Valuing water

Water is a precious resource. Its importance is universally recognised. Over recent decades, it has become an increasingly prominent issue. We face a number of new challenges, including a changing and unpredictable climate, population growth in water scarce areas and affordability issues.

“These challenges mean that we have to look carefully at how we use water. We need to value it and manage it responsibly. The problem is that we do not actually have a value for water. The price that customers pay reflects what has been done to get the water to the tap, but not the value of the resource itself. So, we must start valuing water, using a range of tools to reveal that value, including regulation and water trading” This quote from the Ofwat Valuing Water report misses the point. Water only has a value when it is available at the point of use. The water in Lake Windermere has no value. Its only because there is an water main running all the way down to Manchester that it is then valuable to the people of Manchester. It is of precisely no value to people in London as it would be prohibitively expensive to transport it to London from the Lake District. Ofwat need to recognize that the value is not in the water but in the assets used to store, treat and purify the water. The real question is how can these assets be used more effectively? 

The other implicit assumption behind the Ofwat report is that competition is a good thing. Ofwat  show the electricity and gas markets as ones to aspire to. Yet only today the Energy Secretary has called in the big six energy companies as its clear to everyone that the energy market is not working.

Ofwat should forget about competition and focus instead on ensuring there is a regulatory system that is not biased towards capital solutions and one that encourages and rewards innovation. 

Capex bias in the water and sewage sector

Ofwat’s report on Capex bias is an important contribution to the debate. This is a vital issue for three main reasons.

•  The water industry will continue to need massive investment £22bn over AMP5; the financial structure must ensure that this investment can be funded.
•  Water bills are continuing to rise and with the squeeze on household incomes it is even more important that everything is done to minimise costs.
•  Everyone agrees the water sector needs a lot more innovation. It faces some huge challenges from climate change and rising population and if these are to be solved at a cost customers can afford then new innovative solutions will be needed.  Capex bias limits the options open and is a major constraint on innovation.

Ofwat’s paper makes clear there is a capex bias as this quote illustrates: “When we consulted on SuDS, a number of (water) companies considered that the existing regulatory framework incentivises capex rather than opex solutions. So, they thought that they have incentives to build sewers, rather than investigate alternative approaches”.

The bias is even more starkly illustrated by the Abington reservoir inquiry. The Inspector concluded that Thames Water had not adequately investigated the alternative solutions such as demand management. Instead it had favored the highest capital cost solution. The current debate over the Thames Tideway Tunnel is raising this issue up the political agenda.

The water companies can not be criticized for working to ensure the best return for their shareholders. It is the regulatory framework that must change. This is an issue that has been around since privatization 25 years ago. It is time to stop talking and take action. The responsibility clearly lies with the Government and Ofwat. Decisive action is needed from the Ofwat “future price limits project” supported by the water white paper when it is published at the end of this year.    

Private sewer transfer is completed

October 1^st marked the transfer of responsibility for private sewers from householders to water companies. It’s a huge shift that may have unforeseen consequences. For the water companies the increase in responsibility is massive, it adds over 200 000 kilometres of sewers to their network and worse the condition and maintenance history of most of these sewers is not known.

It will certainly increase water bills, initial estimate suggest that costs for the water companies could increase by £200 million and it is likely some will apply for an interim determination. It is certain that household insurance bills will not decrease even though insurance companies will no longer be liable for the cost.

There will be a huge increase in the number of calls to water companies. This could have a significant impact on their SIM ranking. The arrangements for handling the increased workload vary with each water company, some are using their tier 1 contractors to mange the process. Certainly the transfer is to be welcomed and once the new arrangements have settled down it should lead to proactive approach to sewer management rather than the wasteful just fix it mentality that previously existed.  

ITT spins off water business Xylem

It is ironic when all the concern is over high levels of debt that ITT is to split out its water business into a new company called Xylem. It then plans to raise $1.2 billion in debt to pay off the parent company. Xylem’s 2010 revenue was $3.2 billion but most of its income comes from pumps (87%),  brands like Flygt and Lowara.

