A key Government adviser has said that the Government’s new Water Bill will not address the serious challenges posed by flood risk – and that massive additional investment will be required.

Dieter Helm, Professor of Energy Policy, University of Oxford who sits on the Department of Energy and Climate Change Economic Advisory Committee, says that the floods issue raises an investment requirement comparable to the sewerage one at privatisation, commenting:

“Flood defence investment is a clear national priority on which the Draft Bill is largely silent.”

Professor Helm says that large scale investment in flood defences will be required, both to cope with the consequences in river catchments and also to deal with rising sea levels and more storms with greater weather variance that climate change is predicted to bring. The full powers of the state and the authorities are now needed to address the problems of floods and droughts and that avoiding both - or at least managing the consequences - requires a focus on the supply of water and its rapid disposal through drains and rivers.

In his view;

“This is largely about abstraction and abstraction rights. There can be little doubt that the current ownership and control of the property rights is detrimental to the efficient management of the water supply.”

Serious flaws in Draft Water Bill

 The comments come in a major new paper by Professor Helm, highlighting what he regards as a number of serious and fundamental flaws in the Draft Water Bill – intended by the Government to be the cornerstone of its reform of the water sector.

Professor Helm argues that the Bill does not address the core issues left over from privatisation, including abstraction, the basis for charging, floods and environmental regulation. He also says that it does not address the new investment agenda and warns that it has the potential to raise the cost of capital by potentially undermining the regulated asset base of the industry.

In Professor Helm’s view, the Water Bill in its present format does not provide a credible analysis of the costs and expected benefits resulting from the proposed legislation – and no credible analysis of the impact on the cost of capital in particular.

The paper says that the form of competition promoted by the Draft Bill relies on a significant increase in regulatory discretion - a discretion which could be used by regulator Ofwat to weaken the existing regulatory commitment to the underlying assets.

Water Bill fails on four key questions

 The starting point of Professor Helm’s analysis is “the claimed “problems” with the existing structures.” which he says are not in fact new, although their form and intensity may now be changing. The paper states:

“Contrary to the main thrust of the Draft Bill, the White Paper and much other analysis instead suggests that these problems lie with the needs to cope better with drought and floods, to prepare for climate change and to cope with growing populations.”

The paper identifies four major failings in the privatized structures as the starting point for any reform and says the key questions the Draft Water Bill must answer are:

• Does it address abstraction rights problem, so that in the face of greater water scarcity and the potential for droughts,  water can be efficiently priced and allocated?
• Does it integrate environmental and economic regulation?
• Does it integrate flood defences and river basin and catchment management?
• Does it provide a basis for moving away from a taxation basis for bills, while recognizing the consequences for water poverty and the unwinding of cross- subsidies on a regional and national basis?

In Helm’s view, the answer to all four is "no" and the Bill fails on all four counts. The paper says the current government is now struggling to cope with longer term difficulties resulting from flaws in previous legislation, including failure to address abstraction rights and therefore control over the management of the country’s core water resources, and legislation which in effect granted rights in perpetuity. He says that the Draft Water Bill adds "nothing of substance" on the abstraction issue with reform promised later which will only begin to have impacts in the next decade.

Piping water from Severn Trent to Thames and other companies may be a solution to resource issues

 The paper says that of the key problems now confronting the industry is first and foremost the development of new water resources and the better management of existing ones. Professor Helm makes the interesting point that:

“In some cases, the most efficient solution may be to pipe water from the midlands (Severn Trent) to Thames, Anglian and the smaller south east companies, through greater network integration. It is surprising that so little attention has been paid to analyzing these options and their relative costs.”

On the problem of storm overflows and sewerage and its associated pollution, Helm comments that: "some twenty years after privatisation, these problems have not been fully resolved.”

He also identifies the limited impacts to date of information technology on the energy, transport and water networks as the “third “new” problem which is more long term and in fact an opportunity. In Helm’s view while the new opportunities of smart metering technologies are being applied  to the energy sector via the roll-out of smart electricity meters across the housing stock, “amazingly there is virtually no coordination between energy and water, and hence duplication rather than coordination will both raise costs and slow down the application of an active demand side to water.” 

Helm comments:

“…given one utility is carrying out a nationwide programme it makes sense to use the opportunity for water to piggy back on this enormous roll  out. ..As with the  other “new” problems, what is required is large scale investment. “

New Bill fails to facilitate next twenty year large scale investment programme

 Professor Helm says that the “new” problems provide a further test for the Draft Bill – whether it sufficiently facilitates another large scale investment programme in the next couple of decades and whether it does so at the minimum cost of capital. In his view the answer is  a categorical  “no”. The Bill is instead focused on a particular form of competition, and in some areas, will probably have a negative impact on investment and the core agenda for water industry reform.

