I formally open our meeting and welcome the press and public. As usual, I ask that all pagers, mobiles and BlackBerrys be switched off. This is the last meeting of the Finance Committee in this parliamentary session. We were going to move to agenda item 2 first, but we are delighted to have the Deputy Minister for Environment and Rural Development with us now. I will give the deputy minister and her officials a moment to settle into their chairs.
I welcome the opportunity to discuss Scottish Water's performance. I hope that the letter from Tom McCabe—dated 20 November 2006—and my recent letter have addressed any concerns that the committee might have had about the autumn budget revisions and why the adjustments were required.
I thank the deputy minister for her opening remarks and will begin by asking about something that she mentioned.
Our perspective is that it was more to do with slippage in the capital programme and, related to that, the need to get in place a vehicle to deliver the capital investment. Scottish Water Solutions Ltd was established to build improvements for Scottish Water. A combination of issues was involved; Andrew Fleming might want to comment on that in more detail. Is there anything more that we would want to say?
No—that was fine.
The headline issue was a slipping capital investment programme but, in addition, we needed to get in place a vehicle to deliver it. That is the explanation of why less than expected was borrowed in the early days.
That is helpful. Questions will follow on the extent to which the development constraints that have been experienced over the past four years have been significant.
I want to follow up on the convener's question by examining the numbers that we have in front of us. In 2002-03, the amount of borrowing budgeted for was £256 million, but the actual borrowing turned out to be £51 million. The following year, £250 million was budgeted for, but only £42 million was borrowed. In 2004-05, the respective figures were £191 million and £82 million and, in 2005-06, they were £196 million and £162 million.
There are two issues. The first is about having in place a rigorous system for working out what the priorities were on development constraints. In my opening remarks, I alluded to the fact that, in that regard, we are no longer under the same pressure from local councils as we were in the early days of the Parliament. Development constraints were viewed as an urgent priority that had to be fixed.
We are talking about a four-year programme and my point is that it is only in the final year of that programme that the actual borrowing figure is in any way comparable with the expected borrowing figure—there were three years of slippage in the budgeted borrowing. I quite accept that major projects such as that at Milngavie will get into difficulties when it comes to planning policy, but I want to find out why it was not possible for ministers to address the situation over one or perhaps two financial years, especially when they had set out that increasing economic growth was the Executive's top priority. Given the problems at Milngavie, they could have told Scottish Water to intensify its activities elsewhere.
In effect, that is what ministers have done in setting the Q and S III objectives, in which relief from development constraints has been given priority. The experience over the past year, during which Scottish Water has interacted with the developers and the local authority planning and development community, has begun to show what can be done. Over the previous years of the four-year period, there was a difficulty with the establishment of a system of interaction and effective communication involving local authorities and developers. Many MSPs considered that to be a significant issue and raised it continually with ministers, as you have said, but it has now been addressed by being prioritised in the Q and S III process.
I say with the greatest respect that I accept that that may be correct with regard to what has happened over the past 12 months and where we are now, but I am trying to get at the cause of the frustration with the system that was experienced between 2002-03 and 2005-06, when the Government's top priority was to achieve economic growth and when there was legitimate pressure from MSPs from across the political spectrum and across the country about development constraints. Frankly, when we asked that development constraints be tackled, we were all blanked. The figures show that, historically, there has been a gap between planned investment and the investment that has taken place. I freely accept that, over the past 12 months, a system for the Executive, Scottish Water, local authorities and developers to tackle the issue has been created, but I am trying to understand why such a system could not have been created in 2002-03 or in 2003-04, when MSPs were raising the matter every week.
We must acknowledge that there was such a difficulty over that period. I suspect that many factors should be taken into account, one of which is the significant challenge that Scottish Water has faced in managing a large investment programme while pursuing the set of highly exacting efficiency requirements that were imposed on it by the economic regulator. It is not the case that simply giving Scottish Water more money in line with the budget figures or with any other figures would have enabled the organisation to fix particular problems. That would have caused the constraints or difficulties in managing the investment programme to come out in another area.
I was not a member of the Finance Committee when the extensive discussions on Scottish Water took place in 2004. Contrary to what John Swinney said, it strikes me that the planned investment over the four years was initially £1.8 billion and was raised to £2.1 billion and the actual capital investment was £1.9 billion. Why was so much of the planned capital investment made without the borrowing from the Scottish Executive being required?
