British Water

Slide 1 Overview

Ian Byatt stepped down after 11 years and two terms as the regulator of the 25 private companies that supplied water and sewage services throughout England and Wales.

Ten of the companies provided both water and sewage services while the remaining 15 companies provided water services only

Water and sewage was one of a half dozen utility industries that the British government privatized during the 1980s and 1990s; the others included the telephone, electricity, gas, airport and railways services

Byatt had been one of the first price-cap regulators, and his experience suggested some of the strengths and limitations of the approach.

Slide 2 Privatization of Water

The Conservative Party came to power in 1979 with a program to improve the efficiency of public services and reduce the size of the state by, among other things, privatizing many industries that Britain had nationalized in the decade after World War II.

The government privatized telecommunications in 1984, gas in 1986, water in 1989, electricity in 1990, and railroads in 1994.1

10 large publicly owned sewage and wáter companies and 29 private small wáter companies. Supervised by the Environment Department.

Reasons to privatize wáter:

1. The government decided to privatize the water industry because of the enormous investments needed to bring it up to modern standards.
The government saw privatization as a way to avoid public financing of the investments needed to meet EC standards. If the industry were in private hands, the new investments would be financed by private debt and equity and repaid through a combination of efficiency improvements and higher water prices.

The Water Act of 1989 outlined the basic terms of the privatization, including the system for setting future prices for both the new and existing private companies.2

The Department of the Environment announced the investment program that would be expected and the price increases that would be allowed for each company over the first ten-year period, from fiscal year 1990-91 through fiscal year 1999-00. The shares in the ten new private water companies were successfully floated in 1989.

Slide 3 Price-Cap versus Cost-of-Service Regulation

Price Cap

The government developed the “price-cap” approach to regulation when it privatized telecommunications in 1984, and it applied price cap to all the other utilities it privatized during the 1980s and 1990s, including wáter.

Price were reviewed every five years, and the annual price increases allowed between reviews were “capped” by a formula.

The price-cap formula typically was RPI-X, where RPI was the increase in the retail price index and X was the regulators’ estimate of the productivity improvement possible in the industry.

Cost of Service Regulation

The US approach was so named because regulators were required to set prices sufficient to cover the cost of service including a fair rate of return on capital invested. US regulators reviewed prices whenever they or the regulated firm thought necessary, which typically was once a year.

Price Cap vs Cost Service Regulation Improvements:

1. Price cap was designed to improve on cost-of-service regulation in two ways. First, price cap sought to strengthen the incentives of the regulated firms to improve efficiency and cut costs.
Price cap increased the incentives for the firms to cut costs by lengthening the time between reviews. With reviews only every five years, a firm would be motivated to implement any cost-saving measure that had a payback period of less than five years.

2. Second, price cap sought to reduce the heavy procedural burden of cost-of-service regulation.
Price cap would reduce the burden of regulation simply because price reviews would be conducted every five years instead of every year. Moreover, the British would use a single regulator for each industry rather than a commission, and not require the regulator to hold hearings or take evidence from affected parties.

Ian Byatt

Ian Byatt was appointed the first water industry regulator in 1989 and would eventually serve two full terms, stepping down in the summer of 2000 and being knighted for his service.

Byatt was an economist who had spent most of his career in the government, rising to become the Deputy to the Chief Economic Advisor of the Treasury.

The Department of the Environment did not have a strong incentive to resist tighter standards, because the funding no longer came from its budget and the Department’s constituency was the environmentalists and not water consumers. The companies were also enthusiastic about building new water and sewage treatment plants because they often thought they could build the plants for less than the Department’s estimates and because the new plants would be added to their regulated capital value for the purposes of calculating prices in the future.

