The water industry may not have featured in any of the electioneering debate in the run-up to the General Election but the incoming government will have to make far-reaching decisions that will affect the shape of the industry.

Anticipating this, Severn Trent Water (STW) has challenged government head on with a public attack on the current Ofwat and Environment Agency (EA) regulatory regimes in a report warning that bills could jump as much as 27% above inflation over the next two decades unless the industry radically changes.

In the report, Changing course – a sustainable future, STW says the industry has reached a critical point. It argues that contractors, suppliers, government, regulators, and end-users recognise the need for change, and that there is some degree of consensus too on what that change should be.

This may be overstating the degree of support its proposals have. Robert Miller-Bakewell, an industry consultant says: “The model needs a rethink, but whether it’s a tinkering or a radical overhaul is a debate that will run for some time.”

STW’s unilateral call for change, made in the middle of a general election campaign and coming from an industry notorious for its public reticence, comes at a critical time with Ofwat in the process of a review and, as WET News went to press, the Conservative party pledging reform including similar changes to that Severn advocates.

“We’re not alone in this,” says Tony Wray, chief executive of Severn Trent. “Some of us believe that there are more effective ways of running this industry.” Wray says the sector was too reliant on debt financing and that the regulatory framework in which Ofwat specifies investment levels every five years makes long-term planning difficult.

Wray says there are too many companies in the privatised industry, and warned that it was not “sustainable” in its present form.

“We’re very clear that 22 companies means that we’re getting sub-optimal solutions,” he says. “If you look around at other sectors, there are far fewer companies. What’s important is that there is diversity and competition, but equally there needs to be economy of scale.”

Price tag
The report outlines how the industry needs to invest £96B over the next 20 years, on top of its existing £33B debt, to make improvements to infrastructure and adapt to climate change risks. This multibillion-pound price tag will see the industry’s operating costs rise to £535M a year, hence the prediction of water bills climbing 27% above inflation.

“While historically the industry has been able to make operational efficiencies to limit the impact of improvement programmes on bills, to continue to deliver efficiencies we will need to improve our processes through much great innovation,” says the report.

“Around £80B has been spent over the past 20 years to improve and maintain networks while also delivering rising standards, largely financed via ever-increasing levels of debt,” says Wray. He also cited the likelihood that investment will also rise to cope with the increased risk of drought and flooding associated with climate change.

The company criticised the existing “risk-averse” regulations that it believes favour “capital intensive” rather than sustainable solutions. It calls for an immediate review by government of the current price-setting processes and of the UK’s proposals for implementing the EU Water Framework Directive.

“In order that the industry can continue to fund this investment while also addressing new challenges such as rising carbon emissions, it is now essential that we make significant changes to the policy and regulatory framework to ensure a sustainable future,” Wray says.

Although many of Severn’s suggestions, such as less prescriptive water quality regulation, receive support from industry peers, smaller companies are likely to be much less keen on the prospect of consolidation. “It’s a very controversial topic and one on which they’re not going to get a sympathetic hearing,” explains Richard Laikin, water specialist at Ernst & Young. “A lot of the smaller water companies are pretty efficiently run,” he says.

Companies in the supply chain privately express unease about further consolidation of what many perceive as already overly powerful customers. British Water has commissioned market research company, Research by Design, to undertake a strategic survey of its 600 members to glean the views of companies in the supply chain about the future shape of the industry. No date has been set for publication of its findings.

At present, while it is possible for companies to merge, proposed deals are automatically referred to the Competition Commission. Although Ofwat has indicated that it may consider liberalisation of the merger and acquisition rules at some point, it has also made clear that any reform must be consistent with protecting consumers.

STW argues that efficiencies could be achieved through mergers. Its report notes that the scope for operating efficiencies is declining: “By making operating efficiencies, companies have historically been able to lesson the upward pressures of large investment programmes on customers’ bills. Recent evidence suggests, however, that the scope for making these efficiencies using traditional approaches is declining.

“Ofwat has historically identified the scope for operational efficiency by calculating a common frontier of operational efficiency, and used benchmarking to determine the comparative performance of companies. Ofwat’s methodology relies heavily on economic models which, inevitably, have significant limitations in terms of the ability to accurately compare companies’ efficiency. This mechanism worked well in early price reviews because there were large estimated efficiency gaps between the most efficient and the average company.”

However, the report says that the scope for further efficiencies has decreased over time noting that while Ofwat’s 1994 price review identified increasing scope of efficiencies of up to 2.7%, this dropped to 1.4% in subsequent price reviews.

“This reducing scope for traditional operating efficiencies coupled with an increase in operating costs due to the continuing investment programme, will drive up customers’ bills, unless, new, innovative approaches can be found to hold costs increases to a minimum,” the report says.

Flexible approach
In addition to regulatory reform, the report recommends implementing a new market for water trading. STW says this would encourage greater levels of national and regional competition between utilities and ultimately deliver reduced bills.

“Inter-company transfers of bulk-treated water could be an economic means to move additional water to water-stressed areas,” the report says. “If this allows investment in new resource schemes to be deferred, then the costs of increasing water supply to adapt to climate change and supply a growing population will be lower.”

Nick Herbert, the shadow environment secretary has previously endorsed this approach: “I think that an actual grid can be ruled out as too expensive and environmentally damaging, but we could find ways of facilitating and incentivising more bulk water trading through a virtual grid.”

The report also insists companies that reduce carbon emissions should be rewarded, and called for the EA to bring in a more flexible approach to consenting new infrastructure projects and rejected the existing prescriptive point-based system.

“This would widen the scope for more cost-effective and less energy-intensive approaches to treatment to be taken, but still meet water environment objectives,” it says.

STW says its proposals would save the industry more than £10B during the next 20 years, and reduce carbon emissions by 13%, compared to the current business-as-usual scenario. “By passing on these efficiencies to customers, average bills could be 11% lower than they would have been otherwise,” the report adds.

STW has become the first utility to make a public attack on the current regulatory regime and to set out in detail the changes it wants to see.

The timing meant Ofwat was unable to respond directly as it is in “purdah” during the run-up to the General Election.

However, an Ofwat spokesman said the regulator was already addressing many of the concerns raised in STW’s report, and the next government would determine the future of shape of water industry regulations.

Ofwat plans to consider all the relevant recommendations resulting from the recent reviews of water and sewerage issues including the Pitt review into the 2007 floods, the Cave review of competition and innovation in water markets, and the Walker review of charging for water and sewerage services.

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