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Nick Herbert: Speech to the European Policy Forum on water policy

Thank you very much for allowing me to come to speak to you this evening.

250 years ago, Benjamin Franklin said "when the well is dry, we know the worth of water".1  His remark could hardly be more pertinent today. 

World Water day yesterday reminded us that water is a precious resource which we all too often take for granted globally, but the same is also true on a national level.  Realising the true worth of water is going to be more important for our country, for water policy and so for the industry than it ever has been before.

The co-incidence of the Cave review, the Walker review and PR09 makes this an ideal opportunity to talk to you about some of the early thoughts I have had about the current state of the water industry, and some of the challenges, and possible solutions, for the years ahead.  I am keen to continue to talk about these issues with the industry.

I want to look at the issues of affordability raised by PR09 - and at a time of recession especially - and the challenges posed to the industry by climate change and increasing demand.  And I'm going to set out some of the ways I plan to approach the answers to questions about whether the industry is sensitive enough to consumer demand, how we incentivise water conservation, how we maintain and enhance environmental standards and how we ensure supply meets demand.  But first, I want to explore some of the benefits brought about by privatisation.

<h2>History</h2>

In the run up to the 1989 Water Act which introduced privatisation into the water industry the then Secretary of State for the Environment, the late Nicholas Ridley, set out why he believed it was the right course to take.2

First, he identified that private ownership had a long history within the industry - dating from the Victorian era.  Many privately owned statutory water companies were created in the mid-nineteenth century by Acts of Parliament, and in 1988 these companies were still handling around a quarter of the water supply.  Revealingly, Labour administrations decided not to nationalise them.

Second, Nicholas outlined how privatisation would give the water industry greater opportunity for innovation and diversification, citing the industry in France as evidence for this.  French companies dominated the global market at the time, and some water companies had colossal turnovers of around £5 billion a year.

And third, he stressed that in order for water companies to be able to innovate and diversify, they needed to secure capital investment from the markets.  In the 1970s, companies had not been securing the investment that they needed.  Under the Labour Government of 1974-9, the water authorities saw capital spending fall by a third in real terms.  Within that, expenditure on sewerage and sewage treatment was halved.

The Labour Party, of course, did not support the move towards privatisation, saying that: "Water is our country's largest natural monopoly.  It is the people's most fundamental resource on which their health and well-being depends.  We in the Labour party believe that this natural resource and the water industry's assets should be publicly owned and controlled."3  Those were the days.

And this position was maintained during the Bill's passage through Parliament and even through to the 1992 Labour Party Manifesto, which claimed that "the provision of water is so fundamental that it is a priority for return to public control."

It was only with the rise to the Labour leadership of Tony Blair that the policy of returning the water industry to public control was replaced by a focus on an increased regulatory approach.

<h2>The impact of privatisation</h2>

The Thatcher Government had two clear objectives for privatisation: to improve the efficiency of companies, and to fund the investments needed in infrastructure to meet the new, tougher water quality standards, making up for past under-investment. 

Certainly, investment has soared.  In the six years after privatisation the water companies invested £17 billion, compared to £9.3 billion in the six years before privatisation.4  Whilst there were concerns that the first regulatory cycle (1989-94) set a price cap too high leading to the gold plating of some investment, this investment brought about the much needed modernisation of infrastructure and environmental improvements, all at no cost to the taxpayer.  Today rivers are less polluted5 than in the 1990s and are more able to sustain diverse wildlife.  Beaches are cleaner than before and are safer and more pleasant for families, although progress needs to be maintained and monitored.6

In turn, PR997 delivered substantial reductions in bills, up to 15 per cent for some customers.8 This meant that average bills were lower, in real terms, in 2000 than they had been since 1992, which shows that privatisation delivered a large number of real benefits.

Twenty years on from privatisation we now have a mature and well-established industry. However, there are a number of outstanding issues which need addressing, as well as significant new challenges brought about by the current economic climate, an increase in demand for water and climate change.

