Viewpoint The World Bank = May 1997 Note No. 115 Water Privatization and Regulation in England and Wales Caroline In 1989, England and Wales embarked on one of the first modern privatizations in the water sec- van den Berg tor. The government sold ten publicly owned water companies-encompassing water and sewer- age assets and operating licenses-and set up a new, independent sector regulator. These reforms have delivered an impressive volume of new investment, full compliance with the world's most stringent drinking water standards, a higher quality of river water, and a more transparent water pricing system. But experience during the first regulatory cycle also reveals some lessons about the information requirements of effective regulation and the risks to the political independence of the regulator. This Note reviews these lessons. Before 1989, the water industry in England and as an independent government agency, were Wales consisted of ten publicly owned water supposed to limit political discretion in policy authorities and twenty-nine privately owned and investment decisions. To further strengthen water supply companies. The government ar- independence, the regulator was given broad gued for privatizing the publicly owned ser- discretion in interpreting the law, implement- vices on two counts: privatization would result ing general rules, and modifying company in more efficient companies, and private own- licenses. ers would fund the investments needed to meet tighter water quality standards and make up An important innovation of the British system for past underinvestment. of economic regulation is the use of price caps. These caps set maximum prices for all water The government split the water authorities, companies, in five-year cycles. A second inno- transferring the main environmental regulatory vation-the use of yardstick, or comparative, responsibilities to the National Rivers Author- competition-addresses the problem of the ity and converting the remaining water and water companies' monopoly over information sewerage services into private companies to the regulator needs to do a good job. Through be sold on the stock exchange. The govern- performance comparisons, Ofwat derives yard- ment also set up a new regulatory agency, sticks that it can use to assess the efficiency of Ofwat, which sets the maximum prices that water companies. Less efficient utilities are water companies can charge. The agency's pri- given more demanding efficiency targets and mary duty is to ensure that the companies can are expected to come up to the standard set finance themselves by earning a reasonable rate by the best performers. of return on capital. One of the major objec- tives in the new regulatory design was to avoid Because large investments were necessary and political interference in the regulatory process. water privatization was new territory for the gov- Built-in checks and balances, such as financial ernment, the privatization was done on terms autonomy for the sector regulator and status favorable to shareholders to ensure that the pub- 3IW Private Sector Development Department . Finance, Private Sector, and Infrastructure Network Water Privatization and Regulation in England and Wales lic flotation would succeed: the government of water policies sufficiently into consideration wrote off most of the debt on the public com- when assessing companies' investment pro- panies' books. (As a result, the government's grams. The most striking case in point is water costs ended up exceeding its revenues: the di- metering for residential customers, on which rect net effect of the sale of the companies was almost no progress has been made. Although a deficit of about £1.3 billion.) in the medium to longer term metering is de- sirable as a means of managing water resources The reforms also affected the twenty-nine pri- more effectively, its high up-front costs have vately owned water supply companies. Before led many water companies to drag their feet. the reforms, these companies had been sub- Finally, since privatization, investments in the ject to statutory controls on profits, dividends, regulated water business have occurred in a and borrowings. In 1989, they were brought cycle that corresponds with the regulatory under the same regulatory regime as the priva- cycle. This pattern tends to distort the timing tized water authorities and were able to con- of investments and weaken utilities' incentives vert themselves into public limited companies. to generate cost savings toward the end of the By the end of 1996, after a spate of mergers regulatory cycle. and takeovers, only nineteen such companies remained. Real sector operating costs per unit of water actually increased slightly during the first regu- Impact on investment, operating latory cycle, though staff numbers fell. The com- efficiency, and profits panies attribute this rise in operating costs to the additional investment to achieve higher With regard to the government's two objectives water quality standards. Another reason for the -investment and efficiency-the results have higher costs could have been high transfer pric- been mixed. By volume, the government's in- ing between regulated and unregulated parts vestment targets have been realized. In the six of the business (such as laboratory and con- years after privatization, the water companies sultancy services). As long as cost pass-through invested a massive £.17 billion, compared with is allowed, a holding company can increase its £9.3 billion in the six years before privatization. profits by pricing such internal transactions above cost. The regulator has taken steps to But there are signs that not all this investment prevent these cross-subsidies and requires com- has been efficient. First, because the price cap panies to disclose more information on trans- worked more like rate-of-return regulation fer pricing. But the main factor in the higher during the first regulatory cycle (1989-94), there costs appears to be the generous first price cap. may have been incentives to gold-plate invest- Utilities apparently had few incentives to re- ment plans. Second, the separation of economic duce their operating costs. The regulator tight- and environmental regulatory responsibilities ened the price cap considerably in 1995, made creating the right investment incentives however, so it is likely that companies will re- more difficult-especially given customers' low duce their operating costs during the second willingness to pay for the water quality im- regulatory cycle (1995-2000). provements mandated in European Union directives. Establishing closer coordination The investment boom has led to significant between these two regulatory functions earlier price increases for consumers. The real aver- in the reforms could have resulted in clearer age residential water and sewerage bill has and less conflicting investment incentives. gone up by 28 percent since privatization. The regulator has accepted that there are large dif- Third, because Ofwat's mandate is limited to ferences among water companies and has cal- ensuring the financial viability of the utilities, culated different price caps. As a result, there it does not take the public costs and benefits are large variations in average water and sew- erage bills among utilities. For the average categories. Using moral suasion, the regulator household, water and sewerage are still afford- has insisted on rebalancing tariffs, but many of able but low-income households have difficulty the inefficiencies in the rate structure remain. paying for these services. In most companies, for example, households with water meters still pay higher effective rates At the same time that prices were rising for