by Alan Sutherland, Chief Executive, Water Industry Commission for Scotland

The father of incentive-based (price cap) regulation, Professor Stephen Littlechild famously wrote that economic regulation was required “to hold the fort until competition arrived”. In gas, electricity and telecoms, competition has appeared to a greater or lesser extent.

The water sector, however, is quite different from other utility or asset-intensive industries, and the scope for market pressures is extremely limited. The cost of moving water, unlike electricity, means there is little real choice about where or what to buy. There are no powerful buyers able to exert any real influence on the supplier. In the absence of competitive tensions, economic regulation of the water sector is very different from other utilities and asset-intensive sectors.

What I’m about to say may be regarded as heresy by some professional economists, but in my experience (22 years and counting), monitoring the performance of a regulated entity, which is also a monopoly, and ensuring that it remains accountable, is much more important than setting prices – which is how most seem to describe the role.

I wouldn’t want anyone to take that comment the wrong way, however. Economic regulation does play a vital role in setting prices at the start of any planning period. Regulated companies do need to be given a defined financial envelope to work within. They need, in the economic jargon, to be ‘price takers’ or to face a hard budget constraint.

To that end, economic regulators have to establish the scope for efficiency that may exist. And to do so, they must indulge in some fairly painstaking benchmarking. Information has to be collected and analysed in great (almost stifling) detail. Economic regulators seek not just to compare unit costs, but also to reflect appropriate differences in the operating environment, the assets operated and the quality of the outputs or outcomes being delivered.

Close performance monitoring (as evidenced through that information) ensures that the hard budget constraint is maintained. There can be no cutting of corners in levels of service or investment delivered. Be in no doubt, this is a highly technical, specialist function.

The stronger the management team of a monopoly service provider, the more need there is for robust regulatory scrutiny. A management team will always know more than a regulator about their business, resulting in an inevitable information asymmetry. To compensate for this asymmetry, the regulator must draw on benchmarks over time, across companies or even across borders. There is a lot of devil in the detail….

So to the devilry!

Economic regulation involves close and detailed explorations of any variances between what was set out at the start of a planning period and actual performance. It is a highly pro-active role.

Economic regulators collect a lot of information. This information must be very clearly defined and the regulator will expect commentary to support any submissions. Regulators regularly review what they collect, why they are collecting it, and how often it needs to be collected.

Is it difficult and time consuming to collect? Yes. But is it also an essential pre-requisite for a well-run and sustainable sector? Yes.

A regulated entity will often suggest that collecting this information is an undue burden, an expensive luxury or a distraction from providing a quality service to customers and communities. Foxes and chicken coops come to mind.

Put bluntly, the information an economic regulator asks for is less than the service provider needs to operate efficiently and effectively both now and into the future. As an economic regulator, I would happily stop collecting information where a regulated company can evidence that it does not need to know what is being requested.

On the side of the angels!

Perhaps one of the most important elements of this information is that which relates to performance in delivering the capital programme. The economic regulator must ensure that capital programmes – no matter whether they relate to asset replacement, growth or performance/compliance improvement – are delivered. No ifs, no buts, and no excuses.

In New Zealand this means there should be a close partnership between the economic regulator and Taumata Arowai. The economic regulator will have to draw on the technical expertise of the quality regulator and the water quality information they collect. The quality regulator will need to know whether there are any issues with progress in delivering desired improvements.

Every quarter, jointly with Scotland’s water quality and environmental regulators and customer representative colleagues, I look at how Scottish Water has progressed each project relative to the agreed target: from detailed design to financial approval to start on site to delivery of the output, and finally confirmation that the desired outcome has been delivered. Where projects lag, questions are asked, and assurances and remedial actions sought. It is this process that ensures customers and communities can have confidence that value for money will be delivered. In a public sector context, the owners of the water operations also benefit from knowing that their policy ambitions are more likely to be achieved both in the short and in the long run. Regulation substantially reduces the information asymmetry that would otherwise exist. This means that policy makers and owners can and should expect more for their communities.

A regulated organisation can make this reporting process easier if it is proactive in highlighting variances in its capital delivery, and has robust explanations about how it intends to get delivery back on track. There is no scope to wait until a project’s due date has arrived before asking questions about what has been delivered, or, much worse, about why it has not been delivered. Any changes in the agreed capital programme – which should be few in number – must be carefully reviewed.

Accountability is key – not for policy, but rather for the delivery of policy. An economic regulator usually publishes an annual commentary on the regulated company’s performance. The aim is to make such commentary as clear and accessible as possible. This helps ensure that all parties, be they customers, communities, local councils, or supply chains, can have confidence in the industry, its value for money and its contribution in making our lives better now and into the future.

What does this mean for water sector reform?

Economic regulation ensures that information on performance is carefully monitored. For this to happen, early progress will need to be made in improving the quality of information on assets, on performance levels and the costs of operation. As noted earlier, the information the economic regulator requires is only a subset of what is required to run a water business efficiently and effectively. Collecting this information – in all its gory detail – is a critical building block in ensuring that any water reform will realise its full potential. There will always be scepticism about the scope for efficiency identified in a regulator’s benchmarking. But pursuing this proactive route of information collection and analysis will ensure that these regulatory expectations are met. Indeed, the history of the economic regulation of the UK water sector suggests that regulators have consistently underestimated the efficiency the regulated companies have been able to achieve.

Regulators will look very hard at the information a regulated company provides. The implications of this intense scrutiny are clear. The new regulated entities will need to establish excellent systems and processes for collecting and managing their information. They will need to understand what their information means and its implications. They will have to learn to communicate clearly, logically and consistently. Success will require close detailed conversations with both Taumata Arowai and the economic regulator. Regulated water entities are specialist delivery vehicles that have to be able to evidence their performance and withstand detailed scrutiny. As such, accepting the need to evidence their performance and delivery will need to be central to the new entities’ organisational DNA.

Falling short typically results in greater scrutiny, more challenge and a loss of confidence in organisations, or in the Board or in the senior management – or in all three. When regulated companies are unable to evidence and explain their performance, regulators typically collect more detail, more frequently. It is these ebbs and flows in levels of scrutiny, challenge and confidence in an entity’s performance that generate the dynamic pressure for efficiency. We may never dismantle the Three Waters Fort, but that does not mean that all of us, as citizens and consumers, should not expect real value for money. Step forward, the regulators!