In the previous video, we introduced and worked through, an example of the RPI-X price cap approach to economic regulation of a privatized utility. We said that in theory, RPI-X represented a simpler approach than rate of return regulation. The privatized water companies of England and Wales would simply bid for the price adjustments they wanted to charge. The economic regulator Ofwat would accept, or challenge, these price adjustment bids based on how well a water company performed benchmarked to the rest of its comparator, England and Wales privatized water companies. And this could be done without onerous scrutiny and micromanagement of water company decisions by Ofwat. The water companies would reveal the information through their bids for X. The economic regulator Ofwat would not have to go looking for the information or have to verify it. In this second video on the UK's water sector regulation, we'll see how this simpler approach wasn't what was finally implemented. The England and Wales privatized water sector's economic regulation approach in practice was more complicated. And has become even more complex over time. In the previous video, we mentioned two issues with the theoretical RPI-X approach we'd described. This slide shows these two issues. First, RPI-X is a price adjustment formula. It doesn't allow you to determine the initial price from which you then adjust. As we mentioned, a water company starting from a high initial price, say at or near full cost recovery already, may be less worried about a challenging price adjustment. But a water company starting from a low initial price, perhaps quite far below full cost recovery, may later become unable to finance its functions if given a challenging RPI-X price adjustment. So how do you determine the initial price? Second, we said the economic regulator Ofwat's OPA performance scoring system did not exist at the time of the water privatization in 1989. This meant that, at privatization, there was no standardized benchmarking information that Ofwat could use to accept, or challenge, water company price adjustment bids. Professor Littlechild had proposed a simple economic regulation approach. He'd also originally suggested having just one single X factor for all the privatized water companies. This would be less costly and bureaucratic then for the economic regulator Ofwat to deal with X values for each water company. The official UK government historian of privatization, David Parker, summarizes the high levels of scrutiny of individual water company expenditures and business decisions that the actual economic regulation approach for the England and Wales privatized water industry ended up with. As making something of a mockery of Littlechild's expectations in terms of minimizing regulatory bureaucracy. We'll draw upon David Parker's account here, particularly from his 2012 official history. At privatization in 1989, the RPI-X price cap regulation process was not done by Ofwat. But by ministers and civil servants in the English government's Department of the Environment and the Treasury. And they were involved in setting up the privatization process in consultation with counterparts in other government departments and with the Wales government, the Welsh office. Drawing upon paid expertise from external financial and engineering consultants, and in intensive consultation with the boards of the regional water authorities that were about to be privatized. The economic regulator, Ofwat, did not yet exist, but the key individual, Cerian Byard, that would go on to become Ofwat at privatization, was seconded from his role at the treasury to be involved in the process. The Department of the Environment and the Treasury wanted a separate X factor for every company. This could've meant they could've set a single, national price for all the England and Wales water companies. The water companies could then have bid for price adjustments based on this single, national price. But government ministers felt that each water company should have both an individual, initial price and an individual price adjustment. They based their reasoning on the fact that cost to serve customers in each of the water company regions varied sufficiently, due to geography, population density, and water resource factors. And because the condition of the infrastructure of the various companies varied sufficiently too. The differing predecessor regional water authorities had, after all, invested differently in their public sector water utility systems. The retail prices indexes or RPI measure of inflation was also not the only index considered. Other indices were proposed, like various construction cost indices. However, RPI was finally chosen because government ministers believed it was a widely accepted index. The RPI-X price adjustment formula was also quickly restated as RPI-X+Y. X was still the expected efficiency gains factor that we saw in the last video. But now Y was created by ministers to allow for unavoidable cost increases. This accounted for imminent investments to improve drinking water quality, and environmental quality, due to binding UK and European commitments as we've discussed in previous videos. RPI-X+Y was soon simplified by ministers to RPI+K to make it more easily understandable by various stakeholders. In fact, this meant the England and