<h2>The impact on consumers and PR09</h2>

With PR09 well underway I have come to these issues in the middle of a complex process.  What I want to do is take a step back, and start by looking at the impact of water bills on customers. 

There continue to be wide variations in prices between water companies in different regions with customers currently paying anywhere between £2979 and £49910 a year for their water, entirely based on where they live.  Today I'm publishing a table which tracks the course of water bills over the last decade, showing that since the low point of 2001 bills have risen, on average, by a fifth, but in some areas by as much as a third, above the rate of inflation.11  Of course, there may be local reasons for the variation in prices, whether relating to environmental protection or resulting from a need to improve ageing infrastructure, but whatever the reason, the fact is - and from the consumers' point of view, it's a very salient fact - that some companies have moderated price rises more than others.

I have also looked at the initial PR09 bids from water companies.  Some companies are planning rises of over 20 per cent above inflation, but again, others are doing better and are freezing or even reducing bills.12  Especially in the current economic climate, the proposed increases at the higher end, even if they are only initial bids, will concern consumers.  And when the increases are compared with prices at the post-privatisation low point of 2000-01, they begin to raise eyebrows.

By 2014-15 bills will have risen, in some areas, by as much as 50 per cent13 above inflation and on average by over a quarter since 2000-1.  These sustained, above inflation rises, are in danger of taking bills to unacceptable levels, especially in time of recession.  Water companies, many of whom have historically enjoyed high customer satisfaction rates, are trespassing into a more dangerous zone with consumers.

The Consumer Council for Water has done much good work to champion the consumer voice, and their role is important to help moderate proposed price rises.  I think there is a strong argument for encouraging greater negotiation in the process so that the consumer has a clear role to play when price limits are set.  Not only could this help to improve the outcome for consumers, but it would also improve customer acceptance of the final settlement.

Even before the recession, concerns were growing over the affordability of water bills for vulnerable and low income households.  Government figures produced back in 2004 predicted that the number of 'water poor' - those paying more than 3 per cent of their disposable income on water - was projected to rise from 8 per cent to 12 per cent.14   We know that around one in six households are unable to pay their water bill and have fallen into debt.15   This is a serious problem both for those customers genuinely unable to pay higher bills and for the water companies who have to pass on growing levels of debt to their customers.   

With the average household that does pay subsidising those that do not to the tune of an extra £11 a year on their bills, it is welcome that some companies are actively pursuing creative ways to help vulnerable customers.  Innovative tariffs, flexible payment plans and debt helplines can all work to help those in difficulty, reduce debt and, ultimately, reduce bills.

But such measures should complement, not substitute for, an overall framework which ensures that consumers receive a fair deal and more families are not pushed into debt.  At the moment it is not easy for customers to see what is driving prices and what element of their bills is necessary for securing environmental protection.  In this age of accountability and transparency the public need to see clearly how their money is being spent.  It is hard for customers to assess the true costs and benefits of environmental protection measures and whether companies are acting responsibly.

While PR09 still has some way to go, whatever the final determinations, improved communication with customers will be important.  But this is not just about better public relations on the part of the industry.  I would like to consider the extent to which greater transparency and clarity over spending plans could be afforded to consumers.  Since privatisation the industry has paid out a healthy dividend to shareholders.  I want to be sure that consumers receive their fare share of the dividends from privatisation, too.

<h2>Wider challenges</h2>

Beyond the issues raised by PR09 and concerns about affordability, there are clearly wider challenges facing the sector which need to be addressed.

<h3>Cost of capital</h3>

In the short-term, during the recession, the cost of capital is an important issue.  There has never been a price review in such desperate economic circumstances and if companies are not able to access credit at a satisfactory rate then infrastructure may suffer.  The Indepen investor survey carried out for Water UK showed that concerns over long term funding have risen sharply, with over two-thirds now expressing concern, compared to only one-third a year ago.

