The three waters of Scotland

The Government’s Three Waters Reform Programme continues to generate considerable debate and differing views.

Four new water entities will be established, with councils not able to opt-out of transferring their assets.  MBIE will consult the public on both economic regulation and consumer protections, and the Government, through the DIA, will establish National Transition Unit boards and technical working groups to refine the details of the reforms.

Alan Sutherland is the economic regulator of the Water Industry Commission of Scotland. (WICS). He has also been heavily involved in advising the New Zealand government about its Three Waters policy and understands the challenges and opportunities the sector is facing here.

All sides agree water is critical to supporting good health, sustainable environmental outcomes and a strong economy.  In the following article, Mr Sutherland discusses the lessons learned during Scotland’s water sector reforms and what he believes must be done to ensure successful outcomes are achieved by New Zealand’s reform programme.

What has been the Scottish experience - how can regulation help mature a sector?

In summary, regulation can help mature a sector by acting as a catalyst to:

• Collect consistent, high-quality information from the regulated entity or entities
• Analyse this information to provide an evidence base for reporting on performance and policy development (policymakers are operating on facts rather than whims)
• Ensure proper accountability – providing confidence to customers and communities that the best value is being provided.

Regulation involves a proactive, ex-ante audit, combined with the collection and analysis of vast amounts of information. Arguably from an economic regulator’s perspective this process is more important even than the setting of prices (which is how most seem to describe the regulator’s role).

At first, Scottish Water had only incomplete and inconsistent information. Over the years we have increased the amount of information we collect (through our ‘annual return’ process). The information is clearly defined and we require commentary to support submissions. We use all the information we collect.

The information enables us to:

• Understand what the regulated entity needs in terms of resources, and what is it committing to deliver (capital projects, cost levels, levels of service, levels of compliance with water and wastewater standards, and who will pay what). This provides a clear baseline – a prerequisite of effective economic regulation.
• We can then use this baseline to ensure that what has been committed to is delivered. We do this by regularly scrutinising the progress of each investment project. Any variances must be explained and there needs to be a clear plan about how they will be addressed. So no cutting corners!
• Report back the findings – through direct dialogue with the company (poking and prodding!) and detailed published commentaries covering areas such as investment, customer service, costs and performance.

This reporting of performance allows for evidenced policy to be pursued. It is also the principal force for improving performance – ensuring customers and communities can have confidence that value for money will be delivered.

Reporting performance transparently and consistently has enabled Scottish Water to go from, by some distance, the poorest performer in the United Kingdom (poor customer service, very inefficient, sketchy management information) to one of the best utilities.  Our analysis – based on information provided by the Councils – indicates a similar prize is on offer through New Zealand’s Three Waters reform.

What does it take for a sector to move from short-term to longer-term thinking?

We started to look for answers to this question during the early stages of our last Strategic Review of Charges (the process through which we determine charges), covering the period 2021-27.

We wanted to ensure there were no regulatory barriers that would hinder Scottish Water from facing today’s big challenges. In particular, when we consider both embedded and operating carbon, the importance of the water industry to the government’s ambition to achieve net zero emissions is difficult to overstate. This is why Scottish Water has a requirement to achieve net zero emissions by 2040 – five years ahead of the rest of Scotland.

At the same time, many of Scottish Water’s assets, such as pipes and sewers, are ageing and need to be replaced. And these challenges must be addressed while the high levels of service customers enjoy today are maintained.

We came to understand that the traditional regulatory model, which focuses on how much money is spent in short-term regulatory control periods, did not provide the right incentives or level of flexibility required to tackle the big challenges we face today. When the focus is on the short term (at best a six-year regulatory control period), no regulated entity can make confident plans where payback extends beyond the next price setting exercise. This is because of the basic principle of economic regulation that it is the hard budget constraint which underpins any regulatory incentive framework.

We began to develop an alternative approach, moving away from the short-term thinking inherent in traditional regulatory models to focus instead on how we might work together with other stakeholders to deliver the best outcomes for Scotland’s current and future customers.

As part of this, the regulated entity must ‘own’ its performance. No more “we can’t do this because we are not funded to” and no hiding behind other stakeholders. The onus is on the utility to establish and maintain the trust of society, communities and its customers.

Together with Scottish Water and other stakeholders we’ve agreed that there should be clear, open and transparent discussions about the work that needs to be done, and how much this might cost.

It has been, and will continue to be, a voyage of discovery for our stakeholders but we have agreed that Scottish Water needs more investment and more flexibility to address future challenges. We expect Scottish Water will take full ownership of its strategy, investment plans and relationship with customers.

WICS will assess how candid and forward-looking Scottish Water is being, commenting regularly on its performance. And we’ll continue to check the quality of information and analysis it’s using for decision making.

We believe that if Scottish Water is being appropriately open and candid in the information it provides and uses robust analysis to underpin the decisions it makes, customers and regulators will understand what it is doing with their money (in terms of levels of service, impacts of adapting to and mitigating climate change, performance, investment and so on).

Ultimately of course we hope this approach will give us the best possible chance of addressing the big challenges that span much further than just one or two regulatory control periods. Our aim is to make sure our water system is still fit for purpose more than 30 years from now. This is an aspiration that customers and communities in New Zealand could also reasonably look towards achieving.  

Where does one begin where there has been a large historic underinvestment and there are many competing needs: maintenance of current networks, growing population, new technology and values, higher customer expectations; innovating within set budgets?

Unfortunately, underinvestment in the sector is endemic. If we look back, the whole rationale pre-privatisation was that there had been a substantial lack of investment – both in England, Wales and Scotland.

It was to address the lack of investment and high level of inefficiency that existed that in Scotland we moved from three authorities to the single entity Scottish Water. At that point we again underestimated how much we were going to have to spend to address water quality and environmental issues.

