Cunliffe Commission interim findings: quick read summary and financial analysis

Quick read summary – by Karma Loveday

Regulatory ‘account managers’ for water companies and new duties on water management teams feature alongside the widely expected themes of clearer long-term strategy and better system planning in the Cunliffe Commission’s interim report, out today.

The report offers a direction of travel on key topics, rather than a comprehensive view on all issues.

It sets out the ‘what’ and leaves the ‘how’ still to play for.

Here is an at-a-glance summary of the interim findings.

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CURRENT SITUATION

• The current system is not delivering what people expect and need.

• With the exception of the “highly effective” Drinking Water Inspectorate, regulation has lost trust and is not delivering desired outcomes. Environmental regulation has been compromised by capacity and capability challenges.

• Restoring public trust is paramount.

• “There is no simple, single change, no matter how radical, that will deliver the fundamental ‘reset’ of the water sector that is the governments’ objective. The current position derives from a complex and interlocking set of issues which need to be addressed concurrently.”

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KEY AREAS FOR REFORM

Long-term strategic vision

• “A credible reset must be grounded in a long-term strategic vision that is sustained over political and regulatory cycles. This is also important to support smoothing of customer bills over time, avoiding the spikes we have seen in the most recent price review.”

• To include: clearer direction on objectives, priorities and milestones for the achievement of longer-term targets, and government guidance on trade-offs.

System planning

• A better planning framework is needed to translate the overarching strategic goals and priorities into investment and improvement.

• This should be regional in England, and mapped to hydrological boundaries, such as river basins. There is consideration of how to ensure a strong role for local authorities, given their democratic accountability, planning and economic development responsibilities. There are options for organisational structure – potentially committees within an existing regulatory body or more freestanding bodies. In addition: “They should be clearly connected to local voice and draw on local catchment-based partnerships. It is crucial that such regional water system arrangements have real authority in relation to water industry investment and to water related resources directed at other sectors.” Planning mechanisms from energy, flooding and local government are being considered for lessons.

• System planning should be at the national level in Wales: cross sectoral and involving local groups.

  
  

Business planning

• Current water industry business planning processes must be simplified and rationalised in light of the above changes.

Legislative framework

• The current framework should be streamlined to remove overlap and contradiction; to clarify lines of responsibility; and to reduce complexity that has built up over time.

• It should also be updated to take account of the latest science and public expectations – in particular, on public health given increased recreational water use. This is to include a review of the Water Framework Directive.

• To increase flexibility, in line with the Corry Review, “we see a role for constrained discretion within the regulatory framework – flexibility to support decisions that allow for innovation, such as nature-based solutions, while maintaining clear accountability. Such an approach can help unlock both environmental and economic objectives and support long-term investment in a more adaptive sector.”

Economic regulation

• A strong company-specific ‘supervisory’ function in the economic regulator should be developed to sit alongside its econometric benchmarking function. This would enable greater account to be taken of company circumstances while maintaining customer protection.

• “It should be the responsibility of the supervisory function to develop a strong, judgement-based, senior-level understanding of, and engagement with, each individual firm. This would enable the regulator to better understand its challenges, support positive company action and intervene early to address actions that run counter to the public interest. Price and objective-setting by the economic regulator should be based equally on industry-wide benchmarking and a company-specific judgement that takes into account whether a company has improved or deteriorated relative to its previous performance, as well as relative to an industry-wide benchmark.”

• Building a supervisory function will “demand significant change in the culture, capacity and capability of the economic regulator and to its governance.” This will include recruiting “high calibre engineering and financial engineering expertise” and powers and tools to intervene to ensure companies act in the public interest – and potentially “additional tools to direct companies and intervene in changes of ownership of water companies”.

Environmental regulation

• On top of changes in train, the Commission is exploring how environmental regulation can be strengthened and modernised, including through the use of digital monitoring and permitting technologies to improve regulator capability and efficiency.

• The system planning and legislative review proposals above should also allow the environmental regulator to focus more on monitoring and enforcement and support a less risk-averse culture where that is appropriate.

Regulatory alignment

• Regulatory alignment needs to be improved. “Options for how this might be done range from rationalising the respective duties and remits of the regulators, and more effective processes for reconciling objectives, to more fundamental, structural options for integrating regulatory remits and functions.” All options are on the table, and costs and benefits being looked at.

Customer voice

• The customer voice should be strengthened; other sectors’ experiences are being considered.

• The Commission is also looking at options to strengthen customer protections and customer redress schemes.

Investment

• Water should return to low risk, low return status.

• In large part, this means restoring confidence in the stability and predictability of the regulatory system. The long-term vision from government will help but the Commission is also “exploring how regulatory mechanisms could be developed to narrow the variability of returns, reducing both the upside and downside risks to investors”.