…and increased competition will also fail to deliver

 Professor Helm expresses trenchant views on the proposed introduction of greater competition to the sector, saying it has become conventional wisdom to assert that competition is always and everywhere a “good thing”. He comments:

“... It is indeed remarkable how crude the competition argument has become...The White Paper and the Draft Water Bill preamble repeat this dogma, without any serious engagement at a particularly ironic moment—when much of the competition approach upon which OFWAT relies is currently being slowly abandoned in the electricity industry with Energy Market Reform....crude claims about competition applied to the water industry, have in fact become a barrier to rational argument and debate—and a barrier to the role that markets and competition can usefully play, not least in competitive tendering."

Cave Review estimates are "highly questionable and at best naïve"

 Commenting on the “claimed but not substantiated benefits” from greater competition contained in the 2009 Review of Competition and Innovation in Water Markets by Professor Martin Cave, the paper states:

“…Such crude estimates—over several decades—are highly questionable and at best naïve…it is also remarkable that the claimed gains (around £2 billion) represent about 1% of the total projected  expenditure over the period. A small change in the cost of capital would…swamp  these gains, even if they were to materialize.”

Professor Helm makes the key point that the Bill leaves out “any serious consideration  of  increasing competition for monopoly, and in particular increasing the role of competitive tendering for all and any services provided through the water companies.” This is a particularly interesting comment in the context  of a little known provision of the Flood and Water Management Act 2010 which enables consortia other than water companies to build potential large new infrastructure projects needed in the water sector. (See editor's comment)

More competition likely to result in increased Ofwat regulation, not less

The paper goes on to point out that in order for the various forms of competition promoted in the Draft Bill to develop, "very considerable discretion ..is provided to Ofwat to develop a “flexible upstream  pricing regime”, “establish market codes” and “reform connection charges”.  The paper describes the Draft Bill as enabling  legislation which will give Ofwat the discretion to develop its preferred model.

Professor Helm points out that this discretion matters because it is in the detail that the impact on the current water companies will be felt, commenting:

“Amazingly, it is claimed that these new regulatory initiatives will reduce the regulatory burden. A cursory glance at the electricity and gas industries will reveal that regulation of monopoly is trivial in comparison with regulation for competition.

...Contrary to a number of statements from OFWAT and in the preamble to the Draft Bill, water is not like electricity and gas…..Of all the core utilities, it  is the least amenable to commodity competition, and it is therefore not surprising  that competition has made little headway, and that there would have to be artificial regulatory handicaps placed upon incumbents to make it work—which is where  OFWAT’s discretion would come in.“

Current ownership and control of abstraction rights are detrimental to efficient management of water supply

 In Professor Helm’s view, avoiding droughts and floods (or at least managing the consequences) requires a focus on the supply of water and its rapid disposal through drains and rivers – which is largely about abstraction and abstraction rights. He comments:

“There can be little doubt that the current ownership and control of the property rights is detrimental to the efficient management of the water supply……to  the extent that anyone thinks water commodity competition is desirable, access to abstraction rights would seem like not just a good idea, but also .. a necessary condition. Does the Draft Water Bill address this question? The answer is an emphatic 'no'.”

He goes on to suggest that it is “not surprising that governments’ attempts since the late 1980s to develop a viable abstraction rights trading regime have so far failed to come up with a solution”, leaving commodity competition at the bulk supply level largely in the hands of the owners of rights with no competitive access.

The paper points out that wholesale competition comes down to the ability of in situ rights owners to sell any surpluses to other water companies, and to build the pipelines to do so – which they can already do under current legislation. Helm says it is not clear why any further legal powers are needed and that the regulator could instead ensure at periodic reviews that water companies have exhausted all possible options for bulk  supplies. He goes on to enquire why such opportunities have not been exploited by profit-seeking water companies and why there has been regulatory failure on the issue.

Network access costs should not be decided by Ofwat

 In his view, the issue is really about the costs of access to the incumbents’ pipes and the question of what the cost of using a specific pipe should be. Against the case that it should only be the cost of the pipe (which business customers will argue for), the paper states that water pipes fit into a system, and that disaggregating a system is likely to raise  costs—to the  rest of the customers.  Helm rightly comments that water resources go into a  system, and if one (business) customer claims only to have to pay the cost of large  pipes, other customers (households) will suffer the additional costs passed onto them downstream i.e. the water pipe access charges are really a giant cross-subsidy regime.

Professor Helm points out that instead of setting out how such costs would be allocated, the Draft Bill enables the regulator to do this -  and that the outcome therefore depends upon Ofwat’s underlying “agenda”.  In his view ultimately the allocation of costs is a matter for public policy not regulatory discretion. 