Wales privatized water sector has never actually had RPI-X price count regulation. Other than in popular usage, the formula was RPI+K, or more accurately RPI + or- K to allow for possible price adjustments below the RPI rate of inflation when possible. So each water company was allocated a blended K factor and not a pure X efficiency gains factor. Quite late in the economic regulation development process, the Secretary of State for the Environment, Nicholas Ridley, decided the price cap setting period should be ten years running from late 1989 to early 2000. This clashed with advice from advisors who wanted a five year cycle. And it caused tension with the treasury, who felt not consulted about the change. A ten year cycle was to make the sale look attractive to investors by providing price stability. A possibility was built in, which was later used, to revisit the price adjustment limits and the length of the price setting period, through a so-called interim determination. The water companies would also have to be given sufficient advance notice that an interim determination was going to happen. So that it would not be a shock to companies or investors. The actual setting of the K factors, for each of the water companies, was complicated and protracted. The Department of the Environment asked the pre-privatization public sector regional water authorities to submit 20-year business plans. These had to include ten years of binding capital and operational expenditure plans, plus a further ten years of non-binding broader projections. This step was essentially there for the water companies' bids for both the initial prices they wanted to be able to charge, and for the price adjustments they wanted for the next ten years. Engineering and financial consultants were contracted to scrutinize the water companies' business plans, and their operational and capital expenditure forecast. Various government ministers felt that given prevailing economic conditions and to make privatizations sell attractive, a reasonable real rate of return of 7% for the first ten years should be factored into the K factors that would be agreed with the privatized water companies. And the water authorities, with hired consultants, unsuccessfully lobbied for an 8% real rate of return. So this was not a simple bidding and challenged process here. Instead, there were months of calculations and consultations involved in the initial price and the K factor setting processes. Consultants handled much of the raw data. Water companies reported to complain about how much information they were being asked to submit. They also complained that they felt their information was being handled in an uncoordinated manner by consultants and the government. David Parker described this period as a trial and error process, not a simple bidding process. Consultants were developing new financial modeling software to handle all the data in an accurate and consistent way. Keen to allow the privatization sale to proceed, David Parker also notes that the UK government wanted to avoid a legal challenge to the process, and to the K factors. This slide enables us to see, in hindsight, how this initial RPI+K price setting process worked out. It's an Ofwat graph of planned versus actual operating expenditure for the ten main England and Wales private water companies, from 1989 onwards in constant 2005, 2006 prices. The solid green line on the far left shows what the assumptions about operating expenditure were from 1989 onwards. Water companies were submitting annual financial data in their public annual reports, and to economic regulator Ofwat. It became clear that the water companies were spending less than their forecast operating costs. The actual data on spending levels are shown by the solid black line here. As early as mid-1991, just two years after the privatization, the Director General of Ofwat wrote to the heads of the privatized water companies. He informed that he did indeed wish to exercise the interim determination option from the original privatization settlement. This was the clause we mentioned that permitted Ofwat to review and to change if necessary the length of the price review period. Ofwat's director general notified the water companies that he planned to shorten the price setting period from ten years to five years. This was an attempt to reduce forecasting problems involved with the ten year period. Sector commentator and scholar Dieter Helm described problems we can see in this slide with the original assumptions as of 1989 as perhaps inevitable, since there's always likely to be a large forecasting error associated with long term investment plans. He said two unexpected developments contributed to forecasting errors about the operational expenditure levels of the newly privatized England and Wales water companies. First, a recession in the early 1990s construction industry meant construction prices fell below forecast. A water industry is capital intensive, so this was a significant development. It would have meant a need to decrease the size of the price adjustments. Secondly was a new European Union urban waste water treatment directive that increased the company's environmental obligations and the environmental quality regulators in the England and Wales water sector, the environment agency and the drinking water expectorate