That was broadly because the Scottish Executive has always budgeted for the upper limits on what Scottish Water thought it might need to borrow. I repeat my initial comment that we did not want Scottish Water to be constrained in going ahead with projects by having to come back to us to get permission. The upper limit on borrowing is fairly flexible. We are relaxed that Scottish Water came in under the borrowing requirement; there would be more of a problem if it had gone over it.
According to my rough maths, the potential borrowing was £1 billion, but only £230 million of it was spent. That seems to be a fairly substantial undershoot. I cannot understand how Scottish Water managed to invest so much in capital, given that the minister said that the borrowing had not been required because of slippage in capital projects. It appears that capital investment was very nearly at the projected level—the projected amount was £2.1 billion and the actual investment was £1.915 billion.
I suppose that it is partly because we now have a fairly consistent level of investment every year in the work that is going on. Andrew Fleming monitored the expenditure, so I will ask him to answer.
The key issue to understand is that, like all businesses, Scottish Water draws upon borrowing last, because there is a cost attached to that. It will first use its revenue from customer charges then savings in operational performance. Where there has been slippage in the programme, the borrowing is the element that still remains to be taken. Some of the borrowing has been used up. There is an element of Q and S II funds that still remains to be drawn down.
That rather makes my point. There are obviously projects that need to be attended to, which are creating development constraints. Why was some of that borrowing capacity not utilised to ensure that MSPs were not pushed from pillar to post—as they were—in seeking to get projects undertaken? Mr Fleming's explanation of the protocol for investment is absolutely correct. However, why over four years was there no response to an increase in development constraints? I accept that we have responded now, but why did we not respond then?
I do not think that we can add to the answer that Bob Irvine gave you. If you are gearing up for a large capital programme, you cannot bring in new projects overnight. They have to be designed, worked up and then built.
I am talking about what happened over four years, not overnight. Given the political pressure that has been applied about the volume of water investment and the number of areas that have been hampered in terms of economic development because of development constraints, it is not unreasonable to expect that something be done over a four-year period. You are saying that we have waited four years to have the matter addressed. We have addressed it now. That is fine, but my irritation is that we had to wait four years, given the emerging pattern.
I honestly cannot think of another answer that is different from the previous one.
Right. Thank you.
Members have raised the issue of difficulties with capital investment. The other side of that is charges for customers. Could Scottish Water have considered reducing charges, particularly for domestic users?
Our view is that we are now in a position where we are reducing charges to customers. We have lower increases than the rest of the UK and our charges have in real terms gone down. The profile of expenditure in the first few years of the Parliament was for gearing up a fairly significant programme of environmental improvements to meet European requirements. Our constraints programme is now being implemented. Over that period, we still needed a high level of investment. I do not think that reducing customer charges would have helped us to get on with the major investment programme that was required.
On the direction of travel for charges, how sustainable is the charging policy over a three, five or 10-year period? Do you see charges levelling out or continuing on a downward curve?
We see charges continuing on a downward curve, because of the Water Industry Commission for Scotland's agreement with Scottish Water and the Executive about what the investment profile should be and where charges should be fixed. By 2010, our water charges for customers should be among the lowest in the UK. Some of our big customers will see pretty significant reductions over that period. Charges are on a downward curve. We will end up higher up the scale of low-charging water authorities in the UK by 2010.
I will move, at least temporarily, to the future, rather than the past. Are you satisfied that in the period to March 2010, Scottish Water's investment programme will not be constrained by a lack of investment funds?
We are confident that it will be not be so constrained. The challenge is to keep the pressure on ensuring that the investment programme happens. I was not prepared to give John Swinney another answer on the history, but it does tell us that we have to ensure that, at board level, there is constant pressure on ensuring that, if slippage is identified, the system is geared up to bring forward projects so that we have a strong investment profile year on year, and that there are no dips in investment. We are now at about £400 million of investment year on year. That is important in terms of economies of scale and designing projects. I am broadly happy about the next four years, but at the end of the month we should have an updated delivery plan from Scottish Water, which should give us the up-to-date picture on exactly where it is across the range of developments. I am reasonably happy, but that does not mean that every project in the system is being delivered as fast as it could be.
Without going through all the ministerial objectives, which you helpfully outlined at the beginning, I will focus briefly on the one that relates to minimising odour problems at waste-water treatment works. You will understand that I have a particular interest in the one that is not too far from here—the Seafield waste-water treatment works, the odour from which affects my constituents and Susan Deacon's. It is not too far from your constituency either.
