2nd report - Priorities for water sector reform

Different models of ownership could offer a better culture of responsible leadership, which is key to a thriving water sector. A variety of corporate ownership options should be on the table for the water sector. As well as the publicly and privately owned businesses, options include not-for-profit enterprises, Community Interest Companies (or similar), cooperatives and hybrid approaches. Regardless of the approach taken, other factors may also need to be considered, such as powers to vet potential owners of businesses, a power that Ofwat does not currently have. (Conclusion, Paragraph 7)

We urge the Independent Water Commission to analyse all potential water company ownership models to determine which models are most likely to lead to a thriving and responsible culture. The Commission should then outline the steps needed to encourage those models of ownership. It is not enough to simply look at the type of organisation and their performance: this analysis much consider the context in which they are operating, such as the effectiveness of the regulatory system. The Commission should consider the extent to which different models, within the appropriate regulatory setup, contain the right incentives to encourage the right behaviours, including sustainable and affordable investment. The Commission should also determine how regulators can better vet or veto potential owners of water companies to prevent bad actors from running critical national infrastructure. (Recommendation, Paragraph 8)

Given the wide array of performance issues across the sector, more responsible leadership is clearly needed for better stewardship of our natural water resources. Incremental steps have been taken to improve governance, increase consumer representation and influence bonus cultures in order to improve decision-making, but we are not satisfied that these measures are enough to change the overall culture of water companies and improve performance for customers. (Conclusion, Paragraph 12) 46

The Independent Water Commission should consider what other reforms are necessary to ensure that the right people are put into senior positions and the appropriate bonuses are paid to them. This should include greater oversight or approval from Ofwat before appointments are made and bonuses are paid; clearer statutory expectations on the criteria for bonuses, making sure that they are awarded only for exceptional performance; clearer reporting to show how the needs of the environment and customers have been prioritised; better connections between bonuses and the incentives under the regulatory system; and greater customer involvement in establishing what an appropriate bonus scheme looks like. (Recommendation, Paragraph 13)

Trust and accountability in the water sector is very low and water companies must improve transparency through open data and more collaboration with consumers. (Conclusion, Paragraph 16)

The Independent Water Commission should consider how the link between water companies, communities and citizen scientists could be strengthened and formalised to provide a broader picture of water quality in local regions. These proposals should consider how water companies can be democratised and made as open as possible, with a legal requirement for water companies to publish performance, environmental and financial data on a sufficiently regular basis to be of use to the public. (Recommendation, Paragraph 17) Financial management

Complex financial structures are not necessarily a problem, but they can obscure water company finances, enable bad practices, undermine transparency and worsen the public perception of water companies. Water companies increasingly look like financial institutions rather than businesses servicing monopolised critical infrastructure. These structures have undoubtedly been used, in some circumstances, to increase debt, given they are outside the investigatory remit of the regulator. Simplification and greater oversight are needed to ensure that these entities are used appropriately. (Conclusion, Paragraph 20)

The Independent Water Commission should determine how regulators can have better oversight over debt levels in regulated entities and other connected companies. Its proposals should actively require companies to simplify structures to allow for greater regulation and oversight of any company’s true financial situation. (Recommendation, Paragraph 21)

There has been serious economic mismanagement of companies, leading to unsustainable levels of debt and a high price for consumers. This situation must be resolved and a culture of relying on debt must never be allowed to 47 arise again. Since investment levels and revenues in the sector have clearly not been high enough, debt is likely going towards day-to-day expenditure as well as capital costs, which would be an irresponsible approach. A new understanding is needed about how bill revenues and debt are used. Companies and shareholders have demonstrated that stronger guardrails are needed to prevent the ratcheting up of debt to the point of financial instability while dividends continue to be paid. (Conclusion, Paragraph 25)

The Independent Water Commission should determine new measures to regulate the accumulation and management of debt in the water sector. These measures should allow the economic regulator to intervene when irresponsible debt management is taking place. Any new powers should be tempered by a realistic and consistent understanding of what sustainable debt levels look like. The Commission’s work should help government, water companies and citizens come to an understanding about the most appropriate uses of debt, such as primarily for major new projects, infrastructure and upgrades that could cause surges to customer bills. (Recommendation, Paragraph 26)