I am mindful that when we consider any changes to the sector we need to recognise the industry's need for stability, the potential effect on confidence and in turn on the costs for consumers over the long term.

<h3>Environmental pressures</h3>

The environmental challenges facing the industry are also considerable.  Our water supply is already under pressure, with nearly half the UK population living in water stressed regions. Areas such as East Anglia, London and the South East face particularly serious challenges.  These challenges will grow if rising bills combine with anger over reductions in supply during times of water shortage.  In some water stressed areas customers with restricted supplies could begin to have a more antagonistic relationship with companies if bills also rise.  We do not want water companies to be seen as 21st Century robber barons, demanding price rises from consumers who cannot say no, but refusing to supply them in return.

Climate change is also likely to lead to a greater flooding risk.  The floods of 2007 showed just how unprepared Britain is to deal with heavy rainfall.  Surface water drainage needs to be improved and innovative solutions will need to be found to address the concerns about our sewerage network's ability to cope.  Recent concerns over surface water charging have shown that measures can be put in place but that they need to be implemented in a careful and considered way.

This also raises concerns about the future management of the sewerage system.  We need to take a holistic view of the system to manage rainwater to ensure that issues such as management of drainage from highways can be considered and, where necessary, altered. 

The siting of key infrastructure, such as water treatment works, will also need to be reassessed and flood protection will need to be improved.  The Environment Agency has a key responsibility here, but it is also essential that the Government takes a strong lead and implements the key recommendations from the Pitt review.   This implementation has so far been delayed.

Over the next two decades, the population is expected to rise by 10 million.  There will be further housing development and continued pressure on supplies.  With climate change having a significant impact on supply we will need to prepare for long dry periods such as those in the summers of 2005 and 2006 and for potential problems with abstraction as rising temperatures reduce river flows, possibly by as much as 80 per cent in the summer.16 While overall demand is expected to increase, our supply will be under greater stress. 

Meeting the obligations of the Water Framework Directive to further improve our coastal and inland waters, as well as reducing the risk of flooding and managing the effects of prolonged dry spells, means we must manage our water more sustainably, reduce pollution and continue to improve our water quality to ensure it is safe and clean to drink.   The Environment Agency has warned that a number of our rivers' bodies will not reach good ecological status by 2015 if action is not taken to reduce abstraction.17

At the same time as adapting to the challenges of climate change, water companies, like all businesses, will have to play their part in reducing emissions by becoming more energy efficient.  The industry produces 5 million tonnes of greenhouse gases each year and is responsible for around 2 per cent of the UK's energy use.  Water companies have become too reliant on energy intensive end of pipe solutions to meet environmental responsibilities when the focus should be shifted upstream to reduce pollution at source.  And for that we must also encourage innovation.18  

<h2>Key questions for the future</h2>

These are all significant challenges.  So beyond the anticipated reviews on competition and metering which are on the way, and a draft Floods and Water Bill promised by the Government, I think we need to ask some more fundamental questions about how the water industry should deliver in future.

<h3>1. Is the industry sensitive enough to consumer demands?</h3>

The first question which I want to raise relates to the sensitivity of the industry to consumer demands.  With bills currently arriving through people's letter boxes and initial PR09 bids setting out further price rises on the way, we need to ensure that the industry is truly responsive to its customers.  We surely all accept the role of competition in driving innovation, enhancing efficiency and improving standards of customer service across business in general.  In my view the time has come to examine whether this timeless principle could not play more part in the water industry.

Professor Martin Cave's interim review sets out what I believe to be a sensible road map towards competition.  The introduction of retail competition for water and wastewater will enable businesses initially to make a choice about their provider.  I am sceptical about setting a water use threshold which would be difficult to control and would exclude some from the benefits of competition.  In Scotland, where there is no threshold, competition is already delivering results.  Although only 1 per cent of customers in Scotland have switched provider, 30 per cent have been able to renegotiate their contracts, with customers saving on average 3 per cent.  Some businesses, such as Tesco, have seen savings of £1 million.  At the same time as reducing some bills, competition will also require the industry to become more sensitive to consumer demands.

