In this third and final video on the UK water sector regulation experience, we'll look at how Ofwat and water regulation more generally deals with innovation for future challenges. I said in the previous video that I believe this is an important area that the regulatory framework here has somewhat overlooked. This slide shows two simplified descriptions about how regulation and innovation can act in any particular industry sector like the England and Wales privatized water industry. One review is that regulations prescribed too much detail about what an industry sector can and cannot do. Companies are therefore constrained to have limited possibilities for innovative behavior. In this case the view is that regulation should be minimize or remove entirely to promote more innovation. This is the deregulation stance. An opposing view is the revisionist stance. This takes the view that regulations can in fact set future targets for companies to achieve that would not otherwise emerge from normal market pressures. Often the targets in these regulations would not be fully achievable with present approaches and technologies. Therefore, actors within the global economy would choose to innovate to make such new performance levels possible. This means that regulation can actually spur innovation. However, it's important for regulations like this to allow sufficient time for innovations to be developed and brought to market. One measure of innovation activity by firms is they're spending on research and development or R and D. I should say this is not a perfect or complete measure of innovation activity, it somewhat assumes that innovation is a linear process that starts in the lab and then works its way into products and processes that are then marketed by a particular company. However, things are rarely this simple. But R and D spend data is available for the England and Wales water companies whereas more nuanced indicators of their innovation activity are not, so we'll work with what we have. This slide shows the annual R and D spending totaled for all 10 of the major England and Wales privatized water and sewage companies. The spending levels are shown here in constant 2009 prices in millions of pound sterling. It's interesting to note that after the water privatization in 1989, R and D spending quickly almost doubled. That would support a view that privatizing a sector gives it more freedom to innovate if it done for federal domain in the public sector. It's a complicated picture, of course, among the various from water company to water company. But it is true, at least, through my research, that water companies did experiment with all kinds of innovative activities during this early post-privatization period. Some water companies started or enhanced their existing R and D laboratories, some water companies bought smaller technology companies to try and develop new products or processes. Some water companies even merged with non-water utility companies to experiment with different forms of organizational innovation. These activities then hit a kind of plateau, according to these data at least, around 1999, 2000. R and D spending then declined quite dramatically, eventually falling to around half the level that we'd originally seen at privatization back in 1989. Incidentally, this coincided with the increasing complexity of Ofwat's regulation. Was this dip in this proxy measure of innovation activity caused by these regulation changes? Or other factors? I'm not aware of any systematic quantitative research that can give us an answer to this. I have, however, done some qualitative research on this topic. So I'll give my views on that here. You'll recall that in 1999-2000 was when a decision was made, as we mentioned in our previous video to cut back strongly on the earlier RPI-X price-cap regulation settlement that the water sector had been getting. A somewhat challenging determination was made at the 1999 price review, and it cut the previous settlement by around 10% at a stroke. The then off what Director General Tyrian Biot led this change. What seems to have happened is that the water companies responded to this increased regulatory uncertainty by, among other things, cutting back on their R and D spending. In the broader scheme of things, this is quite a small cost reduction for them to make. There were many other activities that perhaps they could have cut to save money. My research though suggest that the decision to cut R and D spend was a signal of sorts about a new strategy that the water sector as a whole was taking. It was to cut back on R and D activity that could have longer term, less certain outcomes, and to focus more on shorter term priorities. This view is somewhat supported by the data in this slide. These data show subscriptions paid by the ten main water companies to a collaborative research body representing the interest of the whole sector. The collaborative body is called UK Water Industry Research, or UKWIR. The 1999 price review again stands out as a mile stone. So not only did water companies cut back on their internal R and D spending, they also cut back on external R and D spending that were shared in collaboration with the other water companies. Once again, the amounts of money shown here in constant 2009 priced millions are quite small but I think they signal a change of strategic intent. What we see here is not a revisionist stance on the interaction between regulation and innovation. Regulation apparently tightening was not met an increasing R and D spending to try and develop more innovative ways to do the same or to do more with a lower price settlement. At least seen from the perspective of this proxy measure of R and D spend for innovation activity. I'm going to use a short example here to stress why the reduction in R and D spending, as a possible reaction to regulation at any point in time, is an important thing to think about. You may have seen the blue plastic water