accelerated their time table for the water industry's expected compliance with other quality standards. This meant a need to increase price limits in order to increase revenues, which would also depend on price and income elasticities for water, affecting whether revenue would be the same at higher prices. But you'll also see that Ofwat's interim price setting in 1994 had forecasting error. This is the dotted blue line labeled 1994 final determination. Actual total operating expenditure, shown in black, was again lower. Only in the 1999 price setting exercise 10 years after privatization did Ofwat determine price adjustments that more closely matched actual operating expenditure. This is the bright green line here labeled 1999 final determination. So what do these data tell us? First, we see that it is difficult for a government or government nominated economic regulator, to forecast accurately the expenditure levels of a large water sector like this, entering into an uncertain operating and regulatory environment. The initial K factor price limits were difficult to determine and were subject to uncertainty. It seems to have taken the economic regulator Ofwat almost a decade to build sufficient information and capacity to provide a more accurate efficiency challenge to the water companies. Second, there are risks to this regulatory learning. We saw in our earlier UK water privatization experience videos that it was in the 1990s that UK newspaper media interpreted these data as privatized water companies being allowed by Ofwat to make excessive monopoly profits. Third, whistleblowers in the sector highlighted that some water companies were not actually spending the amounts that they'd reported to Ofwat. Ofwat levied fines against certain companies that were seen to be trying to make additional outperformance profits during their price cap period, not by becoming more efficient, but by falsely reporting their spending on promised investments like operational spend to reduce unaccounted-for water due to leakage, and so on. Government inquiries also highlighted that some water company networks were receiving lower scores for their service ability, because they were being under maintained. So it became clear that water companies were perhaps not only profiting by spending less on operating matters through becoming more efficient, but also might be spending less than they perhaps should on areas of operational activity that were less well monitored. Ofwat therefore felt it had gradually to increase over time the number and scope of performance indicators it needed to monitor and to require water companies to report on. This slide shows some of the performance indicators that the England and Wales privatized water companies have been required to report to Ofwat in the past. Key outputs here would include network stability and service ability, customer service, environmental quality measures and leakage estimates. Failures could include unsatisfactory combined sewer overflows that polluted the environment and incidents of foul sewer flooding of properties. Water companies had to report these performance indicators annually, each June, and have them independently audited. The reports were published, and Ofwat said they allowed customers and stakeholders to understand each company's performance. An independent review in 2011 of Ofwat's economic regulation approach called the Gray Review, took the view that Ofwat's information reporting requirements over time had evolved to become unjustifiably onerous for water companies, and so the last June returns were made in 2012. Ofwat then developed a new risk-based reporting system with voluntary disclosure of key information by the water companies themselves, as we'll see. This slide shows Ofwat data on an estimated operating cost to water companies, to submit the required information to Ofwat's 1999, 2004, and 2009 price setting reviews. In the decade from 1999 to 2009, these costs reportedly trebled from around 15 to around 57 million pounds. This may seem a lot, but remember, this is to regulate an industry with annual revenues of around 11 billion pounds. This table suggests why Ofwat might have felt it needed more information upon which to base its challenge to the price adjustment bids by water companies. It shows the ten main privatized England and Wales’s water companies in the left-most column. The average K factor that they bid for as part of their RPI + K price adjustment for the period 2010 to 2015 is shown in the next column. The final K factor that they were actually allocated for their RPI + K price adjustment is shown in the next column. The right most column shows the difference. In all cases here, the difference is negative. Ofwat challenged all of the K factor bids. Why might Ofwat do this? Given the initial forecasting problems in the sector and accusations of excessive profits in the media and so on, might Ofwat feel it had a moral obligation to challenge all bids and set lower K values on behalf of all the customers? Or might Ofwat believe it has got sufficient information reported by the water companies to challenge the bids, given that it has done detailed scrutiny of performance levels and operational and capital expenditures? But what might the water companies do with their bids if they suspected the economic regulator might challenge