Ofwat Chief Eexcutive Cathyrn Ross has described Ofwat’s new risk-based approach with its focus on outcomes rather than outputs as brave, saying that the legitimacy of the sector and the regulatory regime was resting on it.

Ms Ross was speaking at the Regulatory Policy Institute's annual Westminster Conference about the purposes and functions of economic regulation. The Ofwat chief told delegates that at its essence, economic regulation is about aligning the interests of capital and company management with the interests of customers – where companies and investors profit by doing what their customers want.

Economic regulation is the use of a tool kit that is all about allocating risk, she said – some of which is inherent in the sector (eg risk of operational failure) and some of which is created by the regulator (eg risk that outturns differ from assumptions underpinning the regulatory settlement, or the money at risk – downside and upside – within specific incentive schemes).

According to Ms Ross, the regulator is facing a serious challenge in terms of legitimacy and it is important that Ofwat both understands it and meets it. Legitimacy underpins independence and the regulator needs both to be and to be seen to be legitimate if it is to maintain that independence, she said.

Legitimacy is also closely linked to accountability, with the regulator accountable to parliament and in reality held to account by a wide range of stakeholders – including customers, investors, NGOs, and to an extent the water companies themselves.

Describing the need to work in line with the framework set out for regulators by Parliament  - statutory duties and functions, better regulation principles, sound public administration – as hygiene factors, Ms Ross commented:

“Beyond this, we are – whether we like it or not – held accountable by stakeholders for the experience that customers and society have of the sectors we regulate.…

“It is a fact that if the public do not have trust and confidence in provision of the essential public services we regulate, we – and the independent economic regulatory regimes we operate – will not be seen as legitimate.

“There are obvious examples of sectors where that trust and confidence seems lacking. We’ve all been following the debate in energy and in financial services. But even in other sectors we can’t afford to be complacent, in the face of rising public expectations and demands for investment that could easily bring pressure on prices.”

Ms. Ross went on to outline some of the key choices now faced by regulators which would define the forms that economic regulation takes over the next few years, including:

• A broad view of the role, focussed on customer outcomes vs a narrow view of the role focussed on regulatory process.
• A broad view of the regulatory tool-kit, which includes softer elements, including the ability to provoke and challenge by setting an agenda or informing the debate, vs a narrow, formal, view of the regulatory tool-kit, which would be focussed around licence enforcement and determinations.

Ofwat was now outcome-focussed, with a new strategy which "hangs off a vision for the sector of trust and confidence in the provision of water and waste water services", because ultimately that is what customers and society want, she said. 

"We....cannot get to a position where every stage of the water value chain has effectively competitive markets"

Ms Ross said Ofwat saw its regulatory tool-kit as a broad one in which softer tools could be highly effective, especially in the context of the culture change it wants to see in the sector – as it moves from a sector focussed on its regulator to one focussed on its customers, commenting:

“ We aren’t delusional – we will not, cannot, get to a position where every stage of the water value chain has effectively competitive markets. But we can create more scope for transactions to take place –revealing information and creating value. We can improve information and reduce transactions costs, even where markets are regulated, and regulated heavily for example through ex ante price controls.”

The outcomes approach based on customer engagement during PR14 had delivered a better balance of risk and reward, more focussed on delivering real operational efficiencies and more of what customers and society want, together with more flexibility for companies through totex and financeability levers.

Ms. Ross said Ofwat was looking at how to inform, enable and encourage efficient water trading via transactions which would create value. The information they reveal would also inform other decisions, such as those in relation to new capacity, and would support resilience by increasing diversity in the public water supply.

"A network management incentive in some form in place by 2017-18"

The regulator was also looking at the system operator role in the water and waste water sectors in respect of the following:

• geography (local-national),
• time (short term,
• system balancing through to long term capacity planning),
• and depth of function (from thin – just putting information out there through to fat, where the SO contracts for provision).

Cathryn Ross said this was building on a firm commitment made in Ofwat’s PR14 methodology statement to have a network management incentive in some form in place by 2017-18.

"What we're doing still feels  brave"

Commenting on Ofwat’s outcomes focus, she said:

“I have to tell you that it feels brave. It relies on companies, and other market participants, stepping up, making good use of the information, ability and incentives our framework provides for to act in ways that not only make money for investors but also deliver for customers and society. There’s a lot resting on that – the legitimacy of the sector, and the regulatory regime…”

Ms Ross said it was also important the information either collected by Ofwat or others encouraged by Ofwat to set out was not only there for the regulator’s use. Ofwat wants “information out there” that encourages others – customer groups, NGOs, investors - to challenge the sector and hold it to account, she said.  

She concluded:

“What we’re doing still feels brave. If you look at the experience of some other sectors, it could be easier to retreat to that regulator-dominated conversation – with the regulator setting targets and standards, the regulator challenging all companies at a very micro-level about what activity they should and shouldn’t be doing, collecting and assessing lots of information, and beating up on companies that aren’t doing what we told them to...

“But it would be the wrong thing to do – there may be superficial attractions, but if you think about what I said economic regulation was, when it is most powerful – it is all about alignment of investor and company interests with those of customers.”

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