How government can make a splash reforming our water sector
By Dan Corry, Chief Economist, The Future Governance Forum
Former Bank of England Deputy Governor Jon Cunliffe recently published his independent review of the water sector for the government. It’s a very substantial bit of work, with 88 recommendations ranging over almost every aspect of the sector (someone has even calculated that its recommendations include initiating another 45 reviews and consultations…). And none of that is surprising given the state of our water sector. It is also not surprising that the government, while adopting several of the key recommendations already, is taking some time to think about the rest of them.
There will be lots of debate about much of this and I am sure a desire for the government to get on with it as quickly as they can. But this is a moment to get things right and settle things for the long-term, and in that sense the review raises some other interesting questions about the way government works, about the institutions it creates and about the government’s appetite for change.
One of the major questions is when to break up a regulatory system.
Regulatory systems: theory and practice
Almost everyone agrees that the current regulatory system has not been working in water. Cunliffe argues that this is partly down to failures by politicians and regulators as well as the behaviour of investors, boards and CEOs.
But in common with other regulated utilities there is a problem in that England’s regulatory system for water was created at the same time as the natural monopolies of regional water authorities were privatised. The new regulatory system for these new companies aimed at ‘sweating the assets’, in other words, it was based on the assumption that there was a lot of space to make efficiency gains compared to the old nationalised system. The famous (or infamous) RPI-X system, where the regulator set the prices that companies could charge for a period as being a certain amount below inflation (the retail price index), was supposed to give private operators incentives to find those savings because they would get to keep any profits made as a result - until the next price review.
But this failed even from the beginning. As I have argued many times, however good the theory, if a regulatory system does not produce outcomes that have public support it will create uncertainty for all players, and will eventually collapse. A system that gave private monopolies and their CEOs major profits and pay that looked egregiously unwarranted to the public was never going to last. And indeed RPI-X has faded away over time, moving us closer to more traditional ‘rate of return’ regulation (as used extensively in the US) where firms are only allowed to make a given, limited, return on their investment.
An expanding set of concerns
But the other issue is that in more recent times the big need in the water sector has been less about efficiency than about the need to build new infrastructure and better maintain the existing kit. This ‘build and run’ approach is therefore needed alongside the more traditional regulatory role of systems controller or overseer. All this has been obvious for some time.
In addition, while the original post-privatisation regulatory approach was all about the economics and debates about the purity of drinking water, it became clear very quickly that the regulators would also have to have an eye on the environment, pollution, water security and to fairness, so that poorer households were not charged too much for their water.
This started to raise questions. It meant that more duties were added to the regulator’s functions, and trade-offs needed to be made between duties - which again challenged ways the regulation worked and put a premium on policymakers being clearer about what they wanted. It meant that we should really have had companies and regulators knowing - or at the very least wanting to know - which assets were where and in what condition.
However, as Cunliffe points out, this is still massively lacking. The expanded list of regulatory concerns also called into question whether it made sense to have some things looked after by the Water Services Regulation Authority (Ofwat), others by the Environment Agency and yet more by the Drinking Water Inspectorate and other regulators. And it questioned having a top-down, ‘national’ focus when the issues around water vary massively from place to place – which has now led Cunliffe to propose nine new regional water authorities for England.
The status quo cannot hold back the tide - so what now?
Looking back over the last 15 years or so, and considering all of the above, it has been obvious that something needs to change. But we stayed with the status quo, with political pressure to keep consumer prices down above all else, leading to an inevitable lack of investment or care about other things that matter.
Why was this? One reason might be that the dislocation caused by any major change has been seen as simply not worth the bother. Secretaries of State who know they are likely to have limited time in the job rarely want to see their department or associated Arm’s Length Bodies consumed by reorganisations.
To its credit, this government, and this Secretary of State, has taken the plunge and decided that the time for change is well overdue. One of the main recommendations from the Cunliffe review that it is acting on immediately is to abolish Ofwat and replace it with a new regulator.
But now that first hurdle has been passed and we know that change – big change – is coming, we are already slipping into debates about how to manage it all:
There is the tricky and sensitive transition from the old regulator to the new one: so should there be a new transition team straight away or does ‘legacy Ofwat’ run things for the moment?
What about the next price review, scheduled for 2029, which the water companies are already gearing up for: is that even needed?
If we are going for a more supervisory approach - so regulation takes account of the circumstances of each company in terms of its water issues and capacity and moving away from the current one that ranks companies against each other on various metrics - do we need so many water companies and should the system be less bothered about mergers in the sector?
How exactly should the Environment Agency be reconfigured when the water- related environmental side has been ripped out and gone to the new regulator?
And crucially – given the government doesn’t want to renationalise water companies - how can investors and credit rating agencies be confident that a new, unknown and untested regulator and regulatory system will ensure they feel comfortable to invest?
And throughout all of that - and perhaps the most vital question of all - how can public trust in our water system be restored, in what has been literally and figuratively one of the most toxic issues of recent election campaigns?
More prosaically, is the Department for Environment, Food and Rural Affairs (Defra) going to be able to take on all this work of change – including a lot of legislative drafting – without a great deal of increased capacity?
And how can it do this while also keeping its eye on the other considerable reform challenges within its remit (including implementing the recommendations in the review of environmental regulations I did for the department earlier this year)?
This will undoubtedly be a complex process. There will be problems along the way. Campaign groups and opposition politicians will criticise the government for not moving fast enough while others deep in the industry will try to defend elements of the status quo that worked for them, or simply struggle to keep up with the pace of change.
Change then, as we know, is difficult and can get put off. But if this government is to fulfil its claim to be mission-driven, changing not just headline policies but the fundamental way our institutions work and restoring trust in government to make a difference, then it’ll need to take these kinds of bold and difficult actions. The decision on water regulation is one such action, and it must not be the last.