Water is not like electricity or gas.  But if retail competition for business customers is introduced successfully there could be real potential to extend it upstream and to residential customers.  Any move to residential competition must, though, be accompanied by strong measures to protect vulnerable customers and guard against cherry picking to ensure that customers pay no more than they would have done in the pre-competition regime.

Another benefit of competition would be to allow the merger of the retail arms of businesses.  Currently, allowing the merger of vertically integrated businesses has a damaging effect on comparative competition making it not in the best interests of customers.  However, whilst some water companies would like the freedom to merge without the accompanying introduction of competition, I don't believe this will deliver the required benefits.  Mergers should only come with greater competition and then only in close discussion with Ofwat and the Competition Commission.

As I stressed earlier, the introduction of competition must not be allowed to damage the availability of capital.  At the same time, water companies need to recognise that, just as they have traditionally been seen as safe and profitable investments, their customers, as well as their shareholders, need to be valued.  In an industry which has, for a long time, generally taken an asset based approach, I believe that water companies should re-focus on issues of affordability and the sustainable management of water.  Customers need to be more conscious of water issues, and water companies need to be more conscious of customers. 

<h3>2. Are there real incentives for water conservation?</h3>

The second question I want to raise relates to the adequacy of incentives to conserve water.  In addition to growing their value through capital programmes, water companies have traditionally been driven to increase the volume of water sold as a way of increasing revenue. Whilst many companies are now moving to a more enlightened approach, helped by the regulator, it is surely unsurprising if families care too little about how much water they use when water companies have not been motivated to reduce demand and leaks still remain a problem.  Why is it that some water companies are aiming to reduce water usage but others are planning for an increase?19 

Over 3,000 megalitres of water are lost in leaks every day,20 and while I recognise this is an improvement on previous years, many companies are still not doing enough.  Interestingly, some of the companies who have done most to reduce leaks are actually those giving their customers below average bills.21

Just as energy companies must work with households to cut fuel poverty and improve energy efficiency, there need to be more effective measures for the water industry to help families reduce demand and ensure that water saving devices really catch on. 

On average, where people have water meters their consumption is reduced by around 10 per cent.  Around a third of customers nationally now have meters installed, but there is significant variation across the companies.  In the South West, where customers face high bills and have a strong awareness of the need to save water, levels of metering are shortly expected to reach 85 per cent.

I look forward to the recommendations from the Walker review in this area, but I have three points to make at this stage.

First, most people who move to meters currently do so because they believe they will save money through reduced consumption.  There can indeed be substantial savings for these consumers, but this reduction in costs can shift the burden onto other customers.  Given the significant issues of affordability and fairness raised by an extension of metering, we should consider giving Ofwat some responsibility for ensuring that the programme is socially-just. 

Second, where meters are introduced, we should move towards smart meters to provide clear information to consumers, in real time, about the amount of water they were using.  This would not necessarily be linked to the amount they pay for their water but would, instead, give people the clear information they need to help them manage their water use responsibly and reduce waste.

But third, metering is just one part of a new approach to ensure that supply and demand are balanced.  As I will argue later in my speech, we need to change incentives generally to ensure the sustainable use of water.  Putting more customers on meters to try and moderate demand while also trying to sell them more water cannot be the right answer.

<h3>3. How do we improve environmental standards, without new burdens on consumers?</h3>

The third question I want to raise is particularly acute.  How do we improve environmental standards without placing intolerable burdens on consumers?  While we are, rightly, focussing on protecting the customer, we must also ensure that environmental standards are maintained and, where necessary, improved.  In many cases this may require further investment.  It already explains much of the price increases in areas such as the South West. 

