UK: Fluid Prospects - Results Of The Water UK City Conference 2007 Survey

Deloitte was delighted to be involved with the 7th annual Water UK City Conference held on the 8th February 2007. More than 100 people from across the water industry attended the event despite the poor weather conditions on the day. The conference reviewed the year’s key talking points such as:

• the increase in merger and acquisition activity;

• media focus on the sector;

• the accuracy of water companies’ regulatory reporting;

• missed leakage targets;

• drought orders being imposed in the South East for the first time in 11 years; and

• climate change.

Richard Bird, Water Director at Defra, explained how Defra was developing a strategy for water as a basis for long-term resource planning and future investment. "We needed to continue to deliver improvements in water quality while meeting the demand for water". He encouraged customer education in managing water consumption, acknowledging that whilst business had made progress in reducing water usage, much greater effort was needed to engage with households. Richard also discussed the potential for compulsory metering in water scarce areas and an update to the rateable value system. For the long-term, he identified the need for the water industry to play its part in dealing with the consequences of climate change through reducing carbon emissions.

Pamela Taylor, Chief Executive of Water UK, welcomed investors to the conference stressing the crucial role they will play in the future structure of the water industry. She reflected on the 15 years since privatisation, noting the main challenge is still to balance the expectations of investors, companies and customers between costs and returns, set within the longer-term context of the necessary investment. She also highlighted the advantages of a flexible approach to regulation to encourage companies to respond to their own particular customer base. This would mean moving away from the current one size fits all approach. Pamela also emphasised the need to obtain robust evidence about what customers want and what they are prepared to pay for.

Regina Finn, Chief Executive of OFWAT since the autumn of 2006, took stock of the past year. The regulator has seen a slow start to the implementation of some companies’ capital programmes, with companies missing targets, and also problems with reporting of data. Some assumptions set out by OFWAT for PR04 did not come to pass, specifically the cost of debt has not increased as expected. Regina commented that customers are disenchanted with increased water bills when they see drought and leakage but perceive that companies are changing hands at high premia and investors are making high profits. She believes that the next price review must be shaped to respond to what consumers want.

I chaired a panel discussion involving Regina Finn, Tony Smith, Chief Executive of the Consumer Council for Water and Barbara Young, Chief Executive of the Environment Agency. Barbara Young welcomed the commitment from the industry to plan on a more long-term basis. She encouraged a collaborative approach to price control between companies, stakeholders and regulatory bodies and commented that de-coupling the industry’s periodic reviews from the electoral cycle might result in a calmer framework for price setting. Tony Smith confirmed that the Consumer Council for Water wanted a sustainable solution from the next price review.

He highlighted that ultimately consumers needed to understand and accept what they are receiving in return for price increases. The discussion closed with reference to the recent OFWAT hearing before the Public Accounts Committee (PAC) and concern that political and media pressure, whilst often ill-informed, might influence OFWAT. Regina Finn commented that missed targets and regulatory reporting failures by some had tarnished the sector in the eyes of customers and the industry should act to restore confidence. She also stressed that OFWAT is independent and will do the right thing.

Approximately 90 delegates participated in the interactive survey, a mix of senior industry executives, investors, regulators, government and other stakeholders. This report collates the results along with our commentary.

In light of the hosepipe bans and drought orders imposed over the past year the conference explored a number of complex issues, in particular leakage and resource planning. The discussions rightly focused around customers who often do not understand the choices being made on their behalf.

The industry’s challenge for PR09 is to engage with customers to ensure that they understand these choices. If customers see the final determination and agree that it is as they expected, reflecting prices that they can accept for the service that they want, then PR09 will have been a success.
Doug King
Vice Chairman
Deloitte

Sutton and East Surrey imposed the first UK drought order for 11 years in May 2006, with Southern and Mid Kent following later in the same month, limiting or prohibiting the non-essential use of water in their supply areas until November 2006. By August 2006 13 million people across London and the South East were affected by hosepipe bans with the final ban lifted at the end of February 2007. 75% of delegates felt that the restrictions imposed last year will not be forgotten any time soon. It is not just media or political hype that is responsible for the high profile of the drought in peoples’ minds. Some delegates would have been aware that in certain areas aquifers are still not yet full. The industry knows that customers simply do not expect disruption to their supply, therefore resource planning should continue to be at the top of the industry’s agenda regardless of the replenishment of resources after a wetter winter.

The current principle of planning on the basis of a one in ten year hosepipe ban has been called into question following bans two years running. Just over half of the delegates thought this needed to change. Defra is undertaking consultation in early 2007 on the legislative framework relating to hosepipe bans. Barbara Young commented that public attitudes need to change; people should not expect to continue to "water their English country gardens". She even launched an attack on bathroom manufacturers for selling powerful showers. However, customers not unreasonably want security in supply and do not want to be told what they can and cannot do. Nevertheless, a large minority of delegates acknowledge that there has to be a planning principle and it cannot be foolproof. The challenge for the industry is to ensure communication of the choices that are being made and obtain customer buy-in.

