Speech from Water UK Chief Executive Barbara Taylor to key stakeholders at Water UK City Conference, London

 

2007 will be an important year for the water industry. A year of taking stock after an unusually (how shall I put it?) interesting year in 2006. And a year of looking forward. To building on success (or rebuilding in some cases) and to new price reviews. Yes, they are now clearly visible on the horizon in England and Wales and in Scotland. So it’s a good time for all the industry’s stakeholders to debate, discuss, assess differences and shared views.

 

The aim of Water UK’s City Conferences has always been to bring people with a range of interests together under the broad theme of finance and investment. Why is this important?

 

For lots of reasons: because water is probably the most capital intensive of all our industries; because we need huge investment just to maintain the assets; and because society depends on the industry and its investors for an essential economic and social service – and gets upset if it threatened in any way as we saw last summer.

 

So investors and their advisers are crucial stakeholders. If we’re going to be sustainable (in all senses) we need continuing investment - and that means continuing external investment. It’s cloud cuckoo land to think that customers could pay for what is needed through their bills.

 

Today is an opportunity for investors to check out the sort of industry they’re being asked to finance now and in the future with the help of experts from a range of interests. It’s a chance for them to see what companies, regulators and government are doing and how that is likely to influence the level of investment and the potential risk involved.

 

This morning I would like: to highlight some of the questions investors are likely to be asking this year; to remind you why we want to see a longer-term framework for price-setting and investment plans; to say something about how consumers are having a bigger influence than ever before on how the industry should be run and the implications of this; and to look at one of the main implications of this change, which is that we are going to need an alternative to ‘one-size-fits-all’ as a regulatory philosophy.

 

So, first investors.

 

One thing to note is that there’s a quite different atmosphere now from the equivalent point in the 2004 price review. City confidence was low. There were worries about the exit of equity. There was a transparency deficit that made people worry about regulatory risk and government interference.

 

Since then Ofwat and the industry have worked hard to keep the City informed. Ofwat’s City Briefings and the Water UK City programme and conferences are part of this effort. Most people thought the outcome of PR04 was balanced. Ofwat had been tough on efficiency targets but more accommodating on financing (in fact in the same ball park as other regulators on this issue).

 

Today City confidence is arguably not an issue. We have a healthy profit performance and strong markets. But we should be cautious – it’s still early days.

 

Companies have benefited from lower interest rates than expected. But they’ve also faced higher energy costs - and it’s still not clear whether they will end up achieving the targets, let alone out-performing them. For one thing, is it credible that utilities can go on out-performing the economy in efficiency more than a decade and a half after privatisation? In the airport sector the CAA has accepted that this is an issue.

 

Ofwat will want to re-examine, and should re-examine, the cost of capital, financeability and the scope for efficiency. These are big issues for investors who will be assessing the returns on offer against the risk of investing in water. We never forget they have many other options.

 Today is an opportunity to discuss where these parameters are heading and what the regulator should take from market developments and what’s happening in other sectors. But PR09 won’t just be about returns and cost of capital. It will also have to deal with the length of the investment planning period, the place of sustainable development and the role of customers. At last we all agree that price reviews should be set in a longer term context and take account of sustainable development. This inevitably means a bigger role for bill-payers and consumers.

City confidence may not be the number one issue but it still creates dilemmas for Ofwat.

 

We’re now down to 6 quoted companies. How will Ofwat arrive at a cost of capital that satisfies the financial diversity it has said it wants and provides appropriate returns to all parties? Will diversity get quietly forgotten? One consideration will be the size the investment in PR09. We just don’t know about this yet – for one thing we have no real idea about what the Water Framework Directive is going to require. We’ll hear more about these questions this afternoon and I hope everyone will take part.

 

At this stage in the price review process, we’re delighted to offer this forum to help build up a shared understanding of the issues. No one wants the uncertainty of what some people call the pendulum effect where the results of price reviews seem to swing violently from one side to the other.