pipes that are commonly used around the world for clean water supply networks. Some are shown in this photo. Small plastic pellets are melted down then extruded into lens of pipe in various very large factories around the world. The color is an added pigment, it's not critical to the properties of the pipe. I've seen that the manufacturing process first hand and it's very impressive. It's automated and uses surprisingly few staff. These blue high-density polyethylene, or HDPE, plastic pipes replace the previous pipe material that was commonly used in the UK, that was cast iron pipes. This photo shows a cast iron water mains pipe being installed in London in 1925. It's from the Thames Water archive which they permitted us to use here. Obviously, plastic pipes were not available at this time. They did not yet exist. But iron pipes also have several major drawbacks on the water supply. The main one is that they have called rust once in contact with water. This corrosion can build up to such an extent that it practically fills the interior of an iron pipe. It reduces water pressure through the pipes, meaning that the pipes eventually need to be replaced. Also, if the direction of flow needs to be reversed in an iron pipe, say due to maintenance nearby, then the rust can come off the interior of the pipe and contaminate the water supply. By comparison, plastic pipes have a range of advantages. They do not rust, they can be extruded into very long lengths and then coiled up for easier transportation and storage. Their flexible, and so are less likely to burst or leak under pressure. And if the joints between plastic pipes are made correctly they can last long periods of time, at least around 50 years according to sources that I've seen. But how did plastic pipes come to replace most of the cast iron water mains in the UK? And other plastic pipes we see nowadays in the UK, the same one that we were trying to use to replace the cast iron pipes. And there's anything changed in the way that they are used or installed. This slide shows a timeline of the adoption of plastic pipes, by the England and Wales water industry, from the 1960s onwards, from research that I've done. On the left hand side, are rough markers of stages in the adoption process. They go from the start of the innovation, through R and D activity and demonstration, to pre-commercial or trialing stages, to being establish in a wide scale use and finally to being obsolete. Overall here we seem to see a 40 to 50 year time horizon for the adoption of plastic pipes, as an innovative product for the main supply of the water networks in the UK. We also see here that it's a bit of a nonlinear process, with various trips back to the drawing board, as it were, for further stages of R and D and for iterations in the design or properties of the material. The first leg we see here, from the 1960s to becoming obsolete in the mid-1970s involves PVC plastic pipe. PVC plastic pipes became notorious for what is known as rapid crack propagation. That means if they crack, the crack would spread at the speed of sound causing entire lengths of pipe to fail in almost an instant. The second leg we see here from the early 1980s to the early 1990s was the development of medium-density polyethylene or MDPE pipe. A third leg from the early 1990s led to the development of high-density polyethylene plastic pipe or HDPE to give flexibility of use in differing applications. Other new approaches that were developed included dragging a new pipe into installation whilst bursting away the old pipe that lay in its path. Initial problems with joint failures on plastic pipes, say due to dirt onsite contaminating the joint during installation, were also addressed with innovations in peelable pipes. Here, the blue outer layer could be peeled off on site to reveal a fresh clean surface for the welding. In so doing, the costs were also reduced by only having the outer layer colored blue. The remainder of the pipe was left white or unpigmented. The blue color was still useful, as the colors of pipes are used as markers for their intended purpose. For instance, blue for clean water, black for sewers, yellow for gas supply, and so forth. Cold welding techniques were also developed and used, and barrier plastic pipes with a layer of aluminium in the middle of a sandwich between plastic layers were developed to allow clean water supply underneath contaminated land. To avoid the risk of contaminants leaching through the plastic and into the water supply pipe. In short, the move to plastic pipes from cast iron, led to a whole series of innovations following on from the original adoption of a new pipe material, that was originally from the gas sector, in fact. And it brought a whole host of parallel innovations in the areas of installing pipes. The move away from cast iron pipes was in part motivated by new environmental regulations requiring higher drinking water quality standards that couldn't be met with corroding old cast iron pipes. So we have an individual case description here that economic regulation can be a barrier to innovation. And the plastic pipe case is an example where environmental regulation required higher standard for drinking water than could be met with cast iron pipes. So in this case regulation did enable innovation. In my own research I've gathered further qualitative of evidence that EU environmental regulations may also have spurred technology companies supplying the water sector to take a long term view. And try to be the first to market with innovations to the live the water companies to comply with future environmental targets. So now, we have one example that supports the deregulation view of regulation as inhibiting innovation, and one example that supports the revisionist view that regulation can foster innovation. Personally, I'm more persuaded by the revisionist view. But does regulation spur innovation in developing countries? There has been very little research