The quadripartite process of negotiating water company business plans ahead of the 2009 periodic review could be ignored by economic regulator Ofwat as it finalises the water companies' 20010-15 price controls.

Concerns that Ofwat would ride roughshod over the companies' business plans agreed with consumer groups and quality regulators surfaced in discussions after a lecture to the Centre for the Study of Regulated Industries (CRI) by former electricity regulator Professor Stephen Littlechild.

In his lecture, Littlechild extolled the virtues of economic regulators stepping back from traditional RPI-X regulation of monopoly utilities in favour of negotiated settlements where utilities agree investment plans with customer and other interested parties. This would allow more innovation and improved customer service rather than expecting the regulator to decide what the market wanted and setting prices at the minimum level to deliver it.

"We should recast deregulation as a discovery mechanism and not put all the burden on the regulator," Littlechild said. "Regulators should have an explicit duty to establish procedures for negotiated settlements between licensees, customers and other parties."

He claimed that because customer representative bodies only had to look out for customers' interests, while regulators had to balance a range of interests, more innovative solutions would emerge. In addition, negotiations between each company would get away from a regulator's "one size fits all" approach, and could see price controls agreed for different periods rather than a fixed five year term, for example.
While this approach had been shown to work in regulated sectors such as electricity distribution and airports, the CRI audience was more sceptical this could work in the UK water industry. Competition has proven problematic, but in the current 2009 price review, the customer was to be put "at the heart" of the process.

This has involved the companies undertaking extensive customer research and engaging in quadripartite discussions the Consumer Council for Water (CCWater), the Drinking Water Inspectorate and the Environment Agency. CCWater represents both household and business customers, and Natural England may also join the discussions.

The aim is to develop business plans for each company based on what customers want and are prepared to pay for within the constraints of statutory quality and environmental standards. Another expectation was that this process would reduce the friction between Ofwat and the Environment Agency in particular over funding of environmental improvement schemes - especially on the thorny issue of sewer flooding, where the Agency often believed Ofwat should allow more funding. The five year plan should also sit within the context of the companies' 25 year Strategic Direction Statement and Water Resource Plan.

The hope and expectation from these negotiations were that Ofwat would take into account the fact that the plans were drawn up in accordance with the principle of putting customers "at the heart" of the process. But fears were expressed at the CRI event that as it got closer to the Final Determinations, Ofwat would ignore customers' input and apply simple economic principles to drawing up five year plans designed to comply with statutory quality and environmental standards.

"My approach would lead to different outcomes," said Littlechild. "The quadripartite process would include discussions about the quality targets and when they should be met. If there is any choice about quality regulation, let's look at the cost and how customers would change things. Ofwat is encouraging debate but in the end the figures go back to the regulator and it decides."

Transitional pricing
Littlechild's lecture also proposed an improved method for introducing transitional price controls when deregulating former monopoly markets. He argued that tough price controls that screwed down regulated monopoly incumbents' costs and prices were actually a barrier to new entrants and urged an end to price controls as soon as possible in the deregulation process.

Expressing his "sadness" that Ofgem had declared after its energy supply probe it would introduce curbs on prepayment prices, Littlechild said this would "would hinder rather than help" the development of innovation and competition in this market. Citing the appearance of Utilita, a new entrant offering up to 20 per cent savings on prepayment tariffs through lower prices and energy savings using a smart meter, Littlechild said this would be more difficult if Ofgem regulated prepayment prices downwards.
"If a regulator is not sure is a market is competitive, the easiest way is to remove price controls and see what happens," he said.

He also argued that the weighted average cost of capital (Wacc) of around 7 per cent allowed by most regulators for monopoly providers was too low.

Littlechild said that restructuring incumbents into separate business units - together with regulated access to the remaining monopoly network - was "a critical element" in moving to competitive markets. "The level of competition is roughly proportional to the amount of restructuring," he said.

Instead of setting rigid ex ante price limits for the remaining monopoly business, he proposed ex post price bands, based on the Wacc, where there was a "safeguard" level below which prices were definitely OK, a band in which they may be OK and a level above which they were definitely not OK.

Based on an analysis of cases the Office of Fair Trading had referred to the Competition Commission over anti-competitive pricing in a range of industries, Littlechild proposed setting the lower band below which prices were assumed to be OK at 20 per cent - almost three times the current typical regulated Wacc - and the upper band above which prices were deemed excessive at 35 per cent. Between those levels, the regulator would look at each case on its merits.

Competitive confusion
Littlechild was also asked whether highly competitive markets - such as energy retail - could actually confuse customers. Research by the University of East Anglian had indicated that some consumers switching energy supplier looking for a lower price had ended up paying more because of the confusion surrounding the plethora of tariff options.

He said he was "puzzled" by these findings and that more research was needed, but added that in many competitive markets "consumers were not as well informed as economic theory assumes".

"Markets are complicated and people find their own ways of dealing with them," he said. "Consumers are very inefficient when it comes to choosing supermarkets and petrol retailers too."

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