A new report by Citizens Advice published yesterday which criticises utilities regulators for presiding over sustained overcharging to customers, says that while Ofwat has gone some way to correct the mistakes of the past, more work needs to be done.

According to the report - Monopoly Money - How consumers overpaid by billions - water has the highest consumer overpayments in revenue terms - partly because, over the period studied, water has the highest asset values across the utilities sectors.

Citizens Advice says there have been “welcome signs” that regulators are getting tougher on companies: in both water and energy, they have signalled their intent for the lowest baseline rewards for companies in the history of British economic regulation

However, the water industry regulator has been criticised for presiding over 15 years of overcharging between 2015 to 2019. The analysis by Citizens Advice in water covers 3 price control periods: PR04, PR09 and the first four years of PR14, which collectively run from 2005 to 2019. The charity has calculated that during this time, consumers should have paid £13 billion less to companies - or about £920 million less a year.The current value of the businesses that provide water is £73 billion, and they earned £2.8 billion in baseline returns on average each year, the report says.

The report says that the regulated utilities sectors have been “marred by two major failures” - deep, structural price discrimination and “overpayments by consumers for the natural monopolies and other networks underpinning many of these markets for at least the past 15 years.”

Although it is “impossible to document the full extent” of the overpayments, the charity says the research finds that regulators have “systematically set prices too high, leading to consumers facing unnecessarily high bills - that is, bills well in excess of what is required to deliver the necessary investment in these essential services.”

The report says that several energy and water companies have already taken steps to return some money to customers and flags up South West Water’s proposal in its PR19 business plans that they should return past excess debt costs to consumers - explicitly recognising that these were ‘unearned gains’ - in the form of offering shares in the business.

Citizens Advice is now calling for all firms to provide a voluntary rebate to their customers, saying that “if they don’t, the government should step in.”

“We’d like to see all companies, in respect of all years that they have collected too much revenue from consumers for capital costs, return money to consumers. Returning money to consumers is an indication that companies are acting in consumers' interests.”

Errors in regulators’ financial models led to “unjustifiably high” bills

The charity says its report documents mistakes, errors in judgement and poor forecasts that have led regulators to put the wrong values into their financial models, which in turn has led to “unjustifiably high consumer bills.”

The errors in financial modelling have also been biased, sometimes as a conscious strategy from regulators who have ‘aimed up’ on capital costs over concerns about under-investment.

However, focusing on the technicalities would neglect a simpler explanation, according to Citizens Advice – that regulators have simply been “out-resourced and outgunned.”

Serious over-estimates of costs of capital

Citizens Advice has expressed particular concern in the case of Ofwat and Ofgem and how both regulators calculated the cost of capital - how much lenders and investors need to earn in order to persuade them to invest.

The report says one of the “big decisions” regulators make is about the cost of capital which is one of the most critical decisions they make and where mistakes, which are often as little as 1% or 2% off the correct figure, can be most costly. What might seem trivial in percentage terms are hugely consequential, it says : in a given year, across price regulated businesses, a mistake of just 0.5% about the cost of capital could cost consumers £1 billion in a year.

Citizens Advice is calling for regulators to index costs where possible, rather than trying to forecast them, which has led to “serious over-estimates” of the relevant costs.

The report identifies 2 common themes:

• Reliance on forecasts The regulators assumed that their judgement about what capital costs would be were superior rather than trusting available and objective market data.
• Bias Whenever a decision could go companies’ way, it has done. While there could be many causes - from misjudging the risks of underinvestment to hearing industry’s perspective more often than consumers’ - the data clearly shows systematic bias in decision-making.

In addition, Citizens Advice says that the regulators have also erred by aiming high in their approach to setting the cost of capital and choosing what this will actually be. Estimating the various components which make up the cost of capital leads to a range of possible values and regulators “typically choose at the top end of that range.”

Citizens Advice is recommending that for debt costs and the return on Government bonds (2 key determinants of overall costs), the regulators should use real market data to more accurately track costs and they “don’t need to guess it”. The data is available in the form of 10-year debt index and the spot rate for the risk-free rate.

