Waterwise Response to BIS Call for Evidence on Principles for Economic Regulation (2011)

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Waterwise is very supportive of the Coalition Government’s commitment to setting out principles for economic regulation across sectors. Many of the challenges – for example of climate change and population growth – are common across sectors, but because the regulatory framework for each sector has developed independently, these regulatory frameworks do not currently work together and on occasion work in conflict. This consultation and the resulting policy offers the opportunity to address such issues more strategically and deliver multiple outcomes more cost-effectively.

Questions

The principles themselves

1. Do these principles sufficiently encapsulate the characteristics of a successful framework for economic regulation? If not, how could they be improved?

The principles are a welcome and long-overdue strategic approach to ensuring future challenges are met most effectively across the UK.

Waterwise particularly welcomes the principles of vertical and horizontal coherence, andsuggests some improvements below under the “Focus” section.

Vertical and horizontal coherence

At present, the fact that the regulatory frameworks for water and energy have developed independently of one another leads to barriers between joint working between the sectors, where such working would specifcally address the challenges of climate change and effective competition and consumer outcomes outlined in the consultation. For example, the water and energy companies have developed plans to work together under the Water Efficiency Targets set by Ofwat and CERT which is administered by Ofgem, delivering whole- house water and energy efficiency retrofits to customers through a single, more cost- effective approach, but over-application of the “additionality” principle within CERT (where it is deemed that such work would have happened anyway) has led to much of this work being shelved. (For further detail, see the Waterwise-co-ordinated cross-sectoral response to the recent DECC consultation on CERT).

As both regulatory frameworks (water and energy) are currently being reviewed by government, there is a significant opportunity now to ensure that the sectors are working

together to deliver Coalition Government priorities such as climate change mitigation and adaptation, as well as growth of the low-carbon economy and nudging sustainable behaviour. “Vertical coherence” would help ensure this, as would “horizontal coherence”,which might even mean some joint mechanisms across sectors – for example on approachesto retrofitting customers’ homes. Links with other sectors not covered by the Principles ofEconomic Regulation, such as housing, would also help deliver the more sustainable approach set out as an aim in the consultation – for example including water efficiency measures and showers in the Decent Homes standard for social housing, in the Green Deal (a welcome announcement to this end was contained in the National Infrastructure Plan) and in Energy Performance Certificates for homes. Energy and water customers are currently treated in regulatory terms as entirely separate groups, while in practice they tend to be exactly the same people.

Vertical and horizontal coherence in economic regulation would also help ensure the considerable economic, environmental and social opportunity of mainstreamed water efficiency is fulfilled. Water efficiency – wasting less water – is an essential part both of adapting to climate change and building resilience into our systems, and tackling climate change. Water efficiency has an important role to play in the green economy, the big society and safeguarding the environment. It can also help reduce the deficit (through reduced water and energy bills in the public sector). And water efficiency is vital in adapting to the climate change the UK is already seeing and cannot avoid, despite action now –underpinning the statutory National Adaptation Programme for England. Both hot and cold water efficiency measures are important even once the electricity grid is fully decarbonised, because there can be no such thing as a zero water house, and because gas, on which there is a huge reliance for water heating, cannot be fully decarbonised.

“Focus”

Waterwise proposes a change to the section under “Focus” which states that “economic regulators’ duties should be concentrated on economic considerations”, to reflect the need for sustainability.

Ofwat’s primary duty to protect the interests of customers is currently (rightly, Waterwise believes) interpreted by Owfat as including the needs of future customers, and this is reflected in the parentheses set out in this section of the consultation. This means in theory that the costs and benefits of measures taken now both to increase supply and to manage demand both in the next five years and the longer term should be evenly balanced. In practice, because it is not specified in the primary duty, companies tell us time and again that the costs and benefits of measures are biased towards short-term gain (focussed on the five-year price review period), and in particular to those measures which contribute to their regulatory asset value, which tends to mean new, often carbon-intensive supply-side measures such as reservoirs, rather than demand management measures such as a retrofit of tens of thousands of homes.

With no mention in the principles of the need for sustainable development, which is at the core of Coalition Government strategy and policy on the economy and more widely (as well as the necessary reform of the regulatory framework for water itself, to which the Coalition Government is also committed), there is a danger that short-term “price” will continue to triumph over longer-term “value” in the water sector. In water, this would mean in practice that the scarcity and over-abstraction of water both now and in the future would not be reflected in decisions on supply and demand options, with potentially disastrous results for supply to both domestic and non-domestic customers (in turn impacting the economy) and the environment. This also sits at the heart of the economics of water regulation, as it has a direct impact on the costs and benefits of water company processes.

Waterwise would like to see the need for sustainability more explicit in the principles, and proposes the following wording: “economic regulators’ duties should be concentrated on economic considerations, in the context of sustainability, including ensuring an appropriate balance between the needs of future and existing customers and the impact on theenvironment”.

This is particularly important in the water sector not only because of the impact the current bias towards capital expenditure (see below) has on water availability and the environment in the future, but also because there is currently a lack of coherence of application between economic and environmental regulation of that sector. For example, the Water Resource Management Plans and Ofwat’s Price Review are the key strategic drivers on the water companies in England and Wales, but the former does not bear sufficient weight in the latter to justify spend, as implemented by Ofwat. This is despite the fact that Water Resource Management Plans are extensively consulted on with stakeholders and as a result contribute to the stated aim of both the Coalition Government and Ofwat to include a greater role for the consumer in the water sector. Greater coherence between economic regulation and other types of regulation on the water sector is important, and should be inherent in the principles as it undoubtedly also applies to other sectors with important health and safety and environmental considerations, such as energy and aviation.

The regulatory framework for water currently incentivises the water industry in England and Wales towards supply-side measures. As such, the full long-term value of water, in economic, social and environmental terms – for example its value in different places at different times – is not reflected, as noted by Cave and Walker. There is a strong bias towards capital expenditure because this contributes to the regulatory asset base. This bias acts as a barrier to large-scale water efficiency – this is despite the Revenue Correction Mechanism which Ofwat has introduced, which is welcome, but will only bite every five years, so does not drive year-on-year supply-demand investment decisions. The water companies are undertaking excellent work, retrofitting tens of thousands of homes at no extra cost to the customer, including in conjunction with large-scale metering programmes, and encouraging customers, schools and businesses to waste less water. But this is a very small proportion of the amount they spend on supply-side measures. As Severn Trent Waterset out in their Changing Course document in April 2010, “In order to equalise incentives, there needs to be scope for initiatives involving operating expenditure to earn a return”. Abias towards capex also acts as a barrier to sustainability in other sectors, such as transport, energy and communications – and in the public sector – where investment in new capital projects is easier to fund than alterations.