 

On the financial front, companies have been making gains from the rock bottom cost of debt and this has prompted regulators to think about indexing that cost to base rates. This would mean customers benefiting from windfalls earlier in the price review period and it sounds attractive at this point. But would customers be so keen if interest rates were rising and prices were adjusted upwards? I doubt it.

 Index-linking is just one of the ideas we’re likely to hear in the debate about how much risk companies, investors and customers should take on. In an environment with a low cost of capital, what is the role of incentives that inherently mean greater risk? We think there should be a review of the whole package of incentives. Is it right that the strongest incentive will still be to outperform on cost efficiency? Does this force companies into taking excessive operational risk? Should Ofwat instead be looking at mechanisms designed to deliver new forms of behaviour and outputs?

Ofgem has brought in the opportunity for companies to earn additional returns when they meet targets for cutting greenhouse gas emissions. John Cuthbert will consider some of these issues from an industry perspective this afternoon.

 

Of course what happens in other regulated sectors including Ofgem and CAA will be important for PR09. Scottish Water is going through a price review in parallel with Ofwat and we’re delighted to welcome Sir Ian Byatt to explain his expectations for SR09 and the importance of consistency between regulators.

 

Setting price limits in a longer term context

 One point everyone agrees on is that price limits should be set in a longer-term framework. This is my second subject today.

It has seemed to a lot of us for some time that 5 years may be right for setting prices but has also led to inefficient investment planning and disruptions to the supply chain.

 

Ofwat recently decided on the basis of its consultation to stick with the 5 year cycle. Most people agreed, but also said that the decision put the onus on Ofwat to ensure that the cycle is embedded in a longer policy framework.

 

It’s very good that Ministers are taking this question seriously. We’ve just heard from Richard Bird that Defra is developing its new water strategy with elements stretching ahead decades rather than just a few years. All the policy drivers point to the value of a long-term approach and if anyone wants more evidence they should think about the events of 2006.

 

In the industry we’re working on our own vision that we’ll feed into the Defra strategy in the spring. We’re cooperating with the Environment Agency on a joint sector plan. And Ofwat has published some long term scenarios which the industry is looking at.

 

What should we expect from this impressive common effort? The government’s statement seems particularly important to us. We hope it will provide some clear principles on the big policy questions that could cause uncertainty at later stages of the PR09 process.

 For example:  •  who will pay for diffuse pollution (or how will the 'polluter pays' principle be implemented;  •  what weight should be given to climate change mitigation in relation to other objectives;  •  how will the needs and wishes of local consumers be treated as against the tendency to one-size-fits-all regulation; and

 •  what is to happen on metering.

 

As the work progresses there will other benefits. We’ll be able to set a future path for investment in light of long-term goals; this will give us a better grasp on the future trajectory of prices. It will also help create a consensus about where the industry is going; for instance what consumers can expect in terms of service and charging methods; and how much responsibility water companies will take for improving the environment.

 And investors should have a clearer picture of the future that should improve their understanding of the long term risks they are taking on.

If we put all this together it ought to help the industry set out on a more sustainable and stable path. That is a path away from the pendulum swings I mentioned a moment ago which really do no good for the industry, or its consumers, investors or the environment.

 But a longer term framework for price setting isn’t just about targets and aspirations - it’s also about helping us take the right decisions.

We think Ofwat’s new-ish duty to pursue sustainable development should be very influential. But how will it affect the PR09 methodology in practice? Ofwat has been planning its strategy on this and talks about value in the fullest sense but they and all of us need to hear the widest possible range of views on what should be financed and delivered. Investors have a right to know about the risks they are being asked to take on.

 In case you’re wondering, here are 4 issues that are bound to central priorities as the price review unfolds: 1) Water resources and supply security will be the big issue in some areas. There must be a clear-headed review of the levels of service companies are going to provide and the implications for bills. And the consumer’s got to be fully involved. 2) The spotlight on water resources underlines the more general need for continued investment in infrastructure. We are still catching up on the decades of under-investment pre-privatisation. 3) Climate change looks like being the biggest risk we face in planning for the future – whilst addressing maintenance needs, we must look ahead at how to adapt operations to increasing risks of flood and of course drought.