There clearly have been examples of excessive dividends, particularly when poor performance or finances are taken into account, symptomatic of a culture of prioritising profit over duties to regulators and customers. However, dividends for other companies have been in line with regulatory expectations. Dividends are controversial, particularly when total shareholder returns and debt are taken into account. Part of the problem is the lack of clarity about whether dividends have truly been value for money, particularly since they eventually take more money out of a system than they put in. A system based more on higher bills and limited debt may be better. It is also not clear whether Ofwat’s historic expected dividend returns have been set at a sustainable level, although many investors now think they are too low. We must ensure that sufficient safeguards are in place to prevent egregious dividend payments, ensure that services for customers and the environment take priority and to properly link dividend levels to company performance. At the same time, investors need to see stable but modest long-term returns. (Conclusion, Paragraph 31)

The Independent Water Commission must determine whether equity investment has been value for money for customers. If it is advisable to continue with a totally privatised model, the Commission needs to create a comprehensive but stable regulatory environment for water companies and their investors to ensure that the sector is low risk and low reward. As part of its work looking at narrowing the variability of returns, the Commission should investigate whether there should be a clearer ‘floor’ and ‘ceiling’ for dividends to provide reassurance to all sides, one that takes into account all returns that investors receive. Between these thresholds, that regulatory system should encourage higher dividends for better performance, and 48 lower returns for poor performance. To ensure that customer service and environmental outcomes are prioritised, dividends should potentially be blocked entirely where companies have failed to deliver projects required by regulators and where there have serious infringements of licences, permits and performance targets, such as serious pollution events. To ensure that this works as intended, and to prevent the risk of unjustified dividends leaving a company, pre-approval for dividends by the regulator might be necessary. (Recommendation, Paragraph 32)

Special administration should be a last resort. However, it is unclear whether allowing a failing company to struggle on and accumulate progressively more debt is a better outcome than assuming temporary national control more quickly, with the associated costs that it could incur. (Conclusion, Paragraph 35)

The Independent Water Commission must provide recommendations on improving the special administration regime which, while it should still be a last resort, must ensure that the criteria for its deployment are sufficient for ensuring value for money for customers. (Recommendation, Paragraph 36) The price review process

Customers should be protected from paying more than is necessary for maintaining national water infrastructure, and the price review is an important part of doing this. Some evidence suggests that previous determinations have not been sufficient, at least for some companies, to keep up maintenance and stakeholders have suggested a number of reasonable ways to improve the system, such as better ways of calculating expenditure allowances and developing a system that allows determinations to be challenged. However the price review is unlikely to be the sole, or maybe even the main culprit for low overall levels of investment: an irresponsible culture has developed amongst all actors to keep bills low, and customers and the environment are now paying the price. Bills will need to rise, which will be challenging when trust is dropping; government, regulators and water companies will need to ensure that this results in a better deal for consumers. (Conclusion, Paragraph 41)

The Independent Water Commission must ensure that water bills and spending allowances are sustainable and appropriate for maintaining assets and delivering services. If the price review process is retained, the Commission must begin the process of reforming it to ensure that allowances are calculated fairly and openly, and to ensure the process does not impede reasonable challenges. The process should ensure that bill revenues are not lowered in real terms, unless under extreme circumstances. If done in conjunction with reform to the regulation of debt 49 and dividends, ensuring that more revenues can be invested into the sector, it may be possible to make the case for higher bills in return for better performance. More broadly, the Commission needs to get to the bottom of why a culture of unsustainably low bills was accepted by companies, regulators and government, and set out the reforms or principles needed to ensure that this does not happen again. The Commission will likely need to consider all the core planning processes that identify investment and make sure these are fit for purpose. (Recommendation, Paragraph 42)

The incentives that Ofwat puts in place for companies are too complicated, fail to match public expectations, and in many cases are not bringing about a culture of improvement. Despite public consultation, there are too many to provide a clear picture of company performance. There is scope for simplification and, given that the Government is in the process of reviewing national targets for water, there is an opportunity for better alignment and prioritisation. Simplification could clarify company performance and help rebuild trust, as would reconnecting public expectations and rewards achieved. Penalties are important but they also have the potential to create a negative feedback loop, encouraging further failure. These penalties should not be to the detriment of investment. (Conclusion, Paragraph 47)

The Independent Water Commission’s proposals should ensure that the price review system is reshaped so that its system of incentives creates a culture of improvement. The price review should contain a comprehensive but straightforward set of performance metrics that matches public expectations and national targets for water. Targets should be stretching but realistic and never set basic expectations. Incentives to meet these targets should reward consistent improvement that is demonstrably attributable to the work of the company and only penalise regressions. (Recommendation, Paragraph 48) Regulatory environment

Environmental regulation and the delivery of a reliable and safe water must be the first priorities of water companies and regulators. Effective regulation, strongly prioritised towards environmental and customer targets, is needed to make these a core part of the culture amongst water companies; it will also need to cover all actors that have the potential to harm water resources. It is important for regulations to be comprehensive and predictable to close any gaps that can allow pollution, and to ensure a stable investing environment. This should not just be about protection, but also about encouraging water companies, as major landowners, to actively improve the environment. (Conclusion, Paragraph 52) 50