With economic regulation firmly established since 2002 we have improved our understanding of what needed to happen (and the costs of that) but have still, in fact, underinvested relative to what we actually needed to be doing.

Assets are long-life assets and for much of the asset base the consequences of underinvestment do not emerge for a long time. It is only over time that choices become obvious. Truly long-term priorities such as asset replacement and adapting to, and mitigating, climate change may well come down on the list after more short-term priorities including water quality and wastewater improvements and service level improvements. However, that does not make them any less important. In fact, if the company does not make a start on addressing these challenges in the short term then at some point they will become unattainable.

Space needs to be allowed to have the discussions about short and long-term priorities – rather than waiting for things to become urgent.

How can the water entities go about making trade-offs when there are different owners and stakeholder needs? Owner councils (land use planning), iwi, water quality regulator, economic regulator, customers?

The short answer would be that for us that question should never arise – if the right governance arrangements are in place. In our view, it is not for water entities to be making those trade-offs; rather it is for the owners and policy makers (in our case the Scottish Government).

Certainly when reflecting on the experience in Scotland, for maximum benefits to be available for customers, communities and the environment, the overall policy, regulatory and operational governance framework need to be fully aligned.

Several factors are likely to be critical in this regard but key will be to empower regulation and to establish a clear and binding set of policy objectives.

Empowering regulation

The regulatory framework must be charged with achieving specific outcomes, and regulators should be able to work collaboratively to bring about the outcomes the Government sets out.

Regulators should have full latitude in how they fulfil their statutory remit – within the policy framework established by Government. Scottish Water is clear that its ability to manage effectively stems from the clear policy direction it is given.

Regulators should be held accountable as an institution, but should act, and be seen to act, independently within the policy framework. Regulators’ interpretations of legal requirements should also, in that regard, be respected. The focus, for those who do not agree with policy direction, should be on the policy, not on how the regulators implement that policy.

This suggests there are two separate tiers for the input of stakeholder views. The first is to input to Ministers as they formulate their longer-term policy objectives; and then there will be stakeholder views about how specified policy objectives are to be met in practice. 

It is also important that the duties of economic regulators are well defined and do not stray into the policy space. Economic regulation in Scotland is accountable through the courts on the process that it follows (judicial review) and, ultimately, for its charge setting determinations to the Competition and Markets Authority (a merits review).

Establishing a clear and binding set of policy objectives

It is important to be clear about the ambition for the sector. It is not desirable to have regulators or the regulated entities pursuing different agendas. An economic regulator may also tend to favour a ‘pay later’ approach whereas a quality regulator may favour the ‘improve now’ option. Such sources of tension would likely reduce the pressure on the regulated entities to up their game. They offer a source of excuses or opportunities to play regulators off against each other.

In Scotland, Scottish Ministers establish a defined set of policy objectives. This process began in 2005 and substantially resolved many of the underlying tensions that had been counter-productive to improving performance in the earlier years. They also publish a Statement on the Principles of Charging and a set of Ministerial Objectives for the performance of the water sector. Ministers make these decisions after an extended and iterative process of consultation.

What will be the challenges/benefits of aggregating water assets, different governance model, water quality/economic regulation?

We believe there are benefits to be gained from aggregating the water assets, based on our experience in Scotland and our analysis of the information that has been provided to us in New Zealand. For example, larger entities are more likely to have in place specialists performing the role, because they are large enough to sustain those specialists.

However, the benefits are not a given. They require solid management, clear governance and effective regulation. All three legs of this three-legged stool need to be effective.

If New Zealand is to realise the benefits that are available, if the three-legged stool is to stay upright, the key factor will be the quality and consistency of information that is made available by the regulated entities. Good information will be the foundation on which the reform programme rests. It allows what must be done to be defined in detail, to be measured clearly, to be reported on transparently and for the whole sector – for all three legs of the stool – to be clearly held to account. After all, accountability is only ever as good as the information reported and presented. What we want to be in place is fact-based, evidenced policy making, rather than decision making through a political lens.  

What support will boards need to help steer through the change?

Very much in line with my responses above, it is critical that boards are empowered, and have the clarity they will need about what outcomes they are being tasked with delivering. There will also need to be clarity in relation to who will pay for what, and how much will be collected (through, for example, the Principles of Charging type guidance that Scottish Ministers publish.

This level of detail can only flow from an evidence base, founded on high-quality information about customers, the asset base, the investments that will be required, costs incurred and performance levels.

Finally, how might NZ’s Three Waters Programme promote decarbonisation, and build the water infrastructure needed that aligns with our climate change obligations?  Won’t innovative solutions be more expensive?

This brings us back to the three elements of effective reform – solid management, clear governance and effective regulation. In Scotland it is the Scottish Government that determines priorities – in relation to critical aspects of the water and wastewater service including adapting to and mitigating climate, dealing with water quality improvements and environmental discharges. It is all urgent and important, but clearly it cannot all be done at once. Hence the need for clear objectives for the sector to be defined by the owners and policy makers.

Arguably, New Zealand’s sector will be in a stronger position to face future challenges, including decarbonisation and building the water infrastructure it needs, if it grasps the opportunity provided by the reform programme. This assumes the reform is done properly (with no short cuts) and the sector is able to make use of the benefits available through more efficiency, better evidence and analysis, and stronger accountability.

In relation to innovation, innovative solutions are not necessarily more expensive; instead they should be better and more effective.

The IoD supports the use of governance best practice when developing a governance structure for the Three Waters . It will be important to ensure the right people with the right skills and experience are around the table; that directors’ skillsets and experience are sufficiently broad to allow for different perspectives and there are mechanisms in place that allow for clear policy to be set. Once we see more detail on the arrangements, we will be making a submission on the governance arrangements.