Water Clean Up and Transparency: Corporate and Regulatory Accountability in the Water Industry. Jean Shaoul

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1 Water Clean Up and Transparency: Corporate and Regulatory Accountability in the Water Industry by Jean Shaoul Paper for Critical Management Studies Conference Accounting Stream UMIST, Manchester, July

2 April 1999 Dr Jean Shaoul Manchester School of Accounting and Finance Manchester University Manchester M13 9PL UK Tel : Fax : Web site : 2

3 Water Clean Up and Transparency: Corporate and Regulatory Accountability in the Water Industry Abstract Despite the expensive cleanup programme which was used to justify higher charges for the privatised water and sewerage services, there have been repeated complaints about: underinvestment and the quality of the drinking water, as evidenced by the outbreaks of cryptosporidiosis, the disgusting state of Britain's beaches, and the poor quality of the rivers and estuaries. It raises important issues of accountability, both of the corporations and their regulators, that go beyond the specific case of the water industry. This paper uses a case study approach and examines performance, programme and policy accountability, through an empirical analysis of the corporate and regulatory accountability of the privatised water and sewerage industry in England and Wales. The evidence showed that the regulators varied in the degree to which they had put the information into the public domain that enabled the performance of the water and sewerage industry per se to be monitored. But in general there was insufficient information to monitor performance or performance relative to the finances generated by consumers rigorously. The lack of action stems from the lack of regulatory will, not power. Privatisation removed the limited system of parliamentary scrutiny of the industry while instituting no compensating arrangements for holding the regulators to account or seeking private redress. Without ownership and control, few of the conditions for performance, programme or policy accountability to the public for the most essential public services exist. 3

4 Water Clean Up and Transparency: Corporate and Regulatory Accountability in the Water Industry Introduction There have been a number of concerns about the performance of the privatised water and sewerage industry in England and Wales : the adequacy and safety of the water supply, leakages, the state of the infrastructure, and the failure to improve the quality of coastal, esturial and river waters via sewage treatments works which consumers thought they had paid for in higher prices. Yet one of the primary justifications for the privatisation of the water industry, organised as regional monopolies, was that the capital markets would provide the finance, which government could not provide, for the much needed replacement of the crumbling infrastructure and for the European Union (EU) determined 28bn investment programme to improve drinking water quality, public health and environmental standards. The privatised industry would be able to deliver the quality and environmental standards that a publicly funded industry could not. The Government devised a tripartite framework of quality, environmental and economic regulation to ensure consumer protection. The newly established National Rivers Authority (NRA), superseded by the Environment Agency (EA) in 1996, would set environmental standards for river, estuary and coastal water quality which would in effect control the 'dirty water' activities of the water industry. The Drinking Water Inspectorate (DWI) would enforce drinking water quality standards set by the government, and control the 'clean water' side of the industry. A new economic regulatory agency, the Office of Water Services (OFWAT) whose costs would be defrayed by the licence fee paid by the companies, would protect the customer from monopolistic suppliers while at the same time guaranteeing the financial viability of the industry. The basic method of regulation was price capping which would limit prices and provide managers with the pressure and incentives to deliver greater efficiency, quality, reduced costs and effective investment. In addition, the regulator would ensure certain minimum standards of service delivery. So regulation was essentially two dimensional. Firstly the economic regulator would ensure that the companies were able to finance their statutory duties to supply water and sewerage services, by setting prices to cover the cost of maintenance and enhancement of the infrastructure and the additional quality standards set by the quality regulators, clawing 4

