Water regulation: the periodic review

Since the privatisation of the water industry in 1989, issues relating to the pricing of water, charging structures and the conduct of the water regulators have rarely been out of public attention. Water prices have increased ahead of inflation, in some cases by more than 10 per cent per annum, profits have been high, construction costs have fallen dramatically in the recession and the investment requirements to meet EC Directives have been revised upwards. In the first years following privatisation, the Director General (DG) of the Office of Water Services (OFWAT), the economic regulator of the industry, has, in the face of major shocks, used his discretion to intervene in the pricing and investment arrangements repeatedly. Indeed, the shocks have been so large that the DG has brought forward the review of the regulatory formula governing prices from 1999-2000 to 1994-95. It is this review of the price limits (called the Periodic Review) which is the subject of this paper. The review will be far reaching, involving decisions about the appropriate cost of capital for the industry, the valuation of existing assets, the capital expenditures required to meet environmental quality targets, and the level of operating costs and efficiency. To date, the DG has issued a series of consultation papers, culminating in Setting Price Limits for Water and Sewerage Services: The Framework and Approach to the 1994 Periodic Review, published in November 1993, which details his approach to the Periodic Review. The aim of this paper is to examine the economic principles underlying the DG’s approach and to consider the implications for the future of water regulation. The structure of the paper is as follows. Section II provides an overview of the current regulatory regime, which was set up at privatisation. Section III considers how the regulatory framework has developed since 1989, with particular focus on the capital expenditure out-turn, shareholder returns and the revisions to the process instigated by the DG. Section IV analyses the DG’s approach to the Periodic Review and describes the ways in which pressure has been brought to bear on the various components of the capital expenditure, cost of capital, asset valuation and operating expenditure to reduce the rate of increase in prices. Section V provides an assessment of the prospects for the success of the DG’s approach. Finally, in Section VI, we summarise our main conclusions.