Helm is warning that when this discretion at the heart of the Draft Bill is coupled with ambiguity as to whether Ofwat might  “move on” from the existing Regulatory Asset Base framework  after 2015, it could have potentially serious detrimental consequences for the sector. According to Helm, Ofwat has questioned whether the Regulated Asset Base (RAB) is an appropriate way to build up the network costs in the future and is careful to avoid concrete commitments to the treatment of all  assets after 2015 as wholly within the RAB framework.

Helm says that although the regulator has since backtracked under political and other pressures and made “somewhat reassuring statements about its post-2015 treatment of the RAB”, if it in fact follows its earlier inclinations, this would be a much more dangerous path. He also warns that once business customers fully enter the market and become a powerful lobby group, regulatory strategy could become a critical part of their corporate strategy – resulting in more stranded or hived-off assets where investors would have no guarantees of continued revenue support.

Draft Water Bill will perpetuate errors made in energy sector

 The paper says that rather than learn from the mistakes in electricity, the Draft Bill proposes to perpetuate them and that business supply competition is really about enabling business to make a smaller contribution to the system network costs with one of two consequences: either domestic customers will pay correspondingly more;  or the water companies’  revenues will  fall.

The paper states:

“Supply competition requires a further step beyond  reform of abstraction rights. It requires the industry to be unbundled and again the electricity and gas industries are (mistakenly) used—notably  by  OFWAT—as an example.”

Helm says it is not unreasonable to assume both effects and that investors will want to know whether the revenues underlying their investments may be called into question by the exercise of the discretion provided for Ofwat in the Draft  Bill.

Helm warns that the actions and statements by Ofwat and the Draft  Bill  “provide  little  comfort” and that the “new” problems of new reservoirs, the interceptor sewer, new flood defences and new meters all require lots of investment, and all are on the margins of the system i.e. “exposed” investments for which the cost of capital is likely to be particularly sensitive to perceived regulatory risk.

A better way forward - including creation of flood defence companies

 Professor Helm’s paper concludes with proposals for a better way forward, the most urgent priority being reform of the abstraction regime which should be the first item in the Draft Bill. As it stands, Helm says the Bill “adds nothing of substance on the issue with reform promised later with impacts in the next decade.”

The second priority should be floods and flood defences where there is a strong case for getting flood defences out of the “pay-as-­you-go” cash-based public expenditure regime. Helm is proposing the creation of flood defence companies which could remain public, or be private, and could be acquired by water and   sewerage companies, creating greater river basin and catchment area integration. He describes flood defence investment as” a clear national priority on which the Draft Bill is largely silent.”

The third priority should be the basis of customer charges. Helm argues that the  current Council Tax banding is a very inefficient basis for charging, and that if resources become scarcer an element of volume-related peak charging may be appropriate, fairer and more sustainable i.e. metering.

Ofwat should become part of the Environment Agency

 The fourth priority should be to integrate environmental and economic regulation - including agricultural pollution (fertilizers, pesticide and herbicides) which imposes costs on the water industry and thus requires more hard capital investment to deal with the consequences of excess pollution at source.

To accompany this, Professor Helm is proposing a fundamental change to the existing regulatory regime via the integration of Ofwat into the Environment  Agency as a technical regulator. The paper argues that this would not only force consistency but also reduce costs and create greater regulatory clarity for investors.

In his paper Professor Helm highlights the previous resulting conflict from the separation of economic and environmental regulations which in practice led to a battle between Ofwat and the Environment Agency (in its previous format of the National Rivers Authority) …which “Ofwat tended to win ….and ran rings round the environmental regulators.” Helm comments that integrating the considerations of affordability into the analysis of environmental requirements directly was replaced by a battle between competing regulatory institutions:

“It is therefore not surprising that so much lacks “fully functioning ecosystyems.” referred to in the Water White Paper, as “only a quarter of our water bodies are fully functioning ecosystems.”

Professor Helm concludes:

"Comparing the issues which confront the water industry with the answers provided in the Draft Water Bill illustrates just how removed the obsession with a particular model of competition is from the overwhelmingly important investment requirements. The bit that gets lost in the middle is the cost of capital. The RAB-based water model works remarkably well, and is a sound basis for tackling  the new issues confronting  the  industry. A better way forward would be to build upon its successes  and reinforce it so that the cost of capital  remains low for the next  two  decades."

Whether or not the Draft Water Bill sees any changes which reflect and address the concerns raised by Professor Helm remains to be seen. What is clear however is that the fundamental changes to the sector his paper is calling for should now be the focus of a clear and open debate.

Click here to read Professor Helm's paper in full