5 back of any excess profits in subsequent price reviews; and he would also ensure that customers' standards of service were protected. Secondly the quality regulators would ensure that the companies met the quality standards. Given this regulatory framework and the in effect underwriting of the companies' financial viability, the satisfactory environmental performance of the water industry seemed assured. But in practice, the economic regulator sanctioned and justified price rises on the basis of a costly investment programme which turned out to be less expensive than forecast. He did not claw back profits as he said he would. He allowed prices to rise in the second five year period, although less steeply than before. The repeated complaints about the industry raises a series of questions as to whether the industry had spent less than expected, whether the investment as designed and/or implemented complied with the quality standards, and whether and how the regulators had monitored the companies' financial and physical performance - in other words, the accountability of the corporations and the regulators. The concept of accountability has attracted increasing attention in two major ways : firstly the extension of accountability of private corporations for their social and environmental performance to other stakeholders and secondly the accountability of public sector organisations to the public as providers of finance and consumers of its services. In the context of the private sector, the objective of increased accountability is to limit the excesses of corporate behaviour at the expense of other social groups, ethics and the environment (Gray et al, 1987, 1996). If successful, accountability for external costs would change behaviour and probably increase internal costs. Their proposals, and those of the school of Corporate Social Reporting, are to include other stakeholders in management, improve social responsibility via regulation and change formal financial reporting systems and the disclosure of various kinds of information in ways that would be useful to other stakeholders. The view that better management, by actively including or responding to the needs of other stakeholders, will bring benefits to all has been challenged theoretically by Tinker (1980) and Cooper and Sherer (1984). Such proposals are largely concerned with what companies should do in the light of ideas about public and social accountability. Their research has largely examined the extent of, variations in and reasons for corporate disclosure and made suggestions for new forms of social and environmental accounts such as annual External Social Audits and Environmental Reports. Yet much, but not all, of the desired disclosure relates to information which has to be reported to or is collected by the various (public and private) regulatory authorities. For example, the number and severity of 5

6 workplace accidents, the number and findings of fire, health and safety inspectors relating to both employees and the products and production processes and the actions taken, compliance with discharge consents for the disposal of waste and effluent, to name but a few. At present such data have to be obtained from the reports of the appropriate government agencies. But not all such information is published or made available in annual reports, e.g., inspection of food premises, failure to implement the regulations on the separation of Specified Bovine Offal (SBO), so crucial in the spread of Mad Cow Disease. Even where this information is published, it is usually impossible to relate it directly to the individual company or even sector concerned, e.g., microbiological contamination of food (Schofield and Shaoul 1998). This in turn raises questions about the accountability of the regulatory authorities and the extent to which in practice they shield the very corporations they purport to regulate. Hence, in part at least, the distinction between public and private sector accountability may be more apparent than real. In the context of the state owned enterprises and public services, accountability has spawned the development of performance indicators. These appear to have begun with a report recommending the establishment of explicit standards of performance for the nationalised industries (NEDO 1976). The government's White Paper (Cmnd 7131, 1978) accepted the proposal and coined the expression 'performance indicator'. Extended to cover all the public services in the 1980s and 1990s, they are to be used as the basis for allocating resources in the National Health Service (DoH 1997) and paying teachers in the next decade. From its origins at the time of the IMF imposed cuts in public expenditure in the 1970s, accountability in the public sector has emphasised inputs and throughputs at the expense of outcomes and equity (Allen et al 1987, Gray and Jenkins 1986, Pollitt 1986). In effect, accountability in the public sector has come to parallel the financial accountability of an enterprise to its shareholders. As such, it has provided the rationale for increasing throughputs and outputs while holding down costs. Thus accountability is not an unproblematic concept and has been used in different ways in different contexts. It is usually discussed in terms of the relationship between the agent and principal (Mayston 1993). It implies both rendering an account and being held to account for some function(s) that the organisation is required to perform to some external principal. However, in the case of the public sector, the principal is not clear cut. It could be the government, consumers, taxpayers and/or the public(s) at large. Accountability may be a statutory requirement (Normanton 1966) or a legimitating requirement (Stewart 1984). According to Stewart (1984), accountability involves specifying both the scope of the accounts that the agent must provide and the mechanisms whereby the agents can be held to 6

7 account. He proposes an extensive ladder which includes accountability for probity and legality; the adequacy of internal control systems or process accountability; performance in relation to established standards or performance accountability; outcomes in terms of objectives or programme accountability; and outcomes in terms of acceptability or policy acceptability. Much of the New Public Sector Management has been concerned with the lower levels of accountability. Another stream of accounting research into accountability has sought to understand existing accountability practices from a more general theoretical perspective (Roberts and Scapens 1985). While others (Laughlin 1990) have stressed the importance of studying financial accountability in its organisational context to understand how it actually operated before devising alternative schema. This paper seeks to extend some of this research and address the higher levels of accountability : performance, programme and policy accountability, through an empirical analysis of the corporate and regulatory accountability of the privatised water and sewerage industry in England and Wales. It thereby enables an evaluation to be made of the characteristics of useful corporate performance reporting; the claims that regulation can protect consumers and the public at large from the effects of corporate cost cutting in the pursuit of profit; and the conditions under which corporations and their regulators can be held accountable to the public. The water industry is particularly interesting because for public health reasons, performance has been monitored more closely than many other industries. There are only 10 water and sewerage companies (although there are 16 water only companies), making it relatively straightforward to control. Furthermore, the kinds of output measures used to evaluate the performance of the water industry are very similar to those required to evaluate the environmental performance of other industrial corporations. Thus the case and the issues thereby raised have a relevance beyond the regulation of the water industry. The economic regulator recognised that the development of systems for monitoring and reporting performance was crucial to an effective system of regulation and accountability. He said : "Regulation has become more transparent. Quality regulators make independent checks and publish their results - again in advance of practice in other countries. Information from OFWAT dwarfs what was provided in the past. Regulatory decisions are 7