The principles of water resource planning, supported by OFWAT, reflect the fact that some leaks are not economic to repair. The point is reached whereby it costs less to produce more clean water than it does to repair leaks and 64% of delegates seemed to understand and agree with this principle. During drought situations, however, some companies were seen to ignore the economic leakage concept and took a dynamic approach to repair visible leaks. This had a positive impact on customers’ perceptions, but there seemed acceptance amongst those present at the conference that this was more of a PR exercise than an economically efficient response to the leakage issue. This again comes down to dialogue with customers, who perhaps have a different understanding of what level of leakage is acceptable. The challenge is one of communication rather than revisiting the concept.

Currently, if an area is designated as water scarce, the relevant company can require all customers to have meters fitted. At the 2006 conference, 68% of delegates believed that the number of companies with the power to apply compulsory metering would increase. This year, 75% of delegates agreed that compulsory metering should be extended across the South East. The fact remains, however, that to date only one water company, Folkestone and Dover, has applied for and been granted the right to make metering compulsory. This may reflect companies’ concerns over possible customer reaction. There is a broad agreement that metering is not needed in parts of the country where water is not scarce, and indeed, given affordability issues it would not be appropriate to incur the cost of introducing it. Given the current regulatory model, it is perhaps not surprising if companies see this as an industry issue that needs to be agreed and paid for through the periodic planning and review process.

Increasingly, European legislation can require a marginal increase in water quality which is already meeting a very high standard with a disproportionate impact in terms of energy cost. This can have a significant impact on the industry’s carbon footprint. So, it is not surprising that throughout the conference there was a reasonably strong message that the UK needed to push back on some of the environmental regulation from Europe, a message supported by 70% of delegates. Barbara Young explained that many EU regulations were drafted before the climate change debate was fully understood and also stressed that addressing this issue in Europe would neither be easy nor fast.

There are now only six listed water companies in the UK. Within the past year, a Macquarie-led consortium acquired Thames Water, a 3i consortium acquired Anglian Water Group, Hastings acquired South East Water, and there has been much speculation about other potential deals. Public company valuations have risen, which may make it harder for infrastructure funds to justify bids, and perhaps this is why 55% of delegates felt that the public company model would survive. However, as the past year has shown, infrastructure funds have significant capital available to invest in the sector and so the jury is still out. If share prices were to fall, then the funds are waiting.

Views were polarised on this issue; 48% of delegates agreed, 48% disagreed and only 4% were undecided. On the one hand, many believe that the transparency of public companies is important; on the other hand, a similar number are convinced that long-term funding provided by infrastructure funds is better than being in the stock market where water companies may suffer from performance pressures to achieve short-term KPI’s. Regina Finn confirmed that it is not OFWAT’s role to specify a preferred ownership structure for companies and whilst she may like the transparency given by plc status, OFWAT has the tools that it needs to regulate effectively without stock exchange listings being retained.

48% of delegates agreed that infrastructure funds are long-term investors and hence natural owners of this sector. However many disagreed, perhaps recognising that the ultimate shareholders, typically pension funds, are often the same. This highlights a dichotomy. If pension funds have an asset allocation for infrastructure assets, why don’t they simply buy more public listed water shares? Peter Antolik from Macquarie explained the infrastructure funds’ long-term investment view – they are looking for a reasonable return, greater than that of long-term bonds, but with less risk than typical equity. Funds investing in the UK utilities market now include Macquarie, Hastings, Prudential, Deutsche Bank, Terra Firma and 3i.

There is a strong expectation (72%) that consolidation will not be allowed. For consolidation to happen it would need companies to be willing to test the boundaries, which would bring listed companies demonstrably into play for any potentially hostile bids. The Competition Commission inquiry into South East Water/Mid Kent Water is ongoing, and it will be interesting to see what pointers this provides. Sir Ian Byatt oversaw a reduction in the number of water companies within England and Wales from 39 to 22 during his time as Director General of Water Services (1989 – 2000). It is often argued that a reduction in the number of water only companies is inevitable, although Regina Finn made a telling comment in this regard, pointing out that the problems OFWAT is dealing with generally involve the larger companies. However, as far as consolidation of WASCs is concerned, it will take brave management to try.

The audience was completely split on this subject. Infrastructure funds have been able to buy listed companies at a premium, in part because they achieve greater leverage, both current and in respect of funding future investment. The value of that potentially higher leverage, in many listed companies, is now reflected in the share price which brings us back to the dichotomy referred to earlier. If pension funds are comfortable with the leverage model of infrastructure funds, why would they not encourage listed companies to adopt the same model?

Some politicians have suggested that the 2004 price review was soft and set targets too low. This is ill informed, especially given the increase in energy prices compared to the forecasts used for the review. It is interesting that the audience was split on this question, perhaps indicating that some companies are better placed to outperform than others. Nevertheless, a significant number still felt that companies will easily beat the targets set, although this does not mean that the determination was unduly soft. The purpose of the regulatory model is to provide a challenge to management, but to allow scope for companies to outperform. It is important to remember that the benefits of outperformance tend to flow back to the customers in the next price review.

