Finance Committee, 09 Sep 2004

Meeting date: Thursday, September 9, 2004

Official Report 297KB pdf

---

Water Services etc (Scotland) Bill: Financial Memorandum

The third item on our agenda is consideration of the financial memorandum of the Water Services etc (Scotland) Bill. The bill was introduced on 11 June 2004 by Ross Finnie. We have with us the water industry commissioner, Alan Sutherland, and with him is Dr John Simpson, the director of cost and performance. We also have with us from Scottish Water Dr Jon Hargreaves, who is the chief executive, Douglas Millican, who is the finance director, and Ian McMillan, who is a non-executive board director. I welcome you all.

Committee members have a copy of a submission from Scottish Water, and also a submission from Water UK, Scottish Enterprise and the water customer consultation panels. I remind members that—as we agreed at our away day—the Minister for Environment and Rural Development will be coming before the committee on 28 September. He will talk about broader water issues, so today and next week we will concentrate on the financial memorandum. I will be reasonably strict about that, because we must focus.

I will ask the two groups of witnesses whether they would like to make a brief opening statement; I begin by asking the two Scottish Water witnesses.

Good morning. Thank you for your invitation, which went to our chairman. Unfortunately, Alan Alexander is unavailable today and sends his apologies. He has asked me to come here on behalf of the board of Scottish Water.

I will give a brief personal introduction. My utility credentials come from a career in the electricity industry, not in the water industry: I spent my career with Scottish and Southern Energy and its predecessor, Scottish Hydro-Electric. Having experienced full economic regulation and, indeed, the introduction of competition, members can probably guess why I have a particular interest in the proposals in the bill.

Today we are primarily concerned with the financial aspects of the bill, but it is important to summarise Scottish Water's view of the policy proposals in their entirety. Members will gather from our submission that we are pleased that the Executive is proposing the introduction of more certain and transparent economic regulation, in response to this committee's earlier report. We welcome, too, the Executive's proposals to regulate the scope of competition in the water market in Scotland. The formal approach to setting out the limits on competition will, we believe, limit the current risk that Scottish Water is exposed to in terms of any challenge under the Competition Act 1998. We feel that those matters are important.

If the proposed bill is approved, I know that my board colleagues will be seeking satisfaction that certain areas have been addressed. Firstly, the wholesale business that is left in Scottish Water must be properly funded for the conduct of all its activities. No new cross-subsidies should be created between customer groups. Secondly, although Scottish Water is unlikely to take on the role of a general utilities retailer—in the modern way in which that is conceived—we would seek assurances that a stand-alone subsidiary company in Scotland, selling only water services, would have to be viable at the outset. Thirdly, there is the need to ensure that the market that is set up operates in such a way that customers throughout Scotland do not suffer any disadvantage as a result of the changes.

In my experience, new markets are always very unpredictable; and, because this is a small market, it could well be more unpredictable than most. Non-household users of public water services in Scotland will need an assurance either that a sustainable market will develop throughout Scotland or that Scottish Water's retail subsidiary will be capable of delivering retail services throughout the country until such time as a sustainable market presents itself.

I will also take an opening statement from the water industry commissioner before I proceed to ask members whether they want to put any questions to our witnesses.

Good morning, and thank you for the opportunity to give evidence this morning.

From a customer perspective, this is a very important bill and it will benefit customers in a couple of ways. The first way is one that Scottish Water has already touched on: as the bill is precautionary it will bring a degree of certainty to the Scottish water industry that is currently lacking. It is important to understand that the Competition Act 1998 is a fact of life and that the challenge of that act could have potentially detrimental impacts, both on customers directly and on the Parliament's aspirations for the water industry in Scotland.

I will give members some examples of the sorts of thing that could happen were Scottish Water to be successfully challenged under the act: fines of up to 10 per cent of turnover for each year of an offence are possible, which, in Scottish Water's case, would be just short of £100 million per year per offence; charging policies—such as the harmonisation of charges across Scotland, or the offer of support to more vulnerable customers—could be unwound if cross-subsidies were found to be anti-competitive; and there could be a requirement to have the Executive fund Scottish Water on a more commercial funding basis and not give it access to public debt, which would clearly have a material impact, with an increase in costs that Scottish Water, and therefore its customers, would face.