8 explained and properly documented" (Byatt 1996) [Emphasis added] This paper therefore examines empirically the content of the three regulators' reporting and the transparency of the economic regulator's evaluation of the first five year investment programme. This necessarily entails a review of : the investment programme as set out at privatisation; the system of monitoring and external reporting that was put in place; the extent to which the investment programme had been implemented by 1995, the end of the first 5 year phase of the programme; the companies' financial resources and capital expenditure; and the companies' compliance with the quality standards. While the paper presents a financial and physical performance of the industry, it is primarily concerned with accountability rather than either the regulators' quality standards or the industry's environmental performance per se. This paper is divided into several sections. An initial section sets out the relationship between the investment programme and the price setting programme. It then examines the planned and actual expenditure on capital investment and infrastructure renewals. A third section evaluates the activities and outputs of the investment as publicly reported by the regulators. The next section reviews and evaluates the mechanisms for ensuring transparency and accountability in the context of the privatised water industry. The final section discusses the implications for the water industry in particular and accountability in general. The Relationship Between the Investment Programme and the Price Setting Process The investment programme was determined by several factors : estimates of demand for services, wider statutory obligations such as fire, and the need to meet the new and existing waste water and environmental standards, drinking water quality and levels of service measures. Firstly the government determined drinking water regulations based on the 1980 EU Directive (809/778/EEC) and additional domestic considerations. It specified the standards for a large number of parameters and established the Drinking Water Inspectorate (DWI), part of the Department of the Environment to enforce these standards. These standards determined the investment in additional water treatment and the replacement of corroded pipes which affect water quality. The second regulatory agency, the Department of the Environment and the newly formed National Rivers Authority (NRA), reconstituted in 1996 as the Environment Agency (EA), is responsible for the overall management and 8

9 resource planning of the water environment. It determined the standards for urban waste and coastal waters clean up, etc. This in turn determined the level of treatment required before sewage effluent could be discharged into the rivers and seas and the method of sewage sludge disposal since after 1998 sludge could not be dumped at sea, a practice uniquely continued by Britain. The Ministry of Agriculture, Fisheries and Food would determine the standards for the disposal of sewage sludge on farmland. Thirdly, the companies, government and the economic regulator, OFWAT, jointly agreed on and defined various measures of performance, or levels of service indicators, known as DG1-7. These measures relate to the adequacy of the water supply, risk of unplanned interruptions, inadequate water pressure, the risk of flooding from sewers, and customer service. While these measures were to be published annually by OFWAT, no standardised reporting methodology was specified. The companies set themselves targets for with a commensurate investment programme. The processes to meet demand, system maintenance and the regulators' requirements were then costed and submitted to the Government in its capacity as regulator before privatisation, since replaced by the economic regulator, OFWAT, for the and periods, as part of the information required for price setting. If any new and more costly standards were imposed, the companies could apply to OFWAT to raise their price cap. OFWAT has no direct role in assessing the financial implications of and deciding on environmental policies, although as standards are being determined at the national level, it can explain the implications for consumer prices. Thus the regulatory regime, established at privatisation, is very fragmented. OFWAT operates within a wider regulatory regime and the interrelationship between the agencies is important. Prices were then set using a capping formula which consists of two elements : (i) an expected level of efficiency savings of about 2% per year and (ii) the amount which has to cover rising capital investments and quality standards. This price cap or K factor as it has become known was set at about 5% above the Retail Price Index (RPI) for the water industry as a whole, although this varied between the companies depending on their investment programme. The price cap, once fixed, was to stand for five or ten years and was intended to give incentives to the companies to improve efficiency, reduce costs and earn extra profits over and beyond that implied by the price capping formula. Any excess profits could be clawed via the price capping formula for the next period (OFWAT 1992a). Thus several points should be noted. Regulatory control was fragmented and not necessarily complete. Despite the fact the standards were set, in 9