The 1994 price review

Byatt’s strategy was developed in his review of water prices for the five-year period from fiscal year 1995-96 through fiscal year 1999-00

One series was addressed primarily at the investment community, and dealt with the cost and value of capital, important issues in setting utility rates.8

Another series was addressed primarily to policy makers at the Department of Environment. In the initial paper, provocatively titled The Cost of Quality, Byatt laid out the implications of different environmental standards for customer prices and asked the environmental regulators to make explicit the standards they expected to apply.Byatt argued that the seven percent post-tax cost of capital the government had assumed in its 1989 price determinations was too high, and that water utilities were an inherently low-risk business that might justify a post-tax return closer to five or six percent.

When the government adapted the price-cap scheme for the water industry, it recognized that the large number of water companies would make it easier to estimate X. Performance could be compared to identify the most efficient firm, and the efficient firm could be used as a “benchmark” for the others

Byatt had hoped the 1994 review would result in a K factor of zero, which would have been a relief after five years of real price increases of over five percent per year. Byatt did not meet his target but he managed to hold the average K down to +1.5 percent for the coming period. He did this partly by persuading the Department of the Environment to delay the implementation of some standards and partly by estimating that the water industry could increase its efficiency by roughly 1.5 percent per year

Dividends and Drought
In the year that followed, it gradually became clear that Byatt could have set the Ks even lower.

A clearer sign came in the fall of 1994, when other companies began to announce special dividends. Stockholders had been pressing for dividends in part because many companies had embarked on unsuccessful diversification programs. Water companies had used their profits to invest in, among other things, water companies overseas, electricity companies in Britain and even hotels, often with disastrous results.

The scale of the special dividends—over £500 million between the summers of 1994 and 1995 alone—made it clear how profitable the water companies were.

As if these difficulties were not enough, Britain suffered from a drought in 1995-96 that resulted in water rationing in many communities.

Press reports of high rates of leakage in many water systems left the impression that many water companies had chosen to pocket big profits instead of making the investments that might have avoided the shortages.

CHANGE OF WIND

In May of 1997, Tony Blair led the Labour Party to victory in a general election, ending 18 years of Conservative Party rule. High utility earnings had been an important theme in the Labor campaign, and in July the new government imposed a one-time £5 billion “windfall” tax on utility profits. The water industry’s share was £1.8 billion. The new government left the system for regulating private utilities largely intact, however, for lack of a clearly superior alternative.

1999 PRICE REVIEW

Factores medidos en el review:

Releasing consultation papers on issues such as the cost of capital, environmental goals, and opportunities for efficiency gains.

Benchmarking was used more extensively, for example, and Ofwat developed more elaborate measures of service quality, reflecting concerns raised by the drought. A key issue, as in the past, was the expected productivity improvement, or X. X was made up of two parts: a “catch up” component, which was an estimate of how much a firm could improve if it caught up to the most efficient firm in the industry, and a “frontier” component, which was an estimate of how fast the most efficient firm could improve.

Catch up Component:
Benchmarking was used to estimate the catch up component. Even with 10 water and sewage firms and 15 water-only firms, however, the sample size was too small to produce a support a very detailed statistical analysis; in most cases the estimated cost functions had only one or two explanatory variables.

Frontier Component: the industry’s cost of capital, focusing in this review on the mix of equity to debt. Ofwat argued that the pre-tax cost of capital should be cut to 6.5 percent because real interest rates had declined and because water companies could nowincrease their debt to 50 percent of total financing

1999 Results

The 1999 review resulted in Ks averaging –2.1 for the next five years, reducing consumers’ prices for the first time since privatization. The industry would be required to make £15.6 billion in new investments over the five years, which would have required Ks of over +2

The result was an average price reduction of 12.3 percent in 2000-01, followed by a further reduction of 0.4 percent in 2001-02 and gradual increases of 0.1, 1.1, and 1.4 percent in the next three years (Exhibit 3).

The reaction to the 1999 review was different. The industry had hotly disputed many of the assumptions in Ofwat’s consultation reports, but Byatt had stuck to his guns by and large. The prices of water company stocks dropped sharply as the review progressed, with market values falling below the values the regulator set on the companies’ assets for price-setting purposes