The second important aspect of the proposals that will benefit customers is that the separation of retail activities from wholesale activities—and the transparency that that will bring—will identify and release costs that may not otherwise as quickly be released. That is certainly a characteristic of other utility markets where such a separation has happened. It is also quite possible that new entrants who benefit from the proposals on competitiveness will seek to lower prices to customers. The benefits from greater efficiency, and the strengthened regulation regime that is included in the bill, will also ensure that vulnerable customers, and domestic customers in general, do not suffer.

I now invite questions from members. I remind them that they do not need to touch anything on their consoles. All that they need is an indication from me that they may speak.

I am grateful to Mr Sutherland in particular for explaining to us what the alternatives would be if we did not introduce the licensing regime and what the costs to Scottish Water would be if that did not happen. Initially I was a bit alarmed by the costs of establishing the licensing regime and wondered whether it was going to be worth it. However, the question remains whether the financial memorandum is accurate.

Scottish Water's current estimates, which are based on independent research, suggest that establishing the competitive regime will be a lot more expensive than is suggested in the financial memorandum. Do you want to comment on the independent research and the possible costs to Scottish Water, as well as on the statement in the financial memorandum that some of those costs could be offset by a benefit from the division of the retail function? The submission from Scottish Water shows that instead of the costs being £2.5 million plus half a million a year, they tend to be something like £10 million to £18.4 million. I have concerns if the financial memorandum has the potential to be that inaccurate.

It is a big gap.

Scottish Water has no experience yet of operating in the competitive retail market. We have been keen to take sound advice from those who have experience of setting up new markets as to what might be involved and what the costs might be. Our primary concern is to ensure that, when the market is set up, it is set up in such a way that it operates in an orderly fashion to minimise the risk of confusion for customers who want to stay with Scottish Water, for customers who want to switch, and for new retailers within the market. We believe, therefore, that the market should be structured in an orderly fashion. It is important that the appropriate thinking and design in investment are done up front to facilitate the orderly introduction of the market.

With that in mind, we sought advice from IBM Consulting—the former PricewaterhouseCoopers Consulting—which has done similar work in a number of countries throughout the world, on what it would take to set up the market in an orderly fashion. The consultants do not suggest that there is a precise estimate; they have given a cost range of £10 million to £18 million. The cost might be lower or higher, but time will tell. Our main plea is to ensure that, when it happens, the market is set up in an orderly fashion.

I have not had the advantage of seeing any consultants' report from Scottish Water, but I have seen the numbers in its submission to the committee. The most significant difference is in the costs of managing the customer information and the market mechanism.

Among the critical issues is to hear what the regulated company says its costs will be, to challenge those costs, and to understand what scope for efficiency the company believes will arise that would offset the costs in some way. Until we have gone through that process, which is an important part of economic regulation, it would not be appropriate for me to comment in detail on those numbers.

I flag up a concern that we will also pursue with the Executive—the fact that your consultants consider that it could cost five to seven times as much to set up the competitive regime and that the on-going costs could be six to 10 times as much as are stated in the financial memorandum.

Would it be possible for us to have further detail of the research that was commissioned by Scottish Water in advance of following up the matter with the Executive, so that we can probe it further?

We are happy to check with IBM whether it is willing to divulge those details to you.

That would be helpful.

My question concerns charges determination. The financial memorandum states that it is not possible to predict what the costs might be of complying with the ministerial direction. The costs would depend on the nature of the direction that is given. Have you done any scenario planning on the anticipated costs of certain kinds of ministerial direction? That question is first for Scottish Water and subsequently for the water industry commissioner.

The principal circumstance that we envisage in that respect is the direction that ministers will provide at the start of each strategic review charge setting process in relation to the standards and objectives that they want Scottish Water to follow in a given period. The Executive is consulting at the moment on the quality and standards III process in the upcoming period from 2006 to 2010.

We expect to receive guidance from the Executive in January that it expects us to cost in a business plan to be submitted in April. The consultation document on quality and standards III sets out the Executive's thinking on what the range of costs might be for those investment obligations.

From a regulations standpoint, we have an additional budget this year of £1 million to conduct the strategic review. That is in addition to approximately £1.5 million, which is our annual budget.