10 practice the companies determined the processes and actions they would take. This distinction is important because standard setting begs the question of how they are to be achieved. In the absence of a clear one-toone relationship between processes and outputs, this may be problematic. Although the regulations stipulated certain standards or outputs, the processes or means by which they were to be achieved were not. The companies were free to develop their own solutions and plans and if these seemed reasonable to the quality regulators, they were accepted. For example, if water quality fell below the permitted standard on a particular parameter which they were now required to meet, the water companies could specify levels of treatment and this would be incorporated into a 'legal undertaking'. Although the economic uses consulting engineers to check their plans: "Their role was not to pass judgement on the companies' plans". (OFWAT 1994b, p19) Their role was simply to check the costs in relation to the plans. There was therefore no guarantee that the remedial measure would achieve the desired output. But the legal undertaking or plans referred to the process not the standard, the details of which were not published. While the regulatory system appears to build in safeguards via performance and quality indicators, it in practice focuses on processes and activities. This chain therefore leaves unclear who bears the cost if the processes agreed with the regulators fails to achieve the specified standard : the company or the consumer via prices set to meet any additional investment. The clear implication of the financial arrangements is that since the companies were required to deliver certain outputs they should bear the costs of failure. From the perspective of accountability, this implies that the quality regulators monitor, report and enforce compliance with the standards and completion of the stated programme of work and the interrelationship between them; and the economic regulator monitors, reports and enforces compliance with the standards, the completion of the programme of work and the financial costs and their inter-relationship. Without such a system of accountability, the consumer could either be charged again the same work at a subsequent Price Review and/or fail to get value for money. The Cost of the Investment Programme The government issued a privatisation prospectus (Schroders 1989) for the 10 water and sewerage businesses which itemised the investment programme by segment, service and company for each of the two periods and The total planned investment was 12,785m for the first five 10

11 years, 11,800m for the second five years, and 24,585m for the ten years at 1989 prices. The 10 companies planned to spend more on sewerage services ( 6.5bn) than on water services ( 5.0bn). Most of the water expenditure was on water treatment and distribution, with little on supply while most of the sewerage expenditure was on sewage treatment. Spending on the underground network was expected to be about 43% of the total investment programme. While the prospectus broke down expenditure by service it did not provide a detailed breakdown for each service category or even of the programme of work to be carried out, as Tables 1 and 2, which show the planned work on the water mains and sewers, illustrate. The companies themselves provided no systematic financial reporting or breakdown of their projected investment in either their annual report and accounts, drinking water quality reports or environmental accounts. In so far as any information is available, its extent and quality varies between companies and from year to year. The first such breakdown was published by OFWAT eighteen months after privatisation (OFWAT 1991b). OFWAT costed total expenditure for the first five year period at 17,216m in prices for the whole industry including the small water only companies (WOCs). Since the WOCs accounted for less than 5% of the total investment programme and two years' investment had actually been carried out, this meant that planned expenditure had grown by 5bn, an increase of nearly 50%. Water investment had increased by 64% and sewerage by 35%, with the largest increase in sewage treatment. The cause of this increase was not explained. No new obligations were shown, although they were described elsewhere (OFWAT 1992c), and costs in the construction industry were declining due to the recession (NEDC 1992). OFWAT broke down the plans by service for the industry as a whole but not for each company. The service categories were very broad and did not show, for example, the planned number of water treatment works (WTWs) and primary, secondary and tertiary sewage treatment works (STWs) or upgrades per company and the associated costs. Thus to summarise, the publicly available financial information relates solely to the amount of expenditure planned per service for the industry as a whole, not for each company. The expenditure plans are not linked to a specific 'shopping list' of kit for either the industry or the companies. The plans grew from those specified at privatisation for reasons that were not explained. From the perspective of accountability this means that it is impossible to monitor financial expenditure in relation to either the completion of the programme of work or compliance with standards of either the companies, or even the industry, since aggregation may mask changes. 11

