Defra’s independent review of water industry regulator Ofwat, published today, has concluded that regulation in the water sector has worked well since privatisation and that major change is not needed either to the statutory framework or regulatory landscape. However, the water industry regulator has also come in for serious criticism.

The review makes a number of significant criticisms for the regulator as a result of its consultations with the water companies themselves and other stakeholders, including:

• widespread concern about Ofwat’s approach to consultation and engagement, suggesting that Ofwat does not take the views of others properly into account and that the reasons for its decisions are often not clear.
• evidence of a lack of trust between Ofwat and the companies it regulates which appeared to partly relate to historical issues over data falsification and also reflects the point about transparency of decision making.
• a clear consensus that the burden imposed on the companies by the regulatory regime is excessive and needs to be reduced and that the problem in fact went further than just the scale and cost of the regime.
• considerable evidence to suggest that Ofwat goes too far into the detail of company business plans and that, as a result, the companies are very Ofwat-focussed and very cautious and conservative in their approach.
• evidence that the system of incentives applied by Ofwat may be too focussed on penalties and compliance as opposed to positive incentives for desired changes of behaviour
• lack of accountability either to Parliament or to stakeholders in general.

The review, led independently by David Gray, was launched by the UK Government and Welsh Government in August 2010 as a ‘health check’ of the existing arrangements ahead of the publication of the UK Government’s Water White Paper later this year and to inform the development of Welsh Government’s future policies on water.

The review says that in order to achieve continued success, Ofwat needs to reduce substantially the burden of regulation it imposes on the water companies and to work constructively with the other organisations in the sector.

Better stakeholder engagement by Ofwat is key requirement

David Gray said that no-one the review spoke to had recommended radical change to the sector’s regulatory arrangements. However, the review says the sector faces substantial future challenges and Ofwat needs to make some important changes to the way it works to allow the companies it regulates to address them “as best they can”.

In particular, Ofwat must work more closely with other stakeholders and should take a series of steps to allow the companies to be more proactive in their approach.

David Gray said that although the scope of the review was restricted to Ofwat and consumer representation, the regulatory arrangements in the sector are complex and it was clear that implementation of the review’s recommendations would require effective engagement between Ofwat and a range of other stakeholders.

Key recommendations include:

Clarity on policy and roles

The review found a widespread desire among stakeholders for greater clarity on the Government’s objectives for the sector and on the respective roles of Government, Ofwat and the other regulators. This was most evident in relation to the potential extension of the role of competition and markets and the introduction of social tariffs.

The review is recommending that the UK Government should take the opportunity of the forthcoming White Paper to set out clearly its future policies for the sector and the role of the various regulators in implementing policy. The Welsh Government should also clarify any changes to its policy position following the Welsh Assembly election.

Ofwat’s statutory duties

The review has not recommended any changes to the wording or status of Ofwat’s statutory duties. The only area where the review had heard any significant call for change was in relation to the status of its secondary duty to contribute to the achievement of sustainable development. The review acknowledges the concern of some stakeholders that Ofwat does not do enough to fulfil this duty, but states:

“we are not persuaded that elevating its status in the hierarchy of duties would have the effect that these stakeholders seek. “

Relationships with other stakeholders

The review said that given the complex regulatory landscape in the water sector it is essential that Ofwat engages effectively with other stakeholders and that its role is clearly understood and accepted by all concerned, commenting:

“In practice, stakeholders have given the impression of a rather remote organisation that tends to impose its own views on the companies, often without adequate explanation, through the price control process. …. independence of decision making does not require Ofwat to act in isolation.”

The review makes a series of recommendations about how Ofwat should engage with other stakeholders and explain its decisions and says it does not accept that “such engagement would compromise Ofwat’s independence.”

David Gray said that the water companies should feel they are able to predict Ofwat’s decisions with a reasonable degree of confidence so that they can react to changed circumstances without the need for direct regulatory approval of their actions.

Reducing the burden of regulation

The review recommends that Ofwat, in conjunction with the companies, should set clear targets for a substantial reduction in the burden of regulation and that progress towards the targets should be monitored by the National Audit Office.

In its current review of its use of incentives, Ofwat should also seek to ensure that the future framework of incentives sets the right balance between rewards for success and penalties for failure.

Improving accountability

In response to stakeholder criticism that Ofwat was not sufficiently accountable either to Parliament or to stakeholders in general, the review recommends that Ofwat should develop a series of outcome-based objectives and performance measures in agreement with the National Audit Office which would allow its effectiveness to be assessed more readily. The National Audit Office should also be involved in monitoring Ofwat’s progress towards them, as part of its assessment of the value for money Ofwat provides.

The Coalition Agreement committed to reform the water industry to ensure more efficient use of water and the protection of poorer households. UK Ministers will respond to the Review’s recommendations in the Water White Paper to be published later this year. Welsh Ministers will decide on how to respond to the recommendations in due course.

Read the review in full here.