We are about a quarter of the way through conducting the strategic review. The budget is tight, but it is manageable. I hope that the experience of going through the determination process to the current level of detail, and the set-up costs that are inevitably being incurred as this is the first time that we have done it this way, will mean that the process will cost about £1 million every four years in the future.

I have a question about the costs that will be associated with setting up the body corporate, which is covered in the bill. Will there be only marginal, additional administrative costs associated with the process and are the quantifications in the financial memorandum accurate?

When I saw the figure of £150,000, John Simpson and I sat down and counted up the salaries, the number of days and the likely on-costs that go with having a commission. We came to £149,000. Even on a bottoms-up costing basis, which everyone who tries to maximise their budget uses, the £150,000 seemed about right.

Does Scottish Water have any views on the matter?

We would like to keep costs as small as possible, because customers end up paying for them.

I admit to having serious concern about the massive cost to introduce the legislation. I will ask Mr McMillan and Mr Sutherland questions that arise from their opening statements. Each gentleman said that the bill is necessary because if we do not have it, we might be exposed to risks. I think that Mr McMillan said that, and Mr Sutherland referred to some of the sanctions that are contained in the Competition Act 1998—10 per cent of turnover and so on. Each described those as potential problems.

I appreciate that the question whether there is a potential risk, a real risk, an actual risk or a notional risk, might depend on an interpretation of the Competition Act 1998 and its application to the particular circumstances in Scotland where we have a monopoly supplier. However, given that we are to embark on the bill, which has costs of establishing a licensing regime of £10 million plus £2 million each year, should not we be absolutely clear in this Parliament whether there is a real risk or a non-risk? Will Mr McMillan and Mr Sutherland comment and indicate whether they have had legal advice on the matter and, if so, whether we can be in receipt of it?

Yes, indeed. The legal advice that we have at the moment is that we are exposed. The problem with being exposed to, say, the Competition Act 1998, is that the exposure is unquantified, so one tends to use the top limit, which we believe is of the order of £100 million.

Whether that sanction would ever be invoked is debatable and, as you well know, there is only one place in which it could be tested. There is a clear exposure at the moment under the Competition Act 1998, and the bill is a way of circumventing it. Within Scottish Water's risk management, because of the quantum of that exposure, the directors would need to ensure that it was high on their agenda.

I would like a response to the converse of that question. I presume that a company could challenge whether the new arrangements satisfy the requirements of the Competition Act 1998. Have you received advice that a successful challenge is unlikely, based on the proposed arrangements?

One can never be certain in an area such as competition, but we are as satisfied as we can be, given the advice that we have received and the way in which we have examined the bill, that it addresses the fundamental issue of the current exposure. One never knows in a market—somebody may find a different angle or make a challenge based on something that happens in the future, therefore it is probably correct to say that such challenges can never be legislated out of existence. However, the bill will achieve its primary aim of protecting domestic customers, which is part of the Scottish Parliament's desire, and it looks as though it will do that very well.

The bill will open up the market in a way that reduces the possibility of introducing an unquantifiable—and perhaps minute—risk to public health. That exists in England and Wales with common carriage, although they have decided that common carriage is not a risk. Until somebody has run that market for a period of time and lived through several incidents—which inevitably will happen in the industry—it is difficult to say what will happen. The aim is to avoid introducing a risk to public health, the protection of which is fundamental to the water industry. In both senses the bill achieves the objective.

We take that on board. However, Mr Ewing's point was that we would like to see the advice that you have received that substantiates your points. If you cannot give us the original legal advice, a summary of it would be helpful.

We do not have a document sitting in Scottish Water that says, "Here is the advice on the bill." The advice has been built up over time—it is not a single piece of advice—but we can let you have what we have got.

It would be useful to get the advice from both sides that states that the bill is necessary and will be effective. Mr Sutherland, what is your view on those questions?

Likewise, we can share with you the legal opinions that have been provided to us.

It is not just new entrants who could challenge Scottish Water; a customer could challenge Scottish Water. It is important to have the framework, because any such challenge could have consequences. Yes, it is not possible to say when or if a challenge will come, but we are aware from customers of Scottish Water and potential new entrants who have contacted us that challenges are likely. They are considering challenges, and they are waiting to see what happens and whether the bill is passed before they decide whether to challenge.

Who is contemplating a challenge?

It would not be appropriate for me to divulge commercial confidences that have been shared with us.