Once again, I think we need to see more transparency and clarity about potential environmental gains.  No-one - least of all me - doubts the essential improvements that have taken place, or would wish to see them reversed.  But we need to be able to measure the environmental benefits of investment more effectively, and to prioritise accordingly.  Customers will feel environmental improvements are justified if those improvements are made over an acceptable time period and there is clarity from companies.  The shield of vertically structured monopolies has helped to hide those investment decisions.  Greater transparency can be insisted upon by the regulator but greater competition will also help expose where the costs lie and ensure consumers are getting value for money.   

There is currently little relation between the availability of water and its cost, so it is important, in the context of environmental protection and sustainability, that we are able to identify the true financial and environmental cost of water to make investment decisions less complex.  Competition upstream will encourage companies to make more innovative, efficient and sustainable decisions.

Water is not a free resource and its abstraction has environmental consequences.  Upstream competition and tradable abstraction licences, will encourage companies to reduce pressure on water scarce areas and make investments which are more sustainable.  This makes economic and environmental sense.  In the long term, a more sustainable, rational approach to supply management will help keep bills low and encourage companies to return value for money, environmentally, socially and economically. 

We currently have a system where it can be more expensive to abstract water from plentiful areas than from areas which are water stressed.22   Work that Ofwat and the Environment Agency has already done in this area is important, we need to remove barriers to ensure that licence trading encourages the more efficient use of resources and prices are established which reflect the social, environmental and economic value of water.  This is a key part of increasing transparency in our water cycle and in facing up to the growing pressure on our water supply.  Consumers must be protected from changes in abstraction charging but better price signals will be essential for the future supply of water.  And, of course, if companies appreciate the value of water, reduce wastage and take sustainable decisions then we are much better placed to ask consumers to do their bit to value and conserve water too.  

In some cases, where big investment decisions need to be made which might impact heavily on one small area but might provide wider benefits, we need to look at the way in which they are financed.  People in the South West will question whether it is fair that they should have to finance, through their bills, the environmental protection of 30 per cent of the country's coastline when they only make up 3 per cent of the population.  A solution to this disparity is not simple, and we await the Walker report with interest.

<h3>4. How do we ensure supply continues to meet demand?</h3>

The final question I want to pose represents another great challenge for the industry.  How do we ensure that demand continues to be met?  Whilst demand may, at present, be an issue only for areas of water stress such as the South East, climate change is likely to mean that those areas which previously were considered immune to such pressures will have problems.

As I have already touched upon, incentives must be put in place to encourage the sustainable management of water, energise environmental innovation and develop upstream thinking.  Rather than relying on 'hard water' solutions which focus on large infrastructure and heavy engineering we need, as our Quality of Life Review argued, a 'slow water' approach to reduce pressure on our water system and appreciate the value of our water.  This means literally slowing water down to prevent run off and flooding, recognising water's natural flows and cycles, improving permeability in urban areas and addressing the sources of pollution.23 

We also need to explore the potential for greater co-operation between companies.  In considering any case for a national grid for water we must pay close attention to the serious obstacles relating both to high financial and carbon costs, as well as ecological concerns.  Whatever the solution in the long term, there must be more local collaboration to find solutions to supply problems.  It's an irony that companies have been set up in such a way that they don't compete, but they aren't incentivised to co-operate, either. 

As well as addressing the problems of water stress it could also reduce the reliance on capex as resources could be more easily shared.  Again, competition has a role to play in encouraging co-operation, but so does political and regulatory will.

<h2>Conclusion</h2>

All these challenges and potential policy solutions call into question the role of the regulator.  Ofwat has traditionally seen its role as simply an economic regulator with a fairly narrow focus.  I would like to see a smarter regulatory system which looks at social and environmental regulation and issues of affordability as well.  The energy regulator Ofgem has taken an active interest in driving solutions to fuel poverty and Ofcom are pushing the digital revolution.  Whilst they must, of course, maintain their essential function as economic regulator, this is an opportune moment to examine the wider role of Ofwat.  And given the scale of the new challenges we should look again at the scope of the regulator to see if it can be widened to include, for example, water poverty and issues of sustainability.