In PR04 the regulators and companies worked hard to achieve a more balanced and transparent price review process. There is wide acceptance that the swing of the pendulum had been dampened by the PR04 determination. However, there was a significant amount of scepticism in the audience that this result will carry through to the next price review, with 48% of delegates fearing that PR09 may see a return to the dark days of 1999. Will the political pressure on OFWAT, highlighted by the PAC hearing at the end of January 2007, be reflected by OFWAT’s attitude toward the industry in PR09? The PAC Chair told OFWAT that they "were a soft touch with companies, and had handled Thames Water with kid gloves over its leakage targets". Regina Finn was clear in her comments to the conference; stating that OFWAT is an independent body and will do the right thing. Nevertheless, there appeared to be a high degree of nervousness among the delegates.

The audience was told to consider "significant" as greater than 50 basis points. During the transmission price control in 2006, OFGEM set the cost of capital at 4.4% compared with 5.1% in PR04, although it is widely accepted that there are greater risks in water than in transmission, and higher investments to be made. 73% of delegates thought a significant reduction in the allowed cost of capital in PR09 was inevitable. There was recognition amongst those speaking that there is likely to be a cut in the cost of capital and the question now is whether OFWAT will ensure that it does not go too far and destroy investors’ current interest in the sector.

This PR04 pricing principle implied that the affordability question (particular customers’ ability to pay for the service provided) would not be addressed. 59% of participants felt that the principle should be sustained, although some thought that it is important that the next price review does not push prices up (for example through the need to finance environmental improvements) if, as a result, they reach a level that customers do not accept. Ultimately, it is in companies’ interests to be acting within the constraints of affordability. The objective should be engagement with customers to ensure that when they see the final determination for PR09 they are not surprised by it and accept the result.

In setting prices, OFWAT has to understand fully and compare the operating and capital expenditure plans of all water companies in England and Wales. This is done through the review of each water company’s business plan and the question really is; does OFWAT have the tools to understand the companies’ submissions and so perform their role effectively? There was a high degree of confidence that the tools and techniques used by OFWAT are now sufficiently mature and well developed, with 58% in support of OFWAT’s capabilities in this area; there were, however, a few dissenters.

Given the trauma of the past two years, on the face of it this is quite a shocking result, with 73% of participants expecting further regulatory reporting issues to emerge. OFWAT has recently commissioned work on controls around the integrity of the Guaranteed Standards of Service measures and whilst this work is meant to be forward looking rather than analysing the past, perhaps there is concern that it could lead to further issues arising. Furthermore, there is still a genuine concern about what is meant by the requirement for companies to provide information to OFWAT that is "complete, accurate and reliable" (MD209). There is still no guidance on the relative importance amongst a huge volume of information. Given it is impossible for Boards to review all of it themselves; this perhaps explains the continued nervousness. There is an urgent need for OFWAT to outline the use to which all this information is put, so as to help Boards focus their attention effectively.

It is widely acknowledged that water companies do a good job of managing bad debts, particularly given the constraints of legislation specifying that disconnections are not allowed. However, a number of delegates felt that there is a growing problem. Whilst this issue has not been in the media spotlight and so there is no evidence from that source that the price increases have caused a spike in bad debts, affordability clearly remains a critical issue especially with further price increases to come.

83% of participants agreed with this statement, with the majority strongly agreeing. OFWAT has pushed forward the competition agenda for water in the years since privatisation, but given there is no real wholesale market it is difficult to see this being pushed as far as it has been in the UK electricity and gas markets, hence there was a high degree of scepticism in the room. However, competition can be seen in different ways. There is a significant level of competition in the water value chain which covers both the capital and operating programmes. Many companies in the sector demonstrate value on a regular basis through the tendering process for outsourcing certain parts of their own value chain.

The Minister for Climate Change and the Environment, Ian Pearson, is known to believe very strongly in the importance of the climate change issue and the need for the water industry to reduce its carbon output. These views were echoed by Richard Bird, who noted that water companies were responsible for about 2% of energy consumption in the UK and about 1% of the UK’s greenhouse gas emissions. This implies a reasonably low carbon footprint from the industry, and one might argue that it should focus more on its own real sustainability issues and leave the power sector to worry about reducing the carbon impact of energy use. Yet 74% of those present felt that water companies should focus more on their CO2 emissions. This is a strong indication of the perspective that customers and other stakeholders have; OFWAT should be prepared for this and make sure they engage with customers to assess if they are prepared to pay for an industry response to climate change.

The past year has witnessed a number of political attacks on the industry and indeed the regulator. A significant minority of the audience, in agreeing with the above statement, indicated that political pressure increases the risk that the regulator could respond with a short-term view and penalise companies inappropriately. Customers are best served by long-term consistency of approach, with the regulators and industry working together, and not reacting inappropriately to media hype or political pressure. As Tony Smith, Chief Executive of the Consumer Council for Water recommended, companies need to focus on what customers want and feed this understanding into the agenda for PR09.

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