I do not agree with you, sir, because this committee is examining expenditure of £10 million for risks that I am not satisfied will ever occur. As a Parliament, we need to be clear when we authorise expenditure of £10 million that there is a real risk. I am grateful that Mr Sutherland has undertaken to provide us with the original legal advice. I think that that is correct, is it not?

We will provide the advice that we have.

However, I was not quite so enthused—

We will do the same. The assumption was that there was a single document, but because the bill has evolved we have taken advice at different stages. We will let you have that advice.

I have a separate question. The figures for the cost of establishing a licensing regime seem to be vague, ball-park figures. Do Scottish Water and the WIC have confidence in those figures? Can we have more detail on how they were arrived at? Whenever we see a figure of £5 million, I immediately think, "Has someone worked out this huge figure on the back of an envelope"? and I would like to see how the figures are made up. From past experience, when we probe the detail behind a big number we find suddenly that no-one has worked it out or thought it through. Could the representatives of the two bodies give us some comfort on that general point?

Yes, we can. Douglas Millican will help with the detail, but I make the general point that the experience of every utility is that the cost of the regime and systems that underpin the industry is always greater than was originally estimated. There is an interesting record of that happening. Equally, until such time as the details of the regime are laid out and specified, it is difficult to cost it. You are right to say that we are dealing with estimates, but they are estimates based on similar types of systems that have to be implemented.

On the specific point of the £5 million to establish the licensing regime, the cost of which would fall on the water industry commission, the financial memorandum was based on advice given by the water industry commissioner, and we have no reason to believe that that advice did not reflect fairly the underlying costs.

We have had advice on the legal component of £1.5 million and the accounting projects of £0.5 million. On the other advisory work, the figures are in line with our observed experience of changing elements of the regulatory regime. There is a market research budget of £0.1 million, which is one major project. The £2.5 million is over five years—it is £500,000 a year—and covers all staffing, developing licences and consulting extensively on the introduction of those licences over five years.

A written note of the breakdown would be helpful.

I have one point specifically for Mr Sutherland. He can correct me if I am wrong, but the budget of the water industry commissioner was overspent by £140,000. That is a matter of considerable concern, given that the WIC is a financial regulator and there is a substantial overspend in relation to the total budget. Can you reassure us that that overspend was a one-off mistake and will not recur?

It is certainly a one-off, and was a direct function of extra work that we were asked to undertake.

Going back to the regulatory impact assessment, paragraphs 14 and 16 give different figures for the reduced bill for standard connections. One refers to £30, and the other states that there will be a minimum benefit of £25 per standard connection. Is that anticipated to be an annual saving?

The difference between the two figures is that £30 is the pre-cost amount, and £25 is what you would expect the supplier to pass on.

So that is the anticipated annual saving.

Yes, for an average bill.

The RIA goes on to say that the water industry commissioner estimates that there is an efficiency gap of 43 per cent between Scottish Water and most comparable companies in England and Wales. Is that figure agreed between both parties represented? If not, could we hear Scottish Water's standpoint on the matter?

It would be appropriate for the commissioner to explain where that figure came from before we comment.

In our costs and performance report of last year, which covered until the end of the 2002-03 financial year, the gap to the leading company in England and Wales was assessed as 53 per cent. In its recent draft determination, the Office of Water Services—Ofwat—has said that the industry as a whole is likely to be moving forward at around 3 per cent per year. Conservatively, we could consider that as a couple of per cent per year for the frontier company.

John Simpson will take members through the detail, but it is important first to recognise a couple of things. Over the past two years, Scottish Water has made quite impressive progress in reducing its operating costs. We have been particularly encouraged by the progress that has been made over the past year and by the information that is beginning to come out on the trend line for the current financial year. There is good news, but there is still a considerable gap to the frontier company. The estimate that is contained in the financial memorandum is of the right order.

As Alan Sutherland said, the estimated gap in our 2002-03 report was 53 per cent. I would like to take members through some numbers. It is easier to deal in pounds and pence. On the basis of the gap that we published, it would cost Scottish Water £1.86 to deliver a service equivalent to that which the leading company can deliver for 87p. That comparison or benchmark uses tried and tested benchmarking models, which were developed by Ofwat. In fact, the models were developed by me when I worked at Ofwat. We have applied those models to Scotland and we have done a lot of work to ensure that the additional costs of operating in Scotland—which do exist—are properly taken into account.

