The publication of the final Report of the Independent Commission chair by Sir Jon Cunliffe laid out important principles for making the water industry work better. This included the approach to regulation, and the planning and delivery of significant investment.
However, the final report leaves many issues unresolved, for both water companies and investors. As always with these things the devil is in the detail – which now needs to be worked out. It is very much in the water industry’s interest to engage with the process of putting meat on the bones of the reforms, to make sure it works for the industry as well as the public. The history of regulatory reform is littered with examples of getting things wrong that later need further reform – the recent Mansion House reforms announced by the Chancellor were basically corrections to financial reforms introduced after the global financial crisis.
The water industry needs to work hard to make sure that the reforms are got right first time, and more reforms are not needed in a few years’ time to correct mistakes. Fortunately for the water industry, there are many lessons to be learned from other regulated sectors, not least financial services that informed so much of Sir Jon’s thinking.
There are three broad areas that need resolving – the shape of a new prudential regime to ensure the financial soundness of water companies; the balance of economic incentives and the new supervisory tools to improve performance; and the approach to huge capital investment, and ensuring it will attract private investment.
The report recommends prudential supervision comparable to that in financial services. They include a regime that would create minimum capital requirements like those imposed on banks and insurers, the need for a turnaround regime if a water company does get into financial trouble, the need for prior approval of certain transactions like dividend payments, and a regulatory look-through to the owner of the water company. Those are the headlines, but the issues that need resolving include ensuring a clear and proportionate framework for determining capital requirements. A special administration regime – which would have huge impact on investors – also needs to be proportionate. The water industry needs to think what it red lines are for the regulator to look through to their owners.
On the economic incentives, the over-riding issue is how to establish an adequate return on capital to attract investment without economic incentives for performance creating unpredictable, low and volatile returns – something the water industry has struggled with under the current regime. The report sets out concerns about developing the right Weighted Average Cost of Capital (WACC), the asymmetry of risk in the current enforcement mechanism, and the unpredictability of regulation. The water industry needs to develop views on why the CMA and OFWAT have come to different conclusions on the right rate of return on capital. The supervision, incentive and enforcement regime needs to have concerns about investibility at its heart, including mitigating key risks such as construction risk and operational risk.
Any supervision and enforcement tools need to be proportionate, and have the right impact on incentives. The senior managers regime should not make it too onerous to hire – and get approval for – senior staff. What should be in the code of conduct? What powers should the regulator have in terms of enforcement against individuals? What are the tools that the regulator might use to ensure predictable and proportionate regulation? And importantly, how will the regulator itself be held to account? How should disputes between the regulator and companies be resolved? How should the remit of the regulator be changed? Should it answer to Parliament?
But perhaps the biggest change in the reforms are the least remarked on so far – the planning and delivery of large-scale infrastructure programmes. The new System Planners are a major new quasi regulator deciding on and overseeing infrastructure investment. The water companies would have a more limited role in planning, deciding and funding infrastructure, leaving them as little more than operational asset managers.
This leaves lots of major issues unresolved. How would it ensure that the industry remains attractive to private investors? How will the capital expenditure delivery risks be managed? How will the five-year price reviews and interim course corrections be managed without affecting the funding of projects?
It may have been the Final Report of the Independent Water Commission, but the work of implementing its proposals is just beginning.
