The Public Accounts Committee has been looking at the way Ofwat sets price limits on the 18 monopoly water companies and has concluded that the prices are too high.

Background

Ofwat is the economic regulator of the water industry.  There are 18 privately-owned companies which are monopoly suppliers to 22 million households and all but the very largest of the 2 million non-household customers.  As customers have no choice over who they use, Ofwat regulates the prices that the water companies can charge.  Prices are reviewed in 5 year cycles allowing for the operational and financing costs of delivering services to customers, and making assumptions about the efficiency improvements that companies should make. The average household bill in 2014–15 was £396.

Conclusions and recommendations

The PAC's report concluded that:

Ofwat has consistently over-estimated water companies’ financing and taxation costs when setting price limits – so companies have made substantial windfall gains from customers’ bills being higher than they needed to be. Ofwat has repeatedly overestimated the cost of finance in successive price reviews, allowing the water companies to benefit from a reduction in corporation tax. regulator Ofgem updates these allowances annually to reflect changes in corporation tax and the market cost of debt for companies with similar characteristics to those it regulates.

Recommendation: Ofwat should review its approach to setting allowances for the cost of debt and corporation tax, taking into account the methods used by other economic regulators [such as Ofgem which updates them annually], and report publicly on what actions it intends to take to improve its performance.

Ofwat’s efforts to ensure that the windfall gains made by companies were shared with customers secured limited results that varied significantly from company to company – Ofwat does not have any statutory powers to compel water companies to share windfall gains with their customers, so it sought voluntary agreements from companies to raise their bills in 2014/15 by less than the regulator had originally permitted. Only six out of the ten largest water and sewerage companies did so (returning £400 million to consumers, out of at least £1.2 billion windfall gains). Ofwat did not quantify the scale of the windfall gains by company, provide guidance on what an appropriate share for their customers might be, or pass this information on to customers.

Recommendation: Ofwat should monitor water companies’ windfall gains, report publicly on their scale and set out what actions it intends to take to ensure all companies provide a proper share of windfall gains that arise in future to their customers.

Ofwat does not do enough to benchmark the efficiency of water companies against comparators from outside the sector – it only uses cost data from the water companies themselves, meaning it lacks evidence on whether some activities are undertaken more efficiently by international water companies or by other UK-based industries which undertake similar activities.

Recommendation: Ofwat should use comparisons with other sectors and international suppliers to develop a clearer picture of what services should cost if provided efficiently.

Financial support for customers who struggle to pay water bills varies substantially from company to company - Currently 14 of the 18 large companies in the sector have introduced social tariffs. There are varying levels of customer awareness around eligibility for these schemes which is an obstacle to take-up - especially where customers are served by different water and sewerage suppliers.

Recommendation: Defra and Ofwat should ensure that all companies provide a minimum threshold of support for low-income customers who are struggling to pay, and oblige companies to advertise clearly the support they provide to all customers. Defra and Ofwat should monitor take-up rates to identify priority areas where improvements are needed.

Customers in areas of water scarcity are paying to develop expensive new capacity when water trading with other companies might be a more cost-effective option - Since privatisation, the volume of water traded between companies has remained fairly constant at about 4–5% of total supplies. The potential benefits from greater water trading are substantial: Ofwat estimated in 2010 that it could yield benefits of £1 billion over 30 years, but did not set explicit targets for the sector. Changes brought in by the 2014 Water Act will from 2019 make it easier for new entrants to provide water resources, but the lack of visible prices for water resources continues to be an obstacle to a well-functioning market.

Recommendation: Ofwat should set out what it intends to do to promote more water trading between companies and greater transparency of costs, to encourage new more cost-effective suppliers to enter the market.

Comment

This report, coming on top of the National Audit Office's report on the economic regulation of the water sector in October 2015, shows that Ofwat has some work still to do to make sure that water prices are as fair as possible.  However, the Public Accounts Committee was looking at decisions made six years ago and since then Ofwat has adapted and evolved its pricing strategy so most of the recommendations should not be too difficult to implement.

The final recommendation is the one to watch: water trading between companies is likely to increase when the market opens to competition in the next few years.