on this. But it's an important policy relevant question. Another important implication here though, is that innovations in the water sector can take a very long time. Perhaps many decades for something as widely used as plastic water mains pipes. And R and D, in one form or another, has been necessary at various points along the way in the plastic pipe story, stretching back many decades. Reducing spending on this part of the innovation pipeline, as it were, could have unforeseen consequences for the ability of the water sector to develop innovations to address future challenges. To close out this video, I'd like to look at the institution of regulation itself as a source of innovation in its own right. I heard some stakeholders in the England and Wales privatized water safe to ask. What is Ofwat's endgame for its economic regulation? To me, this seems an invalid question. For the sector to be dynamic, there is no endgame. It's rather a matter of continuous innovation for continuous improvement. This slide from Ofwat data shows what might in fact happen if Ofwat did take the endgame view. That is, if it kept its regulatory tools the same forever, and did not innovate in its own approach. In this slide, you can see Ofwat's view on the percentage cost efficiency gains from its comparative economic regulation approach in two successive price review periods. AMP or A-M-P here stands for asset management plan. This is a water company investment period and it roughly overlaps with the five year price review periods as we've already seen. In this slide, there's AMP 3 which last from 2000 to 2005 and AMP 4 which goes from 2005 to 2010. You can see here that both capital or Capex, and operational or Opex expenditure efficiency gains declined from the 2000 to 2005 to the 2005, 2010 period, or from AMP 3 to AMP 4. In other words, Ofwat saw that using the same approach was bringing some kind of diminishing returns in terms of the efficiency gains over time. So should it innovate in its own regulatory tools to create new performance targets and possibilities for the water companies? I believe so. This slide shows my simplification of how I believe Ofwat or the past and the possible future in terms of its role as economic regulator. The past has led to a capitally expensive centralized water supply and waste water treatment system that some have argued has been overly short term in its outlook, and rather reactive to just what the regulator was stipulating. It did what it was told but no more. The possible future would be a system that would be more resilient to a changing climate and changing population dynamics. It would be more sustainable in terms of water and energy resources, and it would take on its own a longer term view. So be more pro-active about shaping its own destiny with less hand holding as it were, from the economic regulator. This slide shows some of the main feature challenges such a system will have to face up to in Ofwat's view. There's a change in climate in the UK with more possible droughts and floods. This is challenging, perhaps increasingly volatile global economic environment. Their changing customer preferences and expectations and the expression of these in future environmental legislation, like the European Water Framework Directive, and these population changes. Ofwat has been quite innovative I feel in mapping out what issues it thinks it can influence through its economic revelation and those which are cannot. Around 2012 or 2013, Ofwat conducted an internal strategic exercise on this. I believe Ofwat doing so showed quite interesting and deliberate attempts to develop more regulatory capacity and foresight. For instance, Ofwat had a stated goal at the time of insuring a fair deal for customers. In its strategic exercise, Ofwat believed it could directly influence water bills through the water price limits it sets. But it could not directly influence the wider issue of affordability. Affordability is a broader matter, affected by government social policy and wider economic factors, clearly beyond Ofwat's direct control. To summarize the three videos on the UK water regulation experience, we have to start by being clear that what we see in the England and Wales case is two distinct but over lacking processes of institutional change. First, it was the full divestiture privatization of the England and Wales water industry. Second, it was the creation of a suite of new regulatory institutions of which the economic regulator, that we mainly focused on Ofwat, was just one part. For most England and Wales stakeholders experiencing or working within the system, these two institutional change processes are quite difficult to separate out. It's hard to understand one in isolation from the other here. There've also been almost three decades in the case now to develop regulatory capacity and there have been trials and errors and learning from apparent mistakes. The approaches taken to regulation have evolved over time such as the drift away from a more simpler form of RPI-X price-cap economic regulation. This means some innovation from the original advocacy of RPI-X by Littlechild. Two Ofwat's recently introduced information and assurance framework for instance. And ongoing attempts to introduce more competition into the system. And the whole UK regulatory enterprise has involved many world class individuals both managers and scholars. All of this, similar to our account of the UK water privatization experiences, introduces a note of caution about trying to transfer the UKs water economic regulation experience to other parts of the world. A lot of what has happened has been local to England and Wales. And once again, the UK is an outlier in terms of its particular water regulation approach, as it was with its water privatization approach. Nevertheless we think that given this caution there's still much that can be learn from the UKs water regulation experience. Thanks for watching this video.