The difficulty is not fundamentally to do with funding. I am close to this project not because of my constituency interests but because it was raised in the Environment and Rural Development Committee as an exemplar of a water treatment works that frustrates members of the public because of the inconvenient and unpleasant smell that it creates.
I am reassured that there is no financial obstacle to the work being carried out.
Absolutely. The water industry commissioner's calculation is that £30 million is available to change PPP contracts, in addition to the £19 million for Scottish Water owned projects.
There is a similar situation in my constituency, which involves a directly provided Scottish Water plant and an odour problem from it that is worsening because of rising capacity. Are you saying that it is now for the local authority to negotiate with Scottish Water what the acceptable level of odour emissions is and then to police it? Is the scheme Scotland-wide or is it at the discretion of the local authority?
It is Scotland-wide. When the odour order came to the Environment and Rural Development Committee, we were dealing with a series of petitions on water odour and were being told by local authorities that they did not have sufficient statutory powers to pursue Scottish Water. Odour is difficult to measure. Members of the public can tell you when the odour is bad, but measuring it is a different matter.
That is helpful. It would be useful if you wrote to the committee reiterating those points.
I will do that.
Minister, are you satisfied that, in the period to March 2010, Scottish Water will be able to carry out the investment programme of more than £2.4 billion that was agreed for it by the water industry commissioner in the final determination of charges for 2006 to 2010?
Yes. That figure was set by the WIC in discussion with Scottish Water and ourselves. It is deliverable, but only if all the projects are managed effectively and there is no significant slippage—we have spent a lot of time discussing that.
My understanding is that around 40 per cent of civil engineering projects in Scotland will have to be water-related projects. Capital expenditure for 2006-07 was forecast at £450 million but is now down to £404 million, so there is already major slippage. The projected capital expenditure in 2007-08 is £735.9 million. Do you believe that there is the physical capacity to deal with not only Q and S III but the leftovers of Q and S II?
The issue is partly to do with how that is managed and partly to do with Scottish Water Solutions Ltd, which was set up to deal with some of the major elements of Q and S II. The issue is also to do with delivering capital efficiencies. A good example of that is the need to ensure that there are standard template designs for projects so that unique approaches do not have to be designed for every new project that needs to be undertaken. A much more standardised approach will enable lessons to be learned from previous projects. Groups of similar projects will be clustered together to ensure that there are economies of scale in design processes. That will lead to a much more efficient use of civil engineering design capacity.
If capital expenditure is less than £2.4 billion—whether because of the innovative measures that you describe or because of project slippage—will that lead to a reduction in borrowing or a reduction in charges?
Andrew Fleming will deal with that.
Do you mean if the same slippage that occurred in Q and S II occurs in Q and S III?
Yes.
In that case, depending on scale, the borrowing would probably be the primary area that would flex.
In 2006-07, the retained surplus, which is the excess of income over expenditure, is twice the amount of planned borrowing. Is it appropriate to fund so much capital investment out of charges in the form of retained surplus instead of out of borrowing? Surely, the fact that so much of the funding comes from charges—as happened in Q and S II—will lead to an imbalance between capital formation and borrowing.
The WIC has worked out the specific amount of borrowing that is required in the current period to support the capital programme with reference to financial ratios that relate to the company's improvement. As a result, it is probably more appropriate to put that question to him.
But is it appropriate to use the income taken through charges as a way of not taking up borrowing, which is what happened in Q and S II and what appears to be happening in 2006-07?
I suppose that the issue in question is the extent to which one can predict the potential underspend. The assumption with this programme—which is over four years and amounts to £2.4 billion with the required level of borrowing—is that it will be delivered, and Scottish Water has indicated that it will be able to do so in that time.
My understanding is that total borrowing by any utility company should approximate to the value of new assets. However, in Q and S II total borrowing was much lower than the value of the new assets that were created over the four years. Was that appropriate in Q and S II? Indeed, will such an approach be appropriate if another situation arises in which the new capital formation is so much larger than the amount of borrowing?
I am sorry; I do not really follow your question. The WIC has set the amount of borrowing over the four years with reference to the nature of the capital programme and the requirement to invest in improving and maintaining infrastructure, and it is really up to him to engage in that debate. I am not sure that I follow your presentation of the issue.
I suppose that the question for the minister is whether the decision to use charges or borrowing to fund new infrastructure is a determination for the WIC or a matter of policy. Is it appropriate for ministers or for the WIC to strike that balance and make that trade-off in, for example, the period covered by Q and S III?
