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Whole systems:              go

 

On Tuesday 13 September, Indepen and THE WATER REPORT will host the 2022 Social Contract Summit – Whole systems go!

 

The event will ask how a whole system approach can deliver more for less from our infrastructure in the face of climate, nature and resources challenges. Added to these is the need for increased resilience of essential services – such as water, energy and transport – in a world where our dependency on them has increased and will continue to do so.

 

This article provides some background to the themes we plan to explore at the Summit. It asks what the terms social contract and whole system can add to our considerations and identifies some implications for infrastructure policy and regulation and for infrastructure companies and their investors.

 

Definitions
The terms social contract and whole system are common parlance in essential services, yet they are capable of meaning many things to many people. Here we set out some thoughts on each of these concepts, and how
they are related. Social contract. The social contract as interpreted by Rousseau and Hobbes is the relationship between citizens and the state in a democracy. Citizens grant power to the state to achieve important things provided the state does not limit unduly the freedom of citizens.

 

As more recently used in business, the term social contract describes the relationship between a company and the society within which it operates. It is sometimes referred to as the company’s licence to operate and make money. This means it is of particular importance to companies that have the clearest form of licence to operate – namely the water and energy utilities whose state sponsored licence grants, for well understood reasons, a monopoly over the provision of services that are essential to society. In return for granting this highly valuable privilege, society is entitled to a quid pro quo.

 

While the quid pro quo is delivered partly via regulation, many think that licensees and their investors should take more responsibility for their legitimacy in the eyes of society than they have done up to now. Government and regulators have their part to play too in maintaining the credibility of the essential services sectors. For example, an efficient solution to getting better water quality in rivers is not solely in the hands of the water companies.

 

Statements and decisions by regulators that do not acknowledge this are damaging to the readiness of investors to fund the massive investments identified as necessary by the National Infrastructure Commission.

 

A whole system, in the context of essential services, includes the activities of all the parties that have a significant part to play in delivering an outcome or outcomes. By definition, these parties and what they do are interlinked, which is why they have to be taken together, rather than being dealt with in silos when forming policy and regulating them. An example would be action to deal with the excessive operation of combined sewer overflows (CSOs). For an efficient and effective approach to this issue, all the parties in the relevant catchment would contribute to providing storm water storage – as well as the wastewater company, the parties would include property owners whose impermeable area runoff went into the sewers, highways authorities, farmers and others.

 

Key aspects of this sort of inclusive, whole system approach.

  • Acknowledging the parties on the receiving end of externalities – benefits and costs imposed on others arising from the production or consumption of goods and services which are not reflected in water and energy bills. Such externalities abound in water and wastewater, such as the effect on local water courses of abstraction for the public water supply, and in energy where the biggest, climate change, takes the form of a global externality.

  • Considering the potential contributions all interested parties can make to the efficiency and effectiveness of the services, as measured for the system as a whole. A topical example is customer flexibility to reduce the peak demand for electricity thereby improving the utilisation of the networks and avoiding or deferring the expense of investing in new capacity. In water, by involving land users in the solution, Entrade has developed services that improve water quality in rivers by changing land use and bringing critical agents together to collaborate. The value delivered includes carbon, biodiversity, soil health and water storage all at a cost which is less than a third of that of conventional options.

  • Considering the full range of options for delivering outcomes – including information based and service solutions as well as built assets. This might entail new business models – such as those we see emerging in the energy sector for flexibility services and community responses. How these will be regulated and governed needs careful thought to minimise the barriers to their success.

 

 

One way of describing this is to say that policy about and regulation of the utilities should be based on the principles set out in HMT’s Green Book and not by the much narrower principles underlying the Financial Conduct  Authority (FCA)’s accounting standards, which are limited to financial valuations for parties to commercial transactions.

 

Markets and regulation

If important parts of the system are left in their separate silos with important interactions unexplored and many interests excluded, we would expect to see policies and regulation that were wasteful and ineffective.

 

Following from this we would seethe legitimacy of essential service providers declining. An example is the reputational damage that has followed revelations about the extent of sewage discharges into rivers. The sector’s reputation, like the solution to the CSO problem itself, is not solely in the hands of the companies. Policy makers and regulators have their part to play and statements that are partial, uninformed or wide of the mark are not constructive and make the problem more difficult to solve.