Allow me to give one example of the type of benefits a new focus could bring. Currently upland farmers are putting fertiliser on their land which, downstream, needs to be removed by water companies. A changed regulatory focus could allow these companies to pay farmers to maintain the water quality, thereby reducing treatment costs further down the line.

As well as outlining some thoughts on how smart regulation could be used to deliver results on cost, environment protection and sustainability I have also outlined my firm belief in the merits of competition.

It is very tempting to view competition and smarter regulation as incompatible means to reach different ends.  However, I strongly believe that they can work in parallel towards the goal of a water industry which delivers more for customers and more for the environment.

These are important issues, and there should be an opportunity to discuss them and to legislate for the necessary changes in the Floods and Water Bill, but if, as it is rumoured, water proposals that form part of the draft Bill will be dropped from the final Bill by the Government then it will be important for them to be picked up again.

Over the coming months I look forward to listening to the concerns of the industry and your customers, learning about best practice and considering options for the future.  Privatisation left the industry well placed for the challenges of the last decades of the 20th century.  Together we now have to ensure we are as well placed to meet the challenges and opportunities of the future.

Thank you.


1  Benjamin Franklin, Poor Richard's Almanac, 1746
2  Hansard, 7 December 1988
3  Jack Cunningham, Hansard, 7 December 1988
4  Caroline van den Berg in Public Policy for the Private Sector: The World Bank Group, Water Privatization and Regulation in England and Wales, May 1997
5  From Environment Agency: "We want to see as many rivers as possible in the top two quality bands of excellent or good. In 2007, 72% of English rivers were at this level - the best on record, compared with 55% in 1990. 87% of Welsh rivers were of good or excellent quality, compared with 79% in 1990."
6  The Good Beach guide: "In total, 443 (57%) UK beaches are 'MCS Recommended' this year [2008] out of 778 tested, compared to 495 last year. This is the biggest year-on-year fall in the Good Beach Guide's 21 year history."
7  According to Ofwat's 2004 Price review: "At the last review of prices in 1999, we were able to reduce customers' bills on average, mainly by taking account of the large efficiency improvements which the companies achieved in the late 1990s. These have not been repeated over the last five years." (Ofwat, Future water and sewerage charges 2005-10, 2004)
8  Between 1999-00 and 2000-01 Yorkshire Water reduced bills by 14.7 per cent
9  Thames
10  South West
11  United Utilities: 30.8 per cent, Wessex: 32.2 per cent
12  Southern: 21.1 per cent, Severn Trent: 0.9 per cent, Dwr Cymru -0.1 per cent
13  Southern: 47.3 per cent
14  DEFRA, 'Cross Government Review of Water Affordability Report', 2004.
15  Water UK, 'Debt and affordability briefing', October 2008.
16  Environment Agency, Water Resources in England and Wales, December 2008; Daily Express, 30 December 2008
17  DEFRA Website; Environment Agency, Water Resources in England and Wales, December 2008.
18  http://www.water.org.uk/home/news/comment/future-challenges?s1=positively
19  http://www.utilityweek.co.uk/features/uk/reducing-water-consumption-is.php
20  3,290 megalitres/day were lost through leakages in 2007-08
21  Since 2003-04 the companies who have reduced leaks by the most are Thames (-24.4 per cent) and Northumbrian (-15.6 per cent), although Thames admittedly started from a high level and still top the league table of leaks. Both of these companies had below average bills in 2008-09.
22 http://www.utilityweek.co.uk/news/uk/water/new-powers-proposed-for-enviro.php
23  Quality of Life Policy Group, 'Blueprint for a Green economy', September 2007; http://www.southwestwater.co.uk/index.cfm?articleid=4313

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