12 Accountability then hinges upon monitoring compliance with standards which in turn begs the question of their scope, validity and reliability. Capital Investment and Expenditure on Infrastructure Renewals This section presents an analysis of the post privatisation expenditure of the ten water businesses on new investment and capital maintenance during the period , the period of the first five year price regime. It examines whether the companies did spend their increased revenues generated from price rises on enhancing and maintaining the industry as agreed with the regulators, how the economic regulator viewed their progress in completing the investment programme. But first of all it is necessary to understand the assets and financial arrangements of the industry. There are two types of assets : (i) the overground assets and (ii) the underground network, the physical infrastructure of water mains, sewers, storage reservoirs, etc. The distinction is important because any expenditure on the overground assets or on enhancement and increasing capacity of the underground assets is classified as investment on additional assets and depreciated annually. Any expenditure on the maintenance or renewals of the infrastructure network is classified as 'renewals' and is charged as an operating expense. Thus from a financial perspective, the investment programme relates to the overground system and expansion of the underground system and is quite separate and distinct from system maintenance. Public discussion however conflates the two programmes. This section will deal with both types of expenditure. (i) Expenditure on Additional Fixed Assets (Capital Expenditure) The accounts show that investment in additional fixed assets over the six years between April 1989 and March 1995 totalled bn (Table 3, col 3). After allowing for capital grants from public and European agencies the net cash outlay was bn (Table 4, col 8). Since the investment programme qualified the companies for tax allowances, the real cost to them was even less. But total expected expenditure for the five year period in prices was, according to the prospectus, bn. Thus despite a rise of 34 points on the Retail Price Index (RPI), approximately equal to 30% inflation, and some new obligations, the actual expenditure over 6 years was less than expected over 5 years. Six companies spent less on both services than outlined in the prospectus. The only detailed breakdown of actual expenditure for the 5 year period is that presented by OFWAT (OFWAT 1995a). But it presents summary and aggregated historical financial data for the industry and the regulated 12

13 water and sewerage businesses rolled up into prices in several different ways. Furthermore, some data is presented for five years and some for six. As a result, the information cannot be reconciled with that in the companies' accounts, the expected expenditure, previous years' planned and expected expenditure, or each other. The effect of rolling up expenditure into prices is to give greater weight to expenditure carried out at the beginning of the period when expenditure was greater than to expenditure at the end of the period, and thus make expenditure appear greater. OFWAT calculated the difference based on water industry construction output price index (COPI) and found that it had overspent on water by 20%, was in balance on sewerage and had overspent on both services by 8% (Tables 5, 6, and 3, col 5). The regulator observed: "In aggregate water service expenditure for five years exceeds by 1.05bn the 1989 expectations and the sewerage service is in balance. The expectations have been adjusted for new obligations imposed on the industry since that time". (OFWAT 1995a, p34) [Emphasis added] He did not indicate what they had spent it on. That is, not only did he not consider that the industry had underspent he also used indexation to show that the industry had overspent! But the issue is surely whether the companies had carried out their investment programmes and met their obligations. The same data used by OFWAT is capable of a very different interpretation. It shows that one company had underspent on water, six had underspent on sewerage and 3 had underspent overall. He also presented actual expenditure in several other ways to reflect expenditure at current prices but did not present expected expenditure in analogous ways for comparative purposes. So, unlike most major capital expenditure programmes, the level of investment even at the height of the investment programme turned out to be less expensive than expected. Expenditure had been expected to peak in and then fall back to the levels of and below. In fact it peaked in OFWAT reported that actual capital expenditure was running at "..15% below the level assumed in 1989 (OFWAT 1992b, p4). In part this may have been due to a decline in real terms in construction costs (NEDC 1992). Yet OFWAT had, in the same report, increased its forecast of the cost of the investment programme to bn at 1991 prices, which included two years' work which had already been completed. 13