all of them? Remember in our previous video, we asked why a water company might make a true X factor bid. Knowing from experience that Ofwat what might reduce their bid, might a water company be tempted to overbid? Technically, of course, they're not permitted to do this. Their plans must be sound and open to independent scrutiny. But clearly there are significant information asymmetry and forecasting uncertainty problems here. Following the Gray review findings in 2011, and after the last June return in 2012, the privatized England and Wales water companies published their own key performance information. Although Ofwat stipulated this information had to cover a certain set of core water business themes around issues affecting customer service, environmental impact, reliability and availability of service and certain financial and risk matters. But the specific details of this reporting were, for the first time since privatization, Left to the water companies themselves. Meanwhile, Ofwat develop a new company monitoring framework and annual performance reporting process for use from July 2016. This new framework bases the immersive information our water companies required to report to Ofwat on how much Ofwat trusted. It's quite an unusual approach. Ofwat calls it an information and assurance framework. Ofwat still expects water companies to provide accurate, transparent, trusted information. And if the water company betrays Ofwat's trust, then Ofwat will use a more intrusive regulatory approach in future. To the best of my knowledge, this approach has not been adopted in the water sector anywhere else in the world so it's worth looking at for just a moment. Ofwat has three trust or assurance categories, self assurance, targeted assurance and prescriptive assurance. Self assurance only requires certain minimum mandatory reporting requirements that apply to all water companies in order for Ofwat to carry out its benchmarking functions. All other reporting is up to the water company itself to determine. Only 2 out of the 19 current water companies to which Ofwat has applied this framework were initiallly put in this highest trust self assurance category. The total is 19 here, by the way, because it includes both the 10 large privatized water companies and the 9 remaining smaller water only companies. Most companies, 15 out of the 19, were put into the medium trust targeted assurance category. This requires that a water company must also consult with its stakeholders to target which issues to address in the next five year period. The water company has to publish draft action plans following the stakeholder consultation, then confirm final plans about the targeted areas. Finally, 2 out of the 19 companies have been put in a third category. These Ofwat says have not provided them with sufficient confidence about their ability to deliver, monitor and report performance. These two water companies have a more prescriptive regulatory treatment by Ofwat. This approach is still very new. Time will tell as to whether it will reduce the costs of regulatory reporting and compliance in the England and Wales privatized water sector or whether over time it will also become a quite extensive costly process. Another measure to watch to assess the changing complexity of economic regulation over time is Ofwat's budget and number of employees. Just like water companies have noted an increase in their cost to comply with the regulatory requirements of the price setting reviews, Ofwat's budget has also increased, presumably to handle the growing amounts of information over time. In 2008, 2009, Ofwat had a budget of 15 million pounds. By 2014, 2015, its budget was 29 million pounds. But Ofwat's number of employees had actually decreased over time. In 2005, Ofwat had 252 full time equivalent staff. But by 2014, 2015, it had almost halved at 136. It's also been reported that part of Ofwat's budget increases have been due to internal skill shortages and the need to pay external consultants to help Ofwat to develop new regulatory approaches, among other things. So overtime Ofwat appears to have been trying to undertake increasingly more complex work with fewer permanent staff and is spending more, some of which has on fees for external consultants. In this slide we can see the typical Ofwat workloads cycle. This was for the price setting cycles from 1994 up to 2014. To determine the K factor for the RPI plus K price adjustments, Ofwat required water companies to submit business plans, including operational and capital expenditure plans. Operational expenditure here is day to day running costs like staff costs, power and chemicals costs, costs of reading meters, and other over head costs. Capital expenditure is planned investment to maintain or enhance existing assets and to construct new capital assets. It could be building new water or waste water treatment works, replacing pipes, installing new IT monitoring or customer billing systems and so forth. Ofwat would then scrutinize the water company's submitted expenditure plans, and compare them to other water companies' submissions in some detail. Ofwat would also look at performance indicators, like network performance, accuracy of billing, customer service, incidents of foul CO flooding of properties, drinking water standards and so on. More recently, Ofwat also