We have set a policy framework of stable pricing that is also benchmarked against the rest of the United Kingdom to ensure that, if there are any lessons that we can learn about how the programme might be managed better, we can do so. The WIC's job is to carry out the detailed work on ensuring that that is translated into effect.
Having read Jim and Margaret Cuthbert's report on current cost and regulatory capital value, I am interested in the mechanisms used by you, Scottish Water and the WIC to ensure that investment is directed at projects that represent the best value for money. For example, in the Highlands, pipelines have been built across lochs to supply schools in Scoraig and Lismore with drinking water. However, when the 14 pupils from Lismore primary school go home at night, they drink water from the burn supply to their homes. The pipe supplying drinking water to their school cost about £2 million, when—I am reliably informed—a borehole and filtration system could have been installed for about £10,000. What mechanisms are in place to ensure that we are getting best value? Moreover, have you thought about the questions that have been asked about regulatory capital value? If not, why not?
The member's example shows very well how certain issues need to be addressed not only by the WIC, as the economic regulator, but by the drinking water quality regulator and the Scottish Environment Protection Agency. Their views must also be taken on board in deciding which projects should go ahead. As that example makes clear, it is important to ensure that other regulatory functions apart from economic regulation are delivered.
Children might drink a couple of glasses of water at school, but they might drink far more back in their own homes. This issue is going down badly in the Highlands.
That is the balance that has been struck by the WIC and Scottish Water. We have already had a lot of discussion about whether the investment programme is on track and I do not think that I have anything to add to my previous comments.
According to the strategic review of charges in 2002 to 2006, the forecast debt was to be reduced from £2 billion to £17 million by 2016. Because of the committee's work, which has, by and large, been informed by the work of Jim and Margaret Cuthbert, we now have prima facie evidence that increases have been modified down and that debt is being held at a more steady level.
All I can say is that there have been extensive debates, particularly by this committee, about the Cuthberts' critique. I do not want to make detailed comments about reports that I, as minister, have not necessarily seen, although I know that, for committees and the Executive, one agreed standard procedure for approving reports is to check matters of fact. However, I honestly do not have any detailed comments on the reports in question. In fact, it would not be appropriate for me as minister to make any.
I was merely keen to establish the general principle. I have with me the edits that were made, and they go beyond what could be classed as matters of fact. Is it a good general principle for a committee adviser to pass his report to civil servants for editing before it is supplied to the committee?
You will have to ask the person in question whether he was satisfied with the process. Indeed, as it is a report for the Parliament, it is a matter more for parliamentary committees than for ministers. I do not want to comment on work that was done for the Parliament. It is up to the Parliament to decide whether it is satisfied with the quality of such reports and the process by which they were produced.
Okay. I will move on to where we are now with the capital expenditure. How were the first and second contracts awarded to Scottish Water Solutions?
Andrew Fleming will answer that one.
Sorry, Mr Mather; did you ask how the first contract was awarded?
How was the process run? Was it an open tender process? What criteria were used in awarding the contract?
I cannot provide all the detail on that, as the matter is more for Scottish Water. The contract was developed early in 2002. There was a tender and an Official Journal of the European Communities notice. European Union procurement rules were followed. I would need to check the date when the contract was finally awarded.
Do you have any plans to ask Scottish Water to benchmark individual installations that are supplied by Scottish Water Solutions against installations that other companies supply for water companies elsewhere?
I expect that part of the process that Scottish Water has in place involves benchmarking to ensure that Scottish Water Solutions provides value for money.
You expect that, but you do not know for certain.
The process that Scottish Water uses in granting contracts establishes that the contract provides value for money. Benchmarking will be an element of that.
The WIC also carries out benchmarking. As part of the agreement between Scottish Water and the WIC about how Scottish Water will develop its investment programme, the WIC benchmarks projects from throughout the UK. There is an interaction between the WIC and Scottish Water to ensure that projects are designed and delivered as efficiently as possible.
To what extent has the money that has been released back to the Executive this year and in previous years been a function of reducing costs, unrealistic budgeting by the Executive and the overcharging that we claim takes place? Has an analysis been performed to break down the amount into its component parts?
We can give figures on the level of efficiency savings. The WIC's report of last October contains extensive information on the efficiencies that have been delivered in the programme. Ministers do not accept that there is evidence of overcharging in the system leading to improved performance, nor do we think that the WIC accepts that. I am sure that if the WIC identified overcharging, he would intervene appropriately to correct that.