14 When these 1991 projections are compared with the earlier ones made at privatisation, the largest increases were for sewage treatment and water distribution which were also the services where there were the greatest discrepancy between expected and actual expenditure (Table 7). Although OFWAT had first made a detailed break down of planned expenditure by service in 1991 (OFWAT 1991b) for the industry as a whole, it did not do so for the individual companies. Neither did OFWAT compare the breakdown with the projections at privatisation or actual expenditure thus far. In 1995, OFWAT also produced data in an appendix, part of which was missing from the original report, in an analogous format to the 1991 data (Table 7). This is shows that the industry's actual expenditure in 1995 prices was less than actual and expected expenditure in 1991 prices, but significantly higher than that expected at privatisation in 1989 prices. Its value lies in the fact that it suggests where the underspend occurred : in water distribution and sewage treatment. There are several possible reasons for the 'savings'. The work may have been postponed, not done at all or done using cheaper methods. Some of the requirements to meet the standards may have been relaxed by the relevant authorities. The investment programme may have been overcosted. There is some indirect evidence of over costing. On the basis of the 1990 projections in prices, the programme was costed at 14.3bn for But in 1994 the investment programme for the next ten years was estimated to cost 24bn (OFWAT 1994b) at prices. Of this, about 11bn related to new investment resulting from the Urban Waste Water Treatment and Disposal programme and other EU requirements, with the remainder relating to the balance of investment outstanding from earlier improved standards and maintenance projects ( 13.3bn). Thus in the intervening period the projected cost had declined from 14.3bn to 13.3bn despite RPI rising at about 3% per year. This implies that the original cost projections for the second five year period for which prices had been set as part of the 1989 arrangements were unnecessarily high. This analysis challenges the economic regulator's assessment that the industry had spent more than expected. OFWAT's review of expenditure obscured more than it revealed. While over costing of the investment programme may have been responsible for the underspend, since the regulator did not compare expected and actual expenditure by service segment, it is not clear that this was the sole reason or that all the companies had fulfilled their investment programmes. Several points follow from this. As far as the regulator was concerned, despite evidence to the contrary, the companies had completed, if not 14

15 exceeded, the investment programme. The clear implication is that the regulator was satisfied that they had done so. But irrespective of the validity of his assessment, there is insufficient publicly available information to understand how the money raised from consumers was spent. This in turn raises questions not only about the companies' but also the regulator's accountability. (ii) Expenditure on Infrastructure Renewals The second aspect of capital expenditure relates to infrastructure renewals. Renewals covers repairs to burst mains, leaks, sewers, etc., ie to both the water and sewerage system. This is because the water industry has a vast and aging underground network of infrastructure assets: mains, sewers, impounding and pumped raw water storage reservoirs, dams and sea outfalls, which have a long life and must be maintained indefinitely. In the accounts this is listed as a 'provision' for renewals. The companies estimated how much needed to be spent over a period as part of their 1989 asset management plan and allocated this annually. Thus the actual spend does not necessarily correspond to the 'provision' in any one year but should over the period as a whole which was originally 5 years but has since changed to 15 years without any explanation. While the 'provision' is included in the operating costs in the profit and loss statement, the actual spend is shown in the cash flow statement. The regulator requires the companies to provide asset valuations based on current replacement cost for capital maintenance purposes. Thus these provide a much better basis for assessing the adequacy or otherwise of the infrastructure renewals provision (Byatt 1985). The infrastructure assets represent 75% of the all assets valued in the accounts at about 150bn and are thus worth about 110bn. Since infrastructure assets have a design life of about years, this would imply an annual renewals programme of about 1-2% of their replacement value per annum or 6-12% over the 6 year period to maintain their asset base. If on the other hand, the infrastructure was already in a poor state, one might reasonably expect this annual spend to be up to, say, 5% a year. While the industry argues that the underground network has a life of not years but 300 years, such a long life does assume that, like a car, the individual parts are replaced and maintained. Table 4 shows that for the years since privatisation while the cash cost of the investment programme was about 11.3bn, renewals were about 1.7bn. Renewals increased until 1992 and then declined quite markedly. After taking account of inflation, renewals in 1995 were lower than before privatisation when revenues were very much lower. Furthermore the cash 15

16 spend was lower than the 'provision for renewals' in every year, meaning that the companies had delayed their maintenance programme and built up a reserve of about 285m to be spent on renewals. But by the time they come to spend their accrued provisions, inflation will have eroded some of its value. OFWAT acknowledged the underspend on renewals and explained it away by saying that it was partly due to the effect of effect of indexation : "The charge is indexed each year by RPI but in recent years this has overstated the required level of expenditure since companies have achieved the volume of work programmed at privatisation at lower prices." (OFWAT 1995a, p43). So as far as the regulator was concerned, the work had been completed, and although it had cost less than expected, the companies could keep the 'savings'. One further point should be made. The prospectus had expected that nearly half of the expenditure would be on the infrastructure assets. In the event, expenditure on the renewal of the infrastructure was 13% of all capital expenditure. While this is probably reflects the different conventions used by the prospectus and regulator, nevertheless, it is indicative of the confusion and incoherence of the reporting and accountability processes. (iii) Implications for Accountability Clearly anticipating criticism of the underspend which he had gone to great lengths to disguise, the regulator explained that the companies were required to achieve certain standards, not spend a specified amount of money, a point we will develop later. Although the regulator did say that where companies had not completed the expected outputs by their due date, OFWAT and the quality regulators would take this up with the companies (OFWAT 1995a), he provided no detailed information. He thereby implicitly accepted that some companies had underspent. But in the absence of criticisms by the regulator to the effect that the companies had fallen behind in their investment programmes to any significant degree, it must be assumed that the regulator was at that time generally satisfied that they had carried out their plans. If the companies had indeed carried their plans as originally specified, then it is difficult to avoid the conclusion that inflated costings provided the basis for higher prices. Even more importantly if the companies had not carried out their investment plans in full and/or had not achieved the relevant standards, then they made cash savings at the expense 16