This financial engineering may make sense to the money markets but the concern has to be whether it diverts attention from its customers and its core business. The water sector is in for a turbulent few years as it can not escape the ramifications of the Euro crisis and drive by Europe and America to reduce debt. This potentially has a big impact on future water investment as funding from the state for water infrastructure projects is bound to get reduced.

Xylem may be insulated to an extent as much of the market for pumps is of course replacement of worn out assets. The concern has to be whether its really healthy for companies like Xylem to have so much debt or will they suffer the same fate as Southern Cross?  

Capex bias in the water sector

Ofwat’s discussion paper on Capex bias clearly outlines the drivers for Capex bias but is silent on what it intends to do. Water companies in their evidence to Ofwat indicated that earning a return on capital is a key driver of Capex bias. This is compounded by the financial ownership structure with many water company boards having performance targets to increase their Regulated Capital Value and hence return to its shareholders.

This was starkly highlighted by BBC Panorama this week (report on water abstraction). The example quoted was Thames Water’s focus on a new £1bn reservoir at Abington. The Public Enquiry early this year comprehensively rejected Thames Water’s proposals and said it had not adequately examined the alternatives.

This is important as innovation is vital to the water industry if it is to meet the challenges ahead. A financial system that rules out operating cost solutions is not in the best interests of the industry or its customers. Lets hope the forthcoming Water Bill and Ofwat in their “future regulation’ review take ‘decisive action’.

Shrinking rivers

Photo: Hobson's Conduit

This year has been unusual yet again. While Scotland may have been deluged many parts of England have had some of the driest weather in 100 years. In Cambridge they have had the driest spring in 98 years. A 400 year old historic watercourse – Hobson’s Conduit – is drying up. Is this just normal variation in weather patterns or are rising population, increasing demand for water and concreting over of countryside equally important causes?

About a quarter of rivers are classified by the Environment Agency as being in danger or “over-abstracted”. The Kennet in Wiltshire is among the worst affected yet over 9.6 bn gallons a year of water are being abstracted. It is perhaps not surprising that the forthcoming water bill is likely to propose increasing the cost of abstraction licences and perhaps make them tradable.

The new planning framework so hotly debated at the moment talks about the need for all new development to be sustainable. Does this mean that it will not be possible for there to be any development in Wiltshire given the perilous state of the Kennet which is clearly not sustainable? Unfortunately the new planning framework does not define sustainable leaving the way open for a lawyer’s paradise.

What is clear is that a holistic approach that really values water and the environment is essential. It is no good just reducing extraction – instead its vital to look at the demand side as well, is 20% leakage really the economic level? Will Metering help? Should building regulations be tightened further to reduce water demand from new properties, should development be restricted in water scarce areas? 

These are not easy questions but the trend is clear low river water flows are an increasing problem and the current position is not sustainable. 

Water bill still on track

Water Minister Richard Benyon confirmed last week that publication of the Governments’ water bill is still on track for December 2011. MPs debated water legislation and flood management in Parliament last week.

The elephant in the room is the rising levels of bad debt in the water industry and increasing concerns over affordability. With the current economic gloom and rising water bills and now the additional cost of transferring private sewers it’s a problem that will only get worse. It is particularly acute in the South West with SWW water having some of the highest water bills but in a relatively poor area.

Changing the structure of the industry and introducing further competition is unlikely to make a significant difference, in deed in the view of this blog restructuring would only make matters worse. Ofwat has just published a report on ‘vertical integration or seperating the companies by discrete function e.g. sales or supply. The conclusion will not come as a surprise to those with long experience in the industry – there is no evidence that either is better.

The water industry needs to focus even more on ensuring it prioritises investment where it will make the biggest difference and delivering schemes as cost effectively as possible. Huge strides have been made on this since privatisation but its clear there is still scope to do better.  Just look at the cost penalty British Water has identified that comes from the 5 year regulatory cycle and loss of experienced people at the end of each AMP period. The forthcoming water white paper is the opportunity to take action and address the elephant in the room.