Financing the private water and sewerage Companies of England and Wales

The statutory duties of the financial and economic regulator

Last update Tuesday 21 August 2007

The statutory duties of the Authority are defined in Section 2 of the 2003 Water Bill, the relevant requirements of which are summarised in the two extracts given below. It is worth noting that these duties remain essentially unchanged from the previous 1991 Act except that the requirement to protect customers "as respects the fixing of charges" - paragraph 2(3)(a) - has for some reason been deleted.

Extracts from the Water Bill (2003)

The Authority shall exercise and perform the powers and duties mentioned in the manner which he or it considers is best calculated to secure that companies are able (in particular, by securing reasonable returns on their capital) to finance the proper carrying out of those functions.
The Authority shall exercise and perform the powers and duties mentioned in the manner which he or it considers is best calculated to promote economy and efficiency in the carrying out of the functions of a relevant undertaker; to ensure that consumers are also protected as respects any activities of such a company which are not attributable to the exercise of functions of a relevant undertaker and in particular by ensuring that the company, in relation to the exercise of its functions, maintains and presents accounts in a suitable form and manner.

The first of the extracts from the Water Bill is concerned with the point that the companies should be able to finance the proper carrying out of their functions. This is obviously in the best interests of customers and the public at large and there can be no sensible dispute. However, the "functions to be financed" are not defined and, significantly, there is no reference at all to "depreciation", "financeability" or "taxation". "Return on capital" is included but in parenthesis giving the impression of being an afterthought not intended to have any real impact on the functions to be financed. There is certainly no indication that the funding should be so generous as to provide, as in the 2005-10 price determinations, a potential operating profit of more than 50% with household bills, in some cases, more than double what they need be.

The lack of intent in the use of the phrase "return on capital" is confirmed in the May 2002 DEFRA report "Water Bill, Consultation on Draft Legislation, Government Response". As reported in paragraph 96 of that report, in the drafting of the 2003 Act it was initially proposed to remove the requirement that companies are able to secure "reasonable returns on their capital". However, Ofwat and the companies apparently believed that this would "increase regulatory risk and undermine the ability to finance their functions". The Government response to the dispute is given in paragraphs 97 and 98 of the same report as follows:

97.    The Government has considered the water companies' concerns carefully. In principle, the removal of these words does not have a real impact on the Director General's statutory duty to ensure that companies can finance their functions. His primary duties would still require him to act so as to secure that the companies can adequately finance their functions. A reasonable rate of return is implicit in this.
98.    However, the Government recognises the importance of perception in the financial markets. There is a risk that the industry and the markets would see the removal of a specific reference to a reasonable rate of return as a negative signal, downgrading its importance. For this reason the Government has concluded that this element of the Director General's duties should not be altered.

As guidance regarding "reasonable returns on their capital" these paragraphs 97 and 98 are not very precise. However, if "companies financing their functions" can be considered as merely implying "a reasonable rate of return" as indicated in paragraph 97, there is obviously no intention that the reference to "return on capital" should have any real impact and clearly no call for revenue surpluses of more than 50%.

The second of the extracts from the Water Bill is concerned with the interests of customers as regards expenditure. As can be seen, the Authority is required to ensure that there is proper financial control and that expenditure is restricted to the activities for which the company is licensed. The Authority is also required, in particular, to ensure that proper accounts are maintained and presented. The extent to which these requirements are met will be considered in the context of a particular company - South West Water.