Ofwat and Ofgem should also adjust the equity beta, a financial measure of risk, to those observed for low risk publicly listed monopoly companies. The report says Ofwat and Ofgem in particular should use the actual market evidence regarding what the right level is, rather than “manipulate the figures in a way that has led to them concluding on higher betas than can otherwise be justified.”

“These regulators have typically assumed that these monopolies are far riskier than the empirical evidence suggests, which has huge consequences for overall returns. For future price controls, beta should be reduced significantly.”

The report concludes that regulators have persistently over-estimated the average cost of capital, for a number of reasons, including misjudgements, errors in forecasting and justification, all of which have “demonstrably increased consumers’ bills over the past 15 years.”

Citizens Advice’ recommendations to redress the errors include:

• The cost of capital should be set at the level the market data indicates will attract the necessary investment and indexation will achieve this.
• All regulators should use a 10 year average for all price controls and Ofwat should commit to full indexation, rather than allowing a proportion of embedded debt.
• Regulators should commit to not changing the length of the average in future decisions. “Particularly as debt costs rise, firms will begin lobbying regulators to increase debt allowances. “
• Where regulators can rely on real market data rather than their own judgement, they should prefer the former. Where possible, the regulators should also consider whether competition can “bust open” the monopolies they regulate with competitive bidding revealing companies’ cost of capital.
• Regulators should block any further transactions that would take utilities private. Estimating betas is reliant on market data from publicly listed companies. If any more are taken private (i.e., off the stock market), it will become increasingly difficult to estimate this figure.

Competition

Citizens Advice is also suggesting that there is greater scope for the role of competition and that “a world where more organisations - companies, trusts, not-for-profits - can compete to deliver monopoly services need may well deliver more for less.”

The report says regulators should review the opportunities and consider opening up more services to competition and that recent evidence in energy and water suggested that companies bidding for delivery contracts reveal far lower costs than existing monopoly providers.

The report cites the cost of capital agreed for the Thames Tideway Tunnel as an example of this – saying it was almost exactly what the Citizens Advice models suggested it should have been at that point in time. “We know that that reduced cost was a consequence of competition - Ofwat had previously indicated it expected a cost of capital 25% higher would be necessary.”

However, it describes the water industry as “perhaps the most price controlled service in the UK” and says that “while occasional flirtations have been made with introducing competition, it looks likely to remain so.”

Next steps

The report says that Ofwat and Ofgem are both headed in the right direction for their forthcoming price controls, “although it's vital they stick to their guns and deliver lower costs for consumers.”

“In their deliberations for setting the next price controls for water and energy, Ofwat and Ofgem have gone some way to correct the mistakes of the past…..Both Ofgem and Ofwat are proposing the lowest costs of capital in the history of British economic regulation: 2.4% in the case of Ofwat and 1.8% in the case of Ofgem.”

“However, both Ofgem and Ofwat need to hold their nerve and implement these changes, as well as commit to reforms that will stop these problems happening again.”

Government must review what has gone wrong

According to Citizens Advice, the findings merit serious review and investigation - the Government should now review what has gone wrong and consider what, if any, institutional reforms might be needed. If firms do not act, the Government must act to ensure that consumers get their money back.

The charity is also calling for the National Audit Office to review the findings, identify lessons learned and launch its own investigation into whether consumers have got value for money.

In addition, the National Infrastructure Commission should incorporate its recommendations into their review of infrastructure regulation and help ensure that the mistakes are not made again.

The report says:

“There’s an opportunity here for firms to recognise that the level of revenue they have received was not in consumers’ best interests. The political atmosphere is not kind to companies who are judged to be ripping off customers. Returning money is in consumers’ best interests: it may be in firms’ best interests as well.”

Commenting on the report, Tony Smith, Chief Executive of the Consumer Council for Water, said:

“Citizens Advice’s report echoes many of the concerns we’ve repeatedly raised about regulatory over-generosity in the water industry, which has benefitted shareholders but not consumers. Ofwat has listened to us and is now setting much tougher price controls, but since 2015 we estimate water companies have pocketed an additional £500 million windfall and we want to see a share of that returned to customers in lower bills or investment in essential services.”

Click here to download the full report Monopoly Money How consumers overpaid by billions