 

For these and other reasons, whole system thinking and the social contract are related. Because of the numerous parties involved in a whole system, the governance and coordination arrangements will have to be subtle and effective if good solutions are to be adopted. Ideally, market mechanisms would provide much of this. We already observe examples of this with flexibility markets in energy and nutrient trading in the water sector.

 

In some of the areas of concern, markets are non-existent or sparse, and in some others they may not emerge. Until they do, the relationships and contractual controls that will form part of an effective social contract can be combined with subtle regulation to deliver improved performance and outcomes.

 

Implications

There are many implications of placing social contracting in the context of the whole system. One important matter for discussion at the 2022 Social Contract Summit is the focus this puts on what shareholders and the essential service businesses they own can do as part of the whole system to meet the quid pro quo under the social contract.

 

Correspondingly, policy makers and regulators also have to broaden their scope. This will mean identifying and engaging with all the interested and relevant parties and all the approaches and options that can result in getting more for less. They should not limit their thinking to services received in return for paying a utility bill.

 

Customers and communities too have their part to play, by engaging with the issues in ways that allow them to take decisions in their own interests that are also in the interest of the system.

 

The list of relevant considerations for policy makers, regulators, shareholders, companies and customers is long. Some of the areas which we hope the Summit will explore are to do with defining, refining and most importantly using the tools in the system toolbox.

 

Examples

  • Agreeing on outcomes in which everyone has an interest.

  • The scope for better and more transparent governance in essential service companies and their regulators, including the acknowledgement of broader purposes and value accruing to all parties – the bigger cake – as well as new business models.

  • Explicit consideration of how the bigger cake should be divided fairly and how tradeoffs, including intergenerational trade-offs, should be made rather than swept under the carpet.

  • Better quality and coverage of data and the insights it gives to encompass all the parties, now and in future.

  • Pooling resources and risks across parties and silos.

  • Having more regard to national, regional and local considerations including the diversity of circumstances and solutions.

  • More effective enforcement – involving regulators and the parties to the social contract.

  • More attention in policy and regulation to:

• system efficiency (referred to by economists as allocative efficiency – and notable by its absence in regulatory thinking up to now);

• behavioural and demand side possibilities – opening up the possibilities of system innovation • better quality customer research; and

• more inclusive stakeholder engagement including with communities and campaigners.

Opportunity

The context of increasing demands on utility services (all well rehearsed), uncertainty (more surprises to come) and concerns about the cost of living and its differential impact on some in society means that action is urgent. Expectations of radical change are, or should be, high.

 

Fortunately, the water sector has the beginnings of a better approach.

  • The principles in the Environment Act 2021 which provide ample scope for improved policy and regulation.

  • The WINEP, a nexus of the matters discussed in this piece, is in the course of redesign, which will incorporate considerations of the social contract and the relevant system.

  • Ofwat’s intention to focus PR24 on longer term considerations and trade offs.

 

The community of investors in the water sector has little to say about these matters, at least in public. Focusing on investment, the National Infrastructure Commission says:

“The current regulatory system has mostly achieved what it set out to do. … Over the last thirty years, this regulatory system has delivered the high and stable investment it was designed to achieve, improved performance, and provided stability and predictability for investors.

 

"However, the regulatory system has not adequately addressed societal interests … To achieve the transformational change required, public and political confidence in the system must be improved, to provide greater stability and certainty for investors. It is vital that the right conditions are in place to ensure government, regulators and industry can respond as effectively as possible to these challenges.”

 

We see this as a description of a social contract between society and the system:

  • the system has worked well for shareholders, not so well for society;

  • we need a lot of investment – most of which will have to be financed by private capital;

  • investors will finance only if customers will pay; and

  • customers will be willing to pay only if they have confidence in the system. To do what is required, the system must earn greater public confidence.

A more effective social contract depends on the role of shareholders being more soundly based in ethical and behavioural considerations and better understood by customers and stakeholders. If this were to happen, but only if, there would be abundant opportunities for investors that would improve the performance and value of our infrastructure for all.

 

What are we waiting for?

If important parts of the system are left in their separate silos with important interactions unexplored and many interests excluded, we would expect to see policies and regulation that were wasteful and ineffective.
 
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