• Governance has a role on top. There will be no further interference in corporate governance, given changes already in train on company Articles of Association, consumer engagement and board requirements. But there could be changes to duties on water company management, drawing on lessons from the finance sector – “taking into account the need to ensure that the water industry can attract and retain high quality management, particularly given the challenges the industry now faces".

Ownership

• Re-nationalisation is out of scope, but the Commission is evaluating ownership models.

• “The Commission’s current view is that, while there are important differences between listed and unlisted ownership models, the most important determinant of performance and resilience is the ‘business model’ of the underlying investors – that is the risks they are prepared to bear, the period and manner in which they aim to take their return and their willingness and ability to increase capital to finance new investment.”

Asset health and resilience

• We have an insufficient understanding of the health of water sector assets and the overall resilience of the system. Not all assets have even been mapped.

• Funding for renewal and capital maintenance by Ofwat continues to be based primarily on previous capital maintenance and incidence of asset failure rather an explicit assessment of the condition of assets and forward risk.

• There is a strong case for setting a forward-looking infrastructure resilience framework and standards at a national level for England and Wales respectively, with a consistent set of targets applied across all companies. “This could include requirements on companies to make forward looking, prognostic, assessments of asset health and provide reports to regulators. Such assessments should inform company plans and funding in price reviews." A more supervisory approach to regulation could support this.

Supply chain

• A long-term view of water industry investment is needed, so the supply chain can plan ahead and build sufficient capacity.

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NEXT STEPS

• Engagement will continue ahead of a final report in summer. This will provide full conclusions and recommendations across all issues in scope, not just the priority areas above.

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Cunliffe on finance, investment, regulation and governance – by Verity Mitchell

Although the Cunliffe interim report has no firm structural conclusions, the direction of travel is increasingly becoming clear on finance and investment. The report is critical of complexity as being a deterrent to all stakeholders including capital providers. Complexity, it said, results from “the misalignment between statutory requirements, guidance and other elements of the regulatory framework, such as performance assessments and incentives, which results in a lack of clarity about the overall intended outcomes”.

One of the key pieces of analysis is titled ‘regulatory reform’, implying that there will be recommendations to change the status quo. The report set out that, in the response to a question in the Call for Evidence, 93% of respondents rated the performance of the regulatory framework as poor or very poor. Cunliffe chose to quote Stephen Littlechild’s observation to the Competition and Markets Authority in 2020 on the complexity of price determinations as being, “a situation where, for all UK regulated water and energy network companies, the price setting process routinely takes about five years, is indeed an ongoing never-ending process. It is like purgatory – a place or state of temporary suffering or misery – except that it is no longer temporary: it is a place or state of permanent suffering or misery”.

He also noted a ‘doom loop’ – where companies that struggle in performance are benchmarked against higher performing companies, resulting in lower funding, and limiting their ability to turn around performance. He has received responses that argue that the doom loop has been exacerbated by a lack of regulatory flexibility, for example, in enforcement actions.

Cunliffe argued there is a need to balance the modelled comparative benchmarking approach to economic regulation with much greater company-specific assessment and engagement, with more emphasis on the supervision of individual companies. He also recommended developing a supervisory approach which would be more like Ofgem’s regulation. Perhaps, he suggests, Ofwat could be given a formal statutory ‘duty to supervise’. There is a need for regulatory flexibility, he contended, combined with powers of direction and enforcement which are key to a judgment-based approach.

On investor appetite, Cunliffe noted that there is appetite and capacity for funding water investment by the capital markets. However, the risks and returns are incorrectly calibrated to achieve this, given the uncertainty about government trade-offs between bills and environmental objectives. Half of the respondents to the Call for Evidence commented on the negative effect on investment of the political and media portrayal of the water industry.

The Commission is considering whether the Government should set a high-level objective of ensuring stability and predictability in the regulatory system for water. This objective could reference several indicators, including the restoration of the regulatory regime’s AAA rating by the credit rating agencies.

The Commission is also exploring regulatory mechanisms to narrow the variability of returns to investors. For example, changes could be made to the price review process to reduce the quantum of returns that are put ‘at risk’ through economic regulation, and to allow more effectively for changes in circumstance. Such mechanisms already exist in the Ofwat framework, and the Commission is considering further how these might be developed to make the sector more attractive to investors who seek low return and low risk.

The Commission is also examining whether the regulator may require a broader set of tools, less focused on remuneration, to ensure water company leaders put the right culture and supporting systems in place. The ban on bonuses, Cunliffe recognised, “may make it difficult to attract and retain high calibre senior managers”.

As part of its final report, the Commission said it will return to the issues of ownership models, and interventions to support the attractiveness of the sector to stable, long-term investors, as well as options to strengthen corporate governance principles. The final report will also consider options to improve financial supervision to support companies’ resilience.