The latest comparisons that we have are for 2002-03; Ofwat has not yet published any information for 2003-04. I would regard the efficiency gap, as stated in the impact assessment, as of the right order. It is interesting to note that both Scottish Water and Water UK have thrown doubt on that, but I would say that that doubt is premature.

Scottish Water has made substantial and welcome improvements over the past financial year, and that is continuing today. On the basis of the figures that Scottish Water has provided to us, my £1.86 figure becomes £1.67 thanks to the 10 per cent improvement of last year. Scottish Water says that it expects to improve by a further 10 per cent in this financial year; that takes us to £1.51. Another 10 per cent improvement in the following year would take us to £1.36. That last improvement would deliver the targets that we set in the strategic review of charges.

Remember that the leading company can deliver for a cost of 87p and falling. Companies continue to improve. If we ask where the leading company will be by 2008, we can only speculate but, if we assume that the leading company improves by 2 per cent per year, which is in line with what Ofwat is saying, then the figure of 87p becomes 77p, so the respective figures for that year would be £1.36 and 77p. By my calculation, that is a 43 per cent gap. The gap is 59p—a 43 per cent gap when divided by £1.36.

If Scottish Water continues to improve, as I am sure it will, the gap will be smaller. If it improves by 15 per cent, the £1.36 becomes £1.16, and the gap is then 39p, or 34 per cent. My point is that there will still be a significant gap in 2008. I do not know whether the gap will be 42 per cent.

Does your methodology factor in topography, geography, the sparsity of population and the relatively smaller market in Scotland?

Very much so. That is at the heart of the benchmarking and modelling process. It is absolutely about that kind of thing.

A response from Scottish Water would be appropriate at this point.

The discussion shows that the relevant question is what the level of efficiency will be in 2008, when the market opens. I am not going to predict what that will be, because it all depends on how we and the companies down south reduce our operating costs.

In England and Wales, there is a wide range of performance. John Simpson has highlighted his assessments relative to the leading company. If you consider the efficiency performance for the companies in England and Wales, which has been quoted by Ofwat, you will see that there is a wide range between the most efficient company and the least efficient company. The relevant factor with respect to the benefit that would be available to customers in Scotland who choose to go with a retailer, rather than with Scottish Water, will be the operating cost base of that retailer compared with that of Scottish Water retail in 2008.

We are talking about a minimum saving to a business of £25 per annum. We know that charges have been high for the business community here. Is it likely, in the opinion of the Scottish Water witnesses and, perhaps more important, in the opinion of the water industry commissioner, that the new regime will force an improvement in the ratio of capital expenditure funded from borrowing, and possibly even a rethink on some of the accounting protocols through which so much of the infrastructure has been written off in year one?

As far as the price determination is concerned, we will shortly publish for consultation our proposals on how we will set prices for the regulatory period. We are in the fortunate position of having considerably more information about the industry in Scotland. In particular, we have a much higher quality of information on Scottish Water's assets compared with the information that was available when there were three water authorities, when the 2002-06 review was written.

We propose to use a method of setting prices that assesses a regulatory capital value, which will be in line with the process that is used in the water industry in England and Wales and in other utilities. That will facilitate comparison: it will make possible, immediately and directly, comparisons on the basis of funding or financial ratios, and without any adjustments being required. In essence, the regime will allow people to make representations in a transparent way.

The current proposals are that, if the bill is passed, we will publish a draft determination at the end of June next year. There will then be a period lasting until about the end of September next year, during which people may comment in detail, having seen the answers—but prior to a final answer being struck. If Scottish Water was not happy with that answer, or if it did not think it to be manageable, it would have the right of appeal to the Competition Commission, in line with that of other utilities. There is a very robust process in place to ensure that we have a proper and transparent regulatory regime for the calculation of prices. Many of the issues that we have discussed previously are therefore being addressed.

Dr Simpson gave us a projection using pounds and pence. It would be useful if members of the committee could have that in writing. I am also conscious that the witnesses from Scottish Water have not had a chance to comment on the pounds and pence figures, so if they would like to they can do so now.