than those without meters. consumers, the profitability of the water and sewerage companies soared, creating a seri- The water companies' performance shows how ous public backlash against the reforms. If these important it is to provide the right incentives. profits are adjusted for the £5 billion debt write- To do this, the regulator must have access to off, the increase is less spectacular, though still good information. But the water companies' positive. control over information affords them opportu- nities to manipulate the information they make Regulatory lessons available to the regulator. Yardstick competition was supposed to address this problem. Under It is still early days for the new regulatory model. yardstick competition, the regulator sets price But the experience so far has shown that the caps on the basis of comparative data from simi- tools of price cap regulation are both complex lar utilities in the United Kingdom or abroad. to administer and critical: if the price cap is set Efficiency levels for inputs, unit costs, and quality too high, the utilities will earn excess profits; if of service are set on the basis of lowest-cost, it is set too low, underinvestment will result. As highest-service standards. Yardstick competition mentioned, in the first regulatory cycle, price is most effective when firms face similar condi- cap regulation did not differ significantly from tions. Ofwat's calculation of individual price caps rate-of-return regulation. The second cycle will for the water companies suggests that each com- be a truer test of the mechanism. But setting the pany operates under different conditions. So far, key parameters in the mechanism-using finan- Ofwat has not been very successful in develop- cial prices, defining the price adjustment factor, ing robust measures of relative performance. choosing the method of asset valuation-has When used, relative performance indicators have been complex and time-consuming. The price resulted mainly in broad groupings indicating cap also suffers from being grafted onto the in- below- or above-average performance. Building efficient tariff structure of the original publicly a reliable database and related analytical tools owned utilities-a tariff regime that was not has proved a regulatory challenge requiring based on water consumption levels and did not much time and effort. provide an incentive for efficient water use. Ide- ally, the rate structure should be revamped be- The water companies' information monopoly fore privatization-after privatization, it is hard increases the risk of regulatory capture. Aware to revise. of this risk, Ofwat has stepped up its efforts to prevent regulatory capture by expanding the Even though price caps are said to reduce the scale and scope of regulation and by applying possibilities for cross-subsidization, the expe- more elaborate tools for monitoring. For ex- rience so far shows that price cap regulation ample, it is using expert engineering appraisals, has not eliminated the incentive for compa- through capital expenditure certification and nies to selectively alter prices. The tariff bas- through cost reductions based on the results of ket formula used by Ofwat still provides the econometric models. But econometric model- companies leeway for price discrimination be- ing suffers from lack of sufficient data to run tween rate categories while they keep the over- regressions, problems in quantifying explana- all price for the tariff basket below the price tory factors, and difficulties in assessing an ap- cap. The companies apply the price cap to an propriate charge for capital assets. Monitoring average price for a group of services or rate the performance of private utilities to ensure Water Privatization and Regulation in England and Wales the effectiveness of price cap regulation has is still too early for a verdict on efficiency be- become an elaborate process that increasingly cause the first price cap was not tough enough resembles Treasury scrutiny and control of utili- to force companies to reduce operating costs. ties under public ownership. This can in the The experience shows that to set appropriate longer run result in excessive control, which price caps, the regulator needs a sound and could erode utilities' management autonomy. reliable database and effective tools to analyze the data. Building the database and assembling The regulator has broad discretionary power the necessary tools takes time and effort. The to modify the licenses of a company, thus al- second regulatory cycle should be a better test tering the fundamental regulations that apply. of price cap regulation. But the early difficul- This discretion, combined with the importance ties have had costs. The combination of steep in the British model of the individual regulator's tariff increases and sale terms that were too personality, adds up to a regulatory environ- favorable for shareholders and firms has cre- ment that is less stable than often presumed. ated credibility problems for the reforms. Pub- At the same time, and despite efforts to insu- lic resistance to the price rises associated with late regulation from political interference, poli- privatization has made the regulatory system tics remain an important influence on the more susceptible to political interference- orientation of regulation. Although price caps against which the built-in checks and balances are supposed to be reset every five years, the have not provided sufficient insulation. The ex- water regulator intervened twice during the first perience has also shown the need for better forum intended to regulatory cycle, forcing two interim price re- coordination between economic regulation of encourage dissemina- ductions-clearly under political pressure. The the water companies and such government tion of and debate on current debate about profit sharing and the in- functions as water resource management and ideas, innovations, and iest practices for troduction of competition in the water industry support for lower-income households. expanding the private is inspired mainly by political considerations. sector. The views As a result of the perceived instability of the Caroline van den Berg, Latin America and published are those of the authors and should regime, investors require higher risk premiums the Caribbean Country DepartmentlIII not be attributed to the and thus higher rates of return. (cvandenberg@worldbank.org) World Bank or any of its affiliated organizations. T Nor do any of the con- The degree of regulatory discretion has led to clusions represent criticism about the regulator's lack of account- official policy of the ability. There are mechanisms to challenge regu- World Bank or of its ExecutiWle Bikrotors latory decisions, but only a few companies have or the countries they used them, suggesting that utilities have little represent. confidence that they can overturn Ofwat's deci- To order additional sions. There is evidently a tradeoff between ac- copies please call countability and maintaining an independent 202-458-1111 or contact regulator. Although the independence of the Suzanne Smith, editor, regulator is important, the balance between in- The World Bank, dependence and accountability needs to be 1818 H Street, NW, shifted in favor of the latter so as to reduce the Washington, D.C. 20433, or Internet address instability of the regulatory system. ssmith7@worldbank.org. The series is also Conclusion available on-line (www.worldbank. org/htmlffpd/notes/ The England and Wales privatization rates as a notelist.html). partial success over the first regulatory cycle. SPrinted on recycled It has delivered the large investments needed paper. to meet higher water quality standards, but it