17 of the environment and public health. As a result of the mounting criticism of the water industry, the regulator announced a Periodic Price Review for the second 5 year period, , instead of allowing the prices set in 1989 to stand for 10 years as originally intended. In the event he allowed prices to rise less steeply than before but did not claw back any of the 'savings', saying: "He considers that any retrospective reduction would be harmful to incentives to save costs in the future" (OFWAT 1994b, p9). Several inter-related points follow from this. Without an inventory of the planned and completed investment programme it is impossible to establish the reason for the underspend and thereby hold the companies, or the public bodies charged with their regulation on the public's behalf, to account. While such an inventory may exist, none of the regulators have seen fit to place it in the public domain. The lack of good evidence to justify OFWAT's assessment also calls into question the decision not to claw back any excess profits as he had said he would (OFWAT 1992a). At the very least, it means that his decision was not properly explained. Finally, in the absence of such an inventory, accountability rests, as OFWAT said, on the achievement of certain standards of performance. It is to this we now turn. The Activities and Outputs of the Investment Programme This section examines the companies' activities and assesses their performance and compliance with the new standards to determine whether the companies had achieved the required standards. It firstly discusses the usefulness of the performance indicators and their relationship to the investment programme. It then evaluates performance in relation to the adequacy of water resources, water quality which relates to expenditure on both water treatment and water distribution, the serviceability of the underground water distribution and sewage networks and the effectiveness of the sewage treatment works. Finally it examines the regulators' interpretation of the companies' performance and what action, if any, was taken to enforce compliance. The following summary is based upon a very detailed analysis of all the available environmental data presented elsewhere (Shaoul 1998). (i) Water Resources The only publicly available measures of the adequacy of the companies' water supply are two levels of service indicators, known as DG1 and DG4 which were agreed between the companies, government and economic regulator. It should be noted that OFWAT's reporting year is the financial year, April 17

18 to March, and thus the data does not correspond to either of the quality regulators' reporting years. In relation to water resources, this means that the summer in any given reporting year refers to the summer of the first year mentioned. The first indicator is an index of risk as assessed by the companies that consumers may be at risk of inadequate water supply and the second is a measure of actual outcome : the number of hosepipe bans. Clearly therefore these two measures provide a very limited means of assessing adequacy of the water supply system as was evidenced by the inability to foresee the failure in 1995 of the public water supply to West Yorkshire which was only maintained by a mass tankering operation lasting for three months. The companies set themselves targets in relation to these levels of service indicators for The regulator set his own criterion for the frequency of hosepipe bans, which are imposed to conserve the domestic water supply: "... hosepipe bans, on average, once every ten years" (OFWAT 1995c, p40). But compliance however was not mandatory but voluntary and the status of these levels of service indicators, and targets, is far from clear. At least one of the companies has argued that they are obligations flowing from the statutory duties imposed on the companies (MMC 1995) and the companies themselves reported in the prospectus that the work flowing from those targets were incorporated into their price cap. But the regulator variously interpreted them to be free standing indicators of performance; criteria of satisfactory performance to be used as the basis for rewards or penalties during the 1994 Price Review (OFWAT 1994b); and indices which determine how much extra maintenance expenditure needs to be allowed for in the 1994 Price Review (MMC 1995). The notion of a target implies an improvement, yet in the Price Review the regulator said that improvements must be achieved without higher price limits (OFWAT 1994b). Similarly the regulator's own criterion of the adequacy of the water supply, hosepipe bans no more than once in ten years, was not reported or used to judge a company's performance. This uncoupling of the indicators from their targets and price caps is reflected in the way the regulator presents, interprets and discusses the data, reported annually since April 1990 (OFWAT 1990, 1991a, 1992b, 1993, 1994a, 1995c). They contain a mix of aggregated and individual company data which are not consistent in their format from year to year. This makes historical comparisons of the companies' performance impossible without recourse to the previous reports. After 1992, the reports no longer 18