4) And PR09 must be sustainable. In other words it must add value in ways which measure up to the government’s sustainability strategy – supporting a strong economy and healthy society, working within environmental limits and using sound science.

 The best way to achieve this is to make sure that investment is based on a proper assessment of costs and benefits. This means 2 things: a proper phasing of investment, for example in the water framework directive; and a deep understanding of what customers want.

I’ll now turn to the consumer perspective.

 

Putting the consumer at the heart of the price review

 

In PR04 we made some progress in understanding customer preferences. For example, all the main stakeholders worked together on a national customer survey. And WaterVoice, the predecessor to the Consumer Council, was influential in the sewer flooding programme.

 

But last summer showed that if we really want to put the consumer at the heart of future regulation we shall have to do more than market research. There will have to be more transparency; more effort to get people to express a view about the value of investment in water; and more energy put into raising the level of public understanding.

 

This is mainly a challenge for companies to take up in their own patch. But we can’t escape the fact that a lot of the time consumers see the industry as a single service provider. So we also need some common principles about how we meet the challenge.

 - For example everyone will need to build up robust evidence about what their customers want and what they’re willing to pay for – this is certain to be different in different areas- Next, companies will want to work hard at getting customers to support or ‘buy into’ what they do. And here a common approach to working with CCWater will be valuable. - More generally, there will need to be a debate about whether there is a role for minimum standards everyone can sign up to, for example on supply security or sewer flooding or quality of service.

- And that leads to thoughts about how or whether regulation should improve the incentives on companies to go beyond the minimum. What would investors make of this? This next session this morning with regulators and CCWater should give us an opportunity to discuss these important questions.

 

One size does not fit all

 

Before concluding I’d like to cover one final theme which I hope has been emerging from this discussion. If the role of the consumer in framing industry policy is really going to grow, we could be on the edge of a genuine culture change. We could be moving on after years in which the overwhelming priority has had to be improving the universal service by engineering higher quality and maintenance, to a time when we can also tackle the needs of individual groups of consumers.

 

This sounds like an exciting change and it is. But it also has one huge implication which I suspect some of us might find uncomfortable. The one-size-fits-all approach was unavoidable in the earlier phase of work on behalf of the whole of society. But it simply won’t work in future if we’re serious about regulating for companies to meet the needs and wishes of their own particular consumers.

 

There will have to be a different kind of relationship between companies and customers based on services that fit expressed wishes in visible ways. I don’t think that anyone here would claim that this is what the system is set up to do at the moment. If you look at the very different short- and long-term priorities and pressures on the industry around the country, you see quickly that the price review must be more flexible if it’s really going to reflect local preferences. And of course companies also differ in terms of their financial and business models.

 Ofwat recognises the change taking place and is asking companies:- to ‘own their business plans’ at next price review; - to be less dependent on ministerial guidance; - to find out what their particular customers want; and

- to work out what is best for environment in their areas.

 I’m pleased to report that companies are up for this challenge, but there is big caveat to this. Companies and investors need to be reassured:a) that if they follow this guidance in good faith it won’t all come to nothing at the end because the new approach is ignored; and

b) that Ofwat won’t allow the chances of sustainable and cost-effective settlements to be reduced because of new uncertainties about what will or won’t be in the final determinations.

 

I’m sure that Ofwat will recognise these concerns. And Defra could help by backing the principle of locally relevant services in the strategy for water it’s planning to publish in the summer.

 

Conclusion

 

Defra’s water strategy will come out in the middle months of the middle year of the AMP 4 period. This might have been a place (between 2 price reviews) where you thought the sector would be becalmed. I hope I’ve shown that we’re a long way from this. Not quite ‘turbulent’ but …well you choose an adjective.

 

Wherever you look the industry is working with our regulators and others to make the service more sustainable and try to gain (or should that be regain?) the confidence of consumers and investors in the future.

 

Looking forward to today’s debates I’ve described some of the big issues for the City and why we’re keen to see a longer-term framework. I’ve talked about the growing influence of consumers on how the industry will run and what this means for the one size fits all regulation which has been so successful up to now but could be in for a change.