I tried to address that issue previously by saying that I would not want to make projections as to where the companies in England and Wales will be in 2008 when the market opens. Ofwat will make assumptions, just as it did at the last periodic review. It is interesting that some of the predictions that were made at the 1999 periodic review of the companies in England and Wales are not holding true. Operating costs in companies in England are tending towards being higher at the end of the current regulatory period than Ofwat predicted. There are always dangers with predictions.

We expect that the gap will be much narrower in 2008 than it is at the moment. However, the most relevant aspect is not what the gap might be against the leading company, because that leading company might have no interest in competing in the Scottish market. The relevant issue is the cost base of Scottish Water's retail activities compared to the cost base of new retail companies that want to come into the market. Those are the companies that might provide benefits to Scottish customers.

Is that the cost base across the current activities of competitors? If we take Thames Water as an example, are we talking about that company's current costs or what it would cost for it to enter the Scottish market and compete here?

Under the proposals that are set out in the bill, the cost of the retail activities is of primary relevance. The wholesale monopoly activities of providing water and treating sewage will continue to be provided by Scottish Water. The most relevant comparison is of the costs of the activities that fall into the new retail element and which will be licensed by the new commission. If new entrants to the market can operate their retail activities for a lower cost than Scottish Water can, that might offer a competitive advantage to customers. Clearly, that will also give Scottish Water retail an incentive to continue to bear down on its retail costs.

I was interested in Dr Simpson's figures, and I take the point that he compared the best, most efficient and most economic of the English and Welsh companies against Scottish Water. Can he produce an average figure that might provide a more direct comparison? Is it anything like 29 per cent by 2008?

The pounds and pence were carefully chosen so that the average company in 2002-03 would have delivered the equivalent service for £1. We have Scottish Water at £1.86, the average company at £1 and 87p for the leading company. Ofwat tells us that the companies are set to improve at a rate of 3 per cent per year. 2008 is five years away from 2003, so that would result in improvement of the order of 15 per cent on our £1, which will mean an amount of 85p by 2008. I return to my original point that the figures are £1.36 for Scottish Water, about 85p for the average company and 77p for the leading company. Douglas Millican is correct to say that the gap is narrower; nevertheless, there is a gap.

There is also a point to be made about retail costs. It was said—rightly—that what matters is the retail cost base. There are issues there with economies of scale and scope in that Scottish Water can allocate its billing costs only across non-domestic customers. The water and sewerage companies down south can allocate those costs right across their customer bases, which gives them better cost bases from which to compete.

Ultimately, what concerns us all is how much our water is going to cost us, whether as individual customers or businesses. I do not know whether you have seen Scottish Enterprise's submission, but I found it to be fairly damning in that it claims that Scotland is not competitive in terms of water charges because it is the fifth most expensive country, with

"countries such as Belgium, Italy and Spain having a comparative advantage in terms of pricing."

I am an amateur, but given the rainfall in Spain and Italy and all the rain that we have seen here this summer, it seems to be utterly incredible that Scotland is among the most expensive countries in Europe. The Scottish Enterprise submission goes on to suggest that the situation makes us particularly uncompetitive in sectors such as paper processing, pharmaceuticals and so on. There are two paper mills in the constituency that I represent: can they look forward to any improvement in that competitive situation five years down the line as a result of the bill?

In the previous review, we said that if Scottish Water were to deliver on its targets, and were the capital programme to run at or around the same level as it does in the current regulatory period, there would be no need for real price increases across the board. The division of who pays what is something on which we will get guidance from ministers in January after the principles of charging consultation closes. Once we get that, we will be in a position to look forward and say what that revenue line will mean for prices for individual customers.

I have a comment on the international comparisons. The data are sometimes difficult to collect, but let us assume for a minute that the data are correct. We are not talking just about Scotland but about Britain, and Alan Sutherland will agree with me that the English and Welsh water companies are now probably among the most efficient in the world after 15 years of pretty tough regulation. I am concerned about where we are going to end up with those data, mainly because of the way in which improvements in environmental conditions and other issues associated with the water industry are funded in the UK versus the funding in other countries in Europe. I am not saying that those countries do not implement European directives in the same way as we do; members are probably a lot closer to that than we are.

The only real example I can give is of a Scandinavian country where nitrogen removal from the water supplies was funded through a grant system rather than its being paid for directly by customers. Such things lead to an ongoing, but false, view that water prices in such countries are lower. Other countries use subsidies that are not used in Britain, in which I include Scotland.

