X marks the spot

Alan Sutherland explains why Wics is returning to the roots of RPI-X regulation for its upcoming Strategic Review of Charges for Scottish Water.

It is now more than 30 years since Stephen Littlechild wrote his report on controlling the profitability of British Telecom (then yet to be privatised) and introduced the RPI-X formula. The idea was that price cap regulation would offer an incentive to managements and shareholders to reduce costs and “reveal” their efficient level.

The approach has worked well, not just in telecommunications but also in the other regulated sectors where it has been used. Our experience in regulating Scottish Water suggests that it can be applied equally well to an industry that remains in the public sector.

The essence of RPI-X is that targets become minimum “acceptable” levels of performance. This contrasts with what might be termed the “aspirational” targets that existed before or could be said to characterise many of the targets set for the public sector. It remains as relevant today as a guiding principle as it was in 1983.

The Water Industry Commission for Scotland (Wics) will shortly publish its methodology for its Strategic Review of Charges, which will set the charges Scottish Water can apply after 2015. Our approach is to strip back our regulation of Scottish Water, closer to the principles that underpinned the original Littlechild report. We are taking a strategic and top-down approach, moving away from an approach that uses any form of “building blocks”. There are three essential elements: empowered customers, encouraging and rewarding innovation, and sustainable financing.

Together with Scottish Water and Consumer Focus Scotland, we have established a Customer Forum. The forum includes retailers operating in the Scottish market and individuals. It is chaired by Peter Peacock, an experienced and widely respected former minister in the Scottish Government.

Our approach is different from that of the Customer Challenge Groups in England in the following ways:

· Wics will provide ongoing commentary on Scottish Water’s performance, its plans and other information relevant to the setting of water and sewerage charges;

· the forum involves only customers, and its focus is on striking the best possible deal within the policy framework set by the Scottish Government;

· Wics has made it clear that if the forum can agree levels of service and charges (consistent with government policy) with Scottish Water, Wics would be minded to adopt that agreement as its draft determination.

We have looked carefully at how regulation might be discouraging innovation. Our review identified three main issues: the different treatment of capital and operating expenditure; the time available to reach payback; and the relative risk attached to different approaches.

The separate calculation of allowances for operating costs and capital expenditure and the payment of a return only on committed capital expenditure introduces a bias. Even in Scotland, where Scottish Water’s profits are 100 per cent reinvested to the benefit of customers and the environment, there is a disincentive to solve problems by making a longer-term commitment to incurring increased operational costs. This reinforces an existing engineering preference for capital- based solutions.

We are explicitly moving away from the separate measurement of capital expenditure and operating costs and will focus rather on outcomes: the level of return that is earned, the compliance, condition and performance of existing assets, and the level of customer service.

Under the traditional approach to regulation, a company would commit resources to a project that either incurred operating costs or capital expenditure provided the payback from this initiative was shorter than five years (the length of a regulatory control period). A similar pressure applied to long-term strategic public health or environmental improvements, such as the project to improve Glasgow’s drainage.

Under the previous framework, any longer-term projects would have had to have been divided up into neat five-year chunks. Our new approach, by contrast, explicitly allows for longer paybacks.

We have taken steps to recognise the total costs of such improvements and explicitly recognise that their funding should be determined by engineering efficiency rather than regulatory convenience.

Perhaps the most important change we are making concerns the handling of individual risk attaching to solutions. Regulation has traditionally favoured the commitment of capital expenditure and offered a relatively low return on the investment committed. This reflected the relatively low risk that these solutions would not deliver their planned benefits. There was a clear responsibility on the regulated company to deliver the required outcome.

Increasingly, companies are able to identify potential opportunities to deliver the required environmental outcome without the commitment of capital expenditure. However, there cannot be the same certainty that the final outcomes will be met successfully 100 per cent of the time. There may also be potential costs in terms of the allocation of senior management attention to such projects.

All this suggests that a higher return on such projects may be appropriate – provided that the regulated company remains responsible for the delivery of the outcome (to the satisfaction of the appropriate quality regulator) and that the total cost (including the additional return) is cheaper on a whole-life net present value basis than the more traditional approach.

We have developed tramlines that force a discussion between stakeholders about how any outperformance is shared out. This could be in the form of price reductions, improved levels of service, new quality initiatives or the improvement of financial strength. A similar process is triggered if Scottish Water should under­perform on its regulatory contract with its customers. The rationale is that performance by a utility above a certain level is unlikely and has almost certainly resulted from the asymmetry of information between the company and its customers and its regulators. Perhaps we should remember that the Water Works and Electric Company were cheap but reliable sources of income on the Monopoly board!

In summary, our approach is to regulate, not to control – in the true tradition of Littlechild’s RPI-X. It is to empower management and customers and encourage them to identify an appropriate combination of prices and levels of service. There is, here, no abdication of regulatory responsibility – quite the reverse, because we will publish our views regularly and in full such that neither Scottish Water nor the Customer Forum could have any doubt on our thinking if they could not reach agreement.

Importantly, this whole process takes place within a clearly defined policy framework set by the Scottish Government – specifically on the social, environmental and public health outcomes to be achieved and the principles that should underpin the setting of water and sewerage charges in Scotland.

Alan Sutherland is chief executive of the Water Industry Commission for Scotland

This article first appeared in Utility Week’s print edition of 10th May 2013.

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