What is the explanation for the deviation from the original strategy in the strategic review of charges for 2002-06 to bring the debt down to about £17 million by 2016? What caused the strategic decision to keep the debt at about £2 billion?
That is a question for the WIC, as he considers the company's financial sustainability. In the statement on the principles of charging, which is one of the framework documents that guide the review of charges, ministers said that they want the company's financial health to improve. The WIC interprets that in considering the company's costs, the capital investment requirements that are placed on it and the continuing strength of its cash flow. As you know, in doing so, the WIC uses a set of ratios that are derived from the English utility experience and the views of the financial community, and arrives at a view as to the appropriate borrowing level and gearing for the company. He will consider those matters again during the next statutory review of charges, which begins this year.
Has the WIC reported to the Scottish Executive on that major change in Scottish Water's balance sheet, which is a material change in strategy?
No. I am not sure that we acknowledge that the situation is a change in strategy. As I said, in the statement on the principles of charging, ministers said that they seek the continuing financial health and sustainability of the company. In the WIC's final determination and the documents leading up to it, he presents a view on what that implies.
I seek clarification on the issue that Mark Ballard raised about the source of funds for capital expenditure. Depreciation and infrastructure charges are by far the largest sources of that funding. I understand half of that, but what role does depreciation have in funding capital projects?
As I understand it, depreciation is the element of investment that is required to take into account the fact that assets get older. That must be acknowledged and money must be invested to improve and maintain assets.
But depreciation in itself does not release funds. That is what I struggle to understand.
It would probably be better if I wrote to you on that.
That would be helpful, because depreciation is a major item in the funding sources, but I do not understand what role it plays.
Scottish Water would have to come to us and the WIC about that, because that would mean a significant change in expenditure. As I said, we have been flexible and have provided an amount that is at the upper limit of what Scottish Water thinks its borrowing requirement will be, the aim of which was to ensure that Scottish Water would not seek more just because it got the capital programme going. Were there a requirement to go significantly beyond that amount, we would expect Scottish Water to come to us and the WIC to review the programme.
Some of the questioning has been about the fact that there is the amount that could be borrowed but it is not taken up fully. Could the layout of the next draft budget be revised to make it clearer that the Executive is providing an optional borrowing facility?
That might be helpful, given that members have returned to the issue again and again. As a matter of principle, it is good for us to examine how we present our budget and accounts. If members want to write to me with any thoughts on how we can improve transparency, I am happy to take them on board.
The minister said earlier that 14 per cent of Q and S II is yet to be completed. Does that mean 14 per cent of the projects or of the investment total? What is that a measure of?
It is a measure of outputs.
Do you mean matters such as the number of sewage works that have been upgraded?
It relates more to regulatory outputs, by which I mean specific requirements and drivers to be addressed, such as improvements under specific drinking water quality regulations, kilometres of mains that have been renewed or unsatisfactory intermittent discharges to be upgraded. "Quality and Standards II: Delivery Position as at 31 March 2006", which has been published on the Executive's website, explains the linkages between those and the outputs and the derivation of the 86 per cent.
That is helpful. I will go away, look at that report and pursue the issues—if I have nothing better to do with my life. [Laughter.] It is amazing what we can come up with.
Andrew Fleming has just told me that the measurements are slightly different in Q and S III—
Excellent.
My heart is sinking.
That is undeniable.
One of the committee members asked whether I was happy with progress, and I commented that I was broadly happy. We are at the start of gearing up to the programme, not at the point of implementing it fully, and we have the overhang from Q and S II, so a huge amount of work is going on at the moment.
The point was made to me that the level of activity that was planned for the run-up to Q and S III between 2002 and 2006 would get the programme off to a flying start. Has performance been in alignment with that expectation? You were not starting a new programme with a clean sheet of paper on 1 April 2006, so has it got off to the expected flying start?
Bob, do you recognise that description?
Yes, I think that it is called the early start programme. The WIC agreed to release a certain amount of funding last year to allow early work on design, for example, which certainly happened, although perhaps not as much as was allowed for as a result of pressure on completing Q and S II.
Several operational and financial issues have properly arisen, including what are essentially operational issues under Q and S III. It might be helpful if the committee drew to the attention of the Environment and Rural Development Committee—whose work the minister is familiar with—the Official Report of this meeting and highlighted to it that there are on-going issues relating to Q and S III that it should consider.