The Independent Water Commission should look at potential reforms of the regulatory frameworks and regulators that govern the water sector to ensure that environmental protection is effective and a priority for water companies. It is vital that the reforms the Commission proposes can accommodate and synchronise with wider reforms, such as those that aim to tackle all water pollution from a variety of sectors and products, and new targets for water quality under a new Environmental Improvement Plan. These reforms should also ensure that water companies are encouraged to invest in nature-based solutions that can provide a suite of co-benefits for the public. (Recommendation, Paragraph 53)

We support the Commission’s focus on creating a better regulatory framework, however a good framework is nothing without well-equipped regulators to act against bad actors and poor behaviours. Without clearer information and standards, it is difficult to have faith that monitoring and enforcement levels are sufficient, and we wonder if this has been a more pertinent problem than the frameworks themselves. The length of investigations and the sudden rise in inspections following injections of funding suggest that regulators have been underfunded in recent years and less able to monitor and catch problems, or enforce the rules sufficiently. Welcome efforts are being made to increase monitoring and inspections. We also believe that there is likely an imbalance between the data held by water companies and that held by regulators: a culture of openness is needed to ensure accountability. (Conclusion, Paragraph 58)

The Independent Water Commission should assess how effectively the regulators audit companies, monitor the water environment, and enforce breaches of licences and permits. It should consider whether regulators are leveraging enough fees from the sector to ensure robust, fair and quick monitoring and enforcement of environmental protections. To bring about greater trust in the regulatory system, the Commission should consider whether public standards for monitoring are needed, including a full understanding of asset conditions, a clear and agreed set of performance metrics, and an agreed rate of inspections. As part of this, the Commission’s proposals should ensure that data on water is as open as possible, with regulators gaining automatic access to data held by water companies that is core to their regulatory functions. The Commission should consider whether more investigations should be made into category 3 and 4 pollution incidents. An evaluation of the “self-reporting” system is needed, which may need to be significantly overhauled or replaced to rebuild trust. (Recommendation, Paragraph 59)

The current regulatory system does not encourage long-term thinking, as already acknowledged by the Commission. This affects both short-term resilience against asset failures and long-term water security. Improved finances may help, but part of the problem is, like in many other sectors, a 51 lack of coherent resilience standards for key aspects such as water supplies and asset health. Consideration of asset replacement rates is a start, but to focus solely on this would be a mistake: a much broader understanding of what resilience looks like is needed. (Conclusion, Paragraph 65)

The Independent Water Commission should determine how the price review and regulatory systems can encourage better resilience, both to protect customers from short-term shocks and ensure that water resources are safeguarded in the future. This should begin a process of creating a robust set of resilience standards for the industry, firmly embedded within the price review process or other central regulatory tools. (Recommendation, Paragraph 66) Relationship with consumers

Evidence suggests that some water companies are not sufficiently protecting or compensating their consumers before, during or after high impact incidents such as supply interruptions and sewer flooding. Regulatory steps are being taken to address most of these concerns, although it remains to be seen if these new measures will be effective. (Conclusion, Paragraph 71)

The Independent Water Commission should assess whether Ofwat’s new customer-focussed licence condition, and the new Guaranteed Standards of Service, are sufficient to improve protective services for consumers during and after high-impact events. The Commission and Defra must address the issues of local coordination with other key bodies and communication with consumers. The Commission should also consider whether statutory standards should be set to create a customer-first culture amongst water companies. These standards could explain how to handle serious incidents—for instance, clarifying how and where water bottles should be supplied, how emergency sanitation should be accessed and how local emergency plans should be developed—and how to ensure that customers are aware of their rights. (Recommendation, Paragraph 72)

The Government has not yet set out a timetable for developing a single and comprehensive social tariff to prevent protect low-income households from bill increases, despite the widespread view that it will be necessary in the context of much higher bills. This is a necessary step that allows the regulatory system to significantly increase investment, while shielding the most vulnerable. Despite record numbers of people being offered financial support, we are also not clear what progress is being made towards sector targets to eradicate water poverty. (Conclusion, Paragraph 74) 52

The Independent Water Commission’s proposals should contain provisions for establishing a single social tariff, or other protections for low-income households, to protect customers from the worst impacts of anticipated bill increases. The Commission’s proposals should also establish how effectively water poverty is being tackled and whether more effective tools are needed to monitor progress. (Recommendation, Paragraph 75) 53