing what we’re doing [due to increased perceived risk to lenders].” Nickols says there is an even more worrying wolf at the door. The threat of water shortage in the UK is closer than it seems, he says. “We will get to that acute point within our lifetimes - if we don’t change anything.”

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