19 presented the companies' targets alongside their performance. Not surprisingly therefore, there was no evaluation of the companies' performance in relation to their targets, the regulator's criterion of the adequacy of the water supply or any analysis of or explanation for the results. But perhaps most surprisingly of all, the regulator focused on industry performance instead of company performance. He largely interpreted the data to mean that the industry's performance was improving. In fact the data shows that several of the companies had not achieved their targets (Table 8). Nevertheless, OFWAT did not take any action before When reporting on the levels of service for , the regulator did explain he had written to those companies whose performance was particularly poor (OFWAT 1995c), but only after public concern over some of the companies' performance began to emerge. There was no indication that this presented a problem to him from the perspective of the investment programme even though some of the companies that had underperformed had also underspent. To conclude, a number of points should be made. Not only is performance in relation to expenditure on water resources reported publicly on only two measures, those measures that are reported do not conform to any consistent reporting methodology either by the companies or the economic regulator. At least some of the companies had not met the required standards. But poor performance does not give rise to concern or action by the regulator until there is public pressure. From the perspective of the investment programme, all companies with supply problems said in the prospectus that with the planned investment and leakage control for which they had received a price increase, they would have adequate supply, yet seven of the companies had failed the regulator's own criterion and three had not reached their own targets. Irrespective of how much they had spent, they had not delivered the outputs promised. Yet some of these companies had also underspent. (ii) Water Quality Water quality is subject to a more extensive system of reporting to the public by both the companies and the DWI than any other aspect of the industry's performance. The DWI prescribed the sampling, measuring and public reporting procedures for the companies. Yet even this is not unproblematic. The checks on water quality are carried out by the water companies themselves. The reliability and validity of the sampling, measurement and reporting procedures is unclear. Company personnel admitted that there was plenty of leeway in the procedures to minimise unsatisfactory results. Neither is it apparent how the criteria have been determined or the nature and extent of the risk that such levels present to 19

20 the public. While companies produce an annual drinking water quality report (DWQ) on standards achieved and provide details of relaxations and undertakings, there is no common or consistent identification of each undertaking and relaxation or with the Inspectorate's report. The DWI's annual reports showed that performance for the industry as a whole improved on all sixty or so parameters measured except the PAHs. But despite the improvement, compliance was not complete (Table 9). On eleven of the eighteen parameters which had given rise to concern in 1989, more than 2% of zones failed to comply at all times. On five : nitrite, iron, lead, PAHs and other pesticides, less than 80% of zones complied. While nitrites and pesticides need to be removed by treatment, excessive lead, iron and PAHs arise from the condition of the water mains and communications pipes and thus require extensive renovation work to the underground distribution system. This raises questions as to whether in fact the investment on the underground network, one of the main areas of underspend, was in fact completed as specified. It is worth noting that failure to comply with the quality standards is not a criminal offence and is therefore not subject to prosecution. After assessing each failure, the DWI can recommend changes in the company's operational procedures and require it to take action. It can serve an enforcement order and usually the company will give a(nother) undertaking to carry out a programme of work to ensure full compliance. This means that the company can apply to OFWAT for it to be reflected in the price cap. Performance can also be assessed by the number of 'serious incidents' that occurred. The number of such incidents did not decline over the period as might have been expected if water quality was improving. While the DWI has the power to prosecute if it considers water 'unfit' to drink, it in fact only did so three times. This is partially explained by the fact that in practice the DWI's powers to prosecute were limited. In summary a number of points should be made. Drinking water quality is characterised by an extensive public reporting system. Since the quality of drinking water is subject to a fairly consistent reporting methodology, performance can readily be monitored. Non-compliance may result in 'enforcement' actions which consumers may have to pay for via the price cap. All the companies had failed to meet at least one of the required standards in more than 1% of samples. All the companies reported major incidents but rarely faced prosecution. While the DWI's and the companies' reports show performance standards attained relative to the criteria, these reports are not a very effective means of monitoring the investment 20

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