required a water company to report and incorporate customer feedback about its plans. And give more emphasis to water resource planning to address population changes and climate change factors. So Ofwat has essentially scrutinized both the inputs and outputs of water companies over time. Remember, this is quite different from Professor Littlechild's approach of RPI- X based price adjustment bids. With and challenges without scrutiny of company's business plans by a regulator. It's the level of scrutiny of inputs and outputs that you'd more typically associate with rate of return regulation. This more intense scrutiny also meant that Ofwat was not dealing with a simple RPI- X or even RPI + K formula, as we can see in this slide. Price-cap regulation is being used as a permanent price control in the England and Wales privatized water sector whereas Professor Littlechild originally saw RPI- X price-cap regulation for British telecoms as a temporary arrangement. It would no longer be needed after a short period once a competitive Telecoms market emerged. But in the end of the Wales water sector, a competitive market was not forecast to emerge and indeed has not. As a permanent arrangement then, the price-cap regulation formula has overtime needed to capture a great many factors. Early we mentioned, the RPI + K formula came out of restating RPI- X + Y. That was -X for the efficiency challenge and the +Y for the unavoidable cost increases from investment obligations to meet drinking water in environmental quality standards. However, given that price control in water sector was permanent, not temporary, the RPI + K, or RPI + or- K, to allow for efficiency challenge when possible, was not going to be enough. The previous performance levels of each water company would also need to be accounted for. This is the U factor in this slide. It's a measure of out performance or under performance, in the water company's previous price setting cycle. That's the profit or loss the water company made in the previous price cycle. When it may either have outperformed cost assumptions, and made and kept a profit for five years, or when it underperformed, and its investors had to absorb the loss. So the price form then becomes RPI + or- K, + U. I've seen the K price limit factor expressed in an even more complicated way. This is shown in this slide with five main elements. If you find this hard to understand, don't worry, you're not alone. Our point here is simply to point out the complexity of the England and Wales economic regulation. And that in practice, Ofwat has been far from using a simple RPI- X price cap form of economic regulation. You can well imagine here the amounts of information Ofwat needs to support its acceptance or challenge of the water company's price adjustment bids. And to protect itself in case of any legal challenge by water companies to the competition authorities to try to get price adjustment limits overturned and revised. And you can imagine the complexity and cost of the water company's price bidding processes too. It's worth mentioning another evolution in Ofwat's approach since 1989. In 1989, the appointed Director General of Ofwat, Ian Byatt, later Sir Ian Byatt, was the economic regulator. He had individual executive power. The Office of Water Services, as it was then known, shortened to Ofwat, was the Director Generals supporting technical staff. Sir Ian Byatt served as Director General until 2000. He was succeeded by Philip Fletcher. Philip Fletcher's appointment led to a bit of an inside joke in the water sector, as a regulatory role is about policing a sector, and Philip Fletcher had previously served in a financial administration role for the Metropolitan Police. There were advantages and disadvantages of having one individual as the executive authority of the economic regulator. The individual was identifiable and accountable for his decisions. But when I interviewed water sector stakeholders in the England and Wales water industry, I heard views that there was too much focus on the individual power of Surrey and in particular, as the very first director general and for Phillip Fletcher. They were felt to wield too much individual influence over the fortunes of the sector. Whether these claims are true or not, the UK government also became convinced that Ofwat's role in the sector was better served by having a less personalized presence. So in 2006, the role of the Director General of Ofwat was converted into a board, with OFWAT becoming a non-ministerial government department, formerly known as the Water Services Regulation Authority. It continues to be financed by license fees paid by the privatized water companies. And Regina Finn became the first Chief Executive of Ofwat in 2006. She was an interesting appointment. She had much regulatory experience, but some of it was from non-water utility sectors. In my research, I've heard this was seen as a way to bring in experience from non-water utility settings. Quite similar to the benchmarking outside the water sector that we saw in the previous video. Philip Fletcher continued on in the role of Chairman of Ofwat until 2011. And Sir Ian Byatt served on Ofwat's advisory panel long after he left the role of director general. And has advised the neighboring public sector, Scottish water regulator I believe that based on stakeholder