Kelda: customers must come first, says Ofwat

Sir Ian, who retires at the end of July, said: “The current system has served customers well. Companies have increased their efficiency. This has resulted in improved water quality, increased investment on protecting the environment and lower prices. I want to ensure that this efficiency continues.

“Shareholders will be able to vote on the Kelda proposals – I am determined to see that customers are given a voice, too. This is why this consultation is important. I must be satisfied that customers do not face additional risks” (see related story)

One of the key points made in the document is that if the proposal is to go ahead, the asset owner must be committed to a regular programme of competition in a contestable market for operations to be provided by arm’s length suppliers. The programme would need to be approved by the regulator.

The document also questions whether the operations would have to be split into elements, either for different services or by geographical area to make full market competition a realistic option. “There is also an issue whether this position needs to be established before implementing the proposals,” it notes.

The point of legal liability is also confirmed – the asset company, as the licence holder, would remain responsible for water quality and safety even after operations are handed over to a contractor. Sir Ian said: “The asset company must at all times be able to control events in order to fulfil all statutory obligations, for example to ensure that it could deal immediately with any incidents.”

Other main points are:

• the new business would continue to operate under a price cap and be subject to periodic reviews alongside investor-owned water companies
• the new structure – known as an RCAM (Registered Community Asset Mutual) – must ensure that incentives for efficiency are not harmed by the absence of shareholder pressure and that risk is not transferred from shareholders to customers
• the regulator must be satisfied from the outset that customers do not face additional risks
• in view of the lack of shareholder pressure, the regulator considers that the Board of the appointee should contain a majority of independent non-executive directors, and must be commercially focused
• two of the non-executive directors should be elected by vote of Kelda’s customers
• licence modifications would be required to ensure the regulator can be confident that the ownership and governance structures of the RCAM are adequate to ensure the board could be replaced if it did not act in an efficient manner
• licence modifications would also be necessary to implement the programme of competition for operations by arms’ length suppliers and the potential disaggregation of services
• the possibility should be considered of the regulated utility retaining the operational capability until the operations can be competitively tendered rather than let initial contracts to Kelda with phased competitive tendering thereafter, as Kelda proposes
• licence modifications would also be necessary to ensure ring fencing; the procurement plan; corporate governance and incentivisation of management; and access to information

Reaction from industry observers has been generally muted, with most doubts centred on the allocation of risk and management incentivisation. Professor John Kay, of London Economics, who wrote a keynote paper on mutualisation, told edie that he has doubts: “The issue as I see it is very straightforward. Yorkshire Water and every other water company is regulated on the basis that if things evolved as the regulator proposed they would get the regulator’s allowed return on assets.

“If this doesn’t happen, that is a risk. At the moment that is borne by shareholders. If you transfer the risk to customers, the cost of capital to Yorkshire Water would fall but only if the regulatory regime was changed, and I don’t think that the regulator would allow that. A management company could take the risk – but I don’t see a management company taking it for less than Kelda.”

Lehman Brothers analyst Rebecca Reehal told edie: ‘The bond market reaction is another key element, especially if all the regulatory risk is given to the asset company. And there are issues around competition. There are other ways potentially of doing this – there may be some equity solutions. It is not clear that to bring about a lot of goals such as asset value transparency and shareholder flexibility that you have to go for the mutual solution for the asset company.”

Mark Clifton of Europe Economics told edie: “As things stand, if things work out badly in terms of performance at present you get a worse deal and very strong incentives to improve. If a company is customer owned, the regulator has strong pressure to bail them out.”