views, Ofwat is trying to reduce the complexity and bureaucracy of its economic regulation approach. The first way that it's doing this that we've already discussed is its trust-based framework. The second is to try to introduce more competition into the privatized England and Wales water sector. This second aspect I feel harks back to our quotes from Mr. Privatization, John Moore MP, in our vidoes on the UK privatization experience. In his 1992 speech that we've already quoted from, John Moore said, an important objective of the UK privatization program has always been to increase competition because competition is the most effective spur to improving quality and service. He said, short term arrangements in markets that were not immediately competitive, like licenses and regulatory agencies, were not the ideal way to protect the customer's interests and to force companies to use resources effectively. He believed, instead, the ideal way is for companies to be faced with the permanent challenge of a competitive market. Ofwat has attempted to introduce competition by allowing companies to apply for a license to supply water services from their own locality to local users, by their own assets, or by using the water company's assets in their area. This could be to supply water more competitively than the incumbent water company. But very few of these arrangements have actually happened. The administrative complexity and costs apparently discouraged potential applicants. This Ofwat graph shows the scale of these bulk supply arrangements over time as a percentage of the volume of the water distribution input into the overall England and Wales system. Note the percentages remained around 4.5% from 1997 to 2007. This kind of competition is not a growing activity, then, but it's still possible that the threat of such competition can have an influence on the water company's behavior. This slide shows research considered by Ofwat in determining its competition promotion approach. Here we see the views of large non-domestic, small non-domestic and domestic household water users. 84% of large business water customers are supportive of competition among water suppliers in principle. And 69% of small business water customers are, as are 57% of household water customers. But will this competition appear soon? And will it allow the economic regulation approach to become less complex and onerous or disappear altogether? Here, I take a pessimistic view. Regulatory changes mean that from 2017, every non-domestic water customer in England and Wales can choose their water company supplier for the first time. Whereas previously only very large non-domestic water users could choose their supplier. This could be a step towards a full competitive market, where all water customers in England and Wales are free to choose their water supplier. But as we've seen in our earlier UK water privatization videos, the planned competitive market here is still only a very small proportion of the overall value chain. This is shown in this final slide. The competitive market that can be contested is primarily in providing customer and billing services to customers. That's about 0.3% of the value chain, taking domestic and non-domestic customers together. There is some possibility that sludge disposal and treatment and water resources and water treatment could be contested too, but this is not currently in UK legislation. And even if it becomes law, it still won't affect 90% of the value chain. That's the remaining non-contestable natural monopoly of the water distribution and sewage collection and transport parts of the water companies' systems. To wrap up, we've seen in this video that the potentially simple approach of Professor Little Charles RPI minus X, price cap economic regulation for the England and Wales privatized water companies never truly materialized. First, government ministers and consultants got involved in scrutinizing water company business plans in great detail. Then Ofwat did, with levels of scrutiny much like rate of return regulation. Over time, Ofwat has been trying to reform its economic regulation to a simpler, less intrusive approach. It's also attempted to promote the introduction of more competition. But competition seems unlikely to remove the need for permanent, complex economic regulation. We should also remember from our earlier UK water privatization videos that the water regulation approach used in England and Wales has been associated with high levels of capital investment. Improved drinking water quality, improved environmental quality, and improved customer service standards. And Ofwat's stance to its various stakeholders has that these investments and improvements have been achieved more efficiently than would've been the case without Ofwat's regulatory challenge to the privatized water companies over the years. So does regulatory complexity matter or is Ofwat's approach well suited to the task here? Or might a simpler approach like Little Charles' original water price bidding better serve the various stakeholders of the England and Wales privatized water sector? Do let us know your views in the discussion forum. In our next and final video on the UK water regulation case, we'll look at the possible interaction between regulation and prospects for innovation. Thanks for watching this video.