Looking down the line, how we will end up is of concern. At the end of this period, Scottish Water will not be the least efficient of the big water and sewerage companies. We believe that that is an amazing—I mean that—feat given that we have had four years to achieve it when the other companies have had 15 years and some time before that. It is important that Scotland should recognise that.

Nevertheless, the amount of money that needs to be spent on the infrastructure in order to maintain and improve the standard of service to customers, and the continuing flow of environmental legislation requiring huge sums of money are of concern in respect of the bill and as a general question about the competitiveness of the water industry. Although water falls out of the sky a lot in Scotland, that does not mean that it is cheap. Parts of Spain have much higher rainfall than Scotland. It is about the treatment that the water requires once it has been collected, whether it has to be pumped over hills, how far it has to be pumped and so on.

Like other members, I was struck by the figures that John Simpson offered the committee. I want to pursue them.

Obviously the committee's concern is about stewardship of the public purse and value for money for Scottish consumers and taxpayers. I seek a professional opinion. I am struck by the fact that having a near-monopoly provider and a sole regulator—with all the risk of regulatory capture that that carries—is not a structure that has commended itself historically to closing efficiency gaps, to reducing cost bases or to innovation. Most historical evidence suggests that a more competitive market will close an efficiency gap. Will you comment on whether, based on the evidence of which you are aware professionally, we have a structure that commends itself to closing the efficiency gap? I will ask a follow-up question.

There is no risk of regulatory capture.

I take that point.

The regime that Ofwat has operated in England and Wales has shown that an independent regulator can create a regime and incentives under which companies feel pressure to improve. It is fair to say that since the companies became fully regulated by Ofwat, they have made great strides in improving their efficiency—that is true of every company. If there had been no regulation, but there had been competition instead, would improvement have been greater? I do not know. All I know is that the regime under Ofwat seems to have worked and to continue to work.

The arrangements in the bill to establish powers of determination and so forth will give us a similar regime to Ofwat's. We have made a good start—Scottish Water has made a good start by achieving considerable efficiencies. I hope that we can now build on that initial progress.

In your professional opinion, are savings such as have been made in England and Wales more difficult to achieve because, although we have an independent regulator, we have a sole provider in large parts of the market?

We are in a fortunate position because we have access to all the information that comes from England and Wales. If we had no easy benchmarking opportunities—as was the case with the Royal Mail and the Postal Services Commission, Postcomm, which cannot make immediate and easy comparisons because of accounting differences and statutory and other legal differences in postal services—regulation would be much more difficult. However, when information about 10 large water and sewerage companies and another 13 water-only companies is being collected and audited consistently on both sides of the border, very detailed comparison work can be undertaken. John Simpson has talked about that important point.

Most economists would probably argue that at least the potential for competition—if not competition itself, the idea that competition may occur, which might be market competition, outsourcing or competition for capital in financial terms—would help to stimulate further improvements.

I say with respect that John Simpson has not had the chance to answer my question; he may choose not to. The question is whether, in your professional opinion, having a sole provider in large parts of the market in Scotland in any way inhibits closure of the efficiency gap.

The answer is no, for the reasons that Alan Sutherland gave. We have the information and techniques that we think we need to establish the relative level of performance, which allows us—through committees such as this and through the Scottish Executive—to put appropriate pressure on Scottish Water.

I will ask just one follow-up question. If the sole-provider ownership structure, which was chosen several years ago, does not of itself represent a barrier to closing the efficiency gap, why have we made such slow progress on delivering the promise that was held out for the sole-provider model just a few years ago?

I am not sure whether I understand the question. We had three providers in 2001 and our judgment at that time, in the strategic review of charges, was that the best chance to close the efficiency gap would arise from having a sole provider, rather than three providers. That was our judgment then and I would not revise it now.

In the past, we have had flawed and unhelpful comparisons with England and Wales, so I am keen to go through the methodology of your comparison of charging down south and up here in Scotland. Does your methodology adjust Scottish Water's accounts and those from England and Wales on to a similar basis for borrowing levels and the protocol of writing off infrastructure replacement in the year in which it occurs?

At the heart of the comparisons that we make are comparisons of cost—operating and capital cost.

So that is a no.

We think that because the inefficiencies lie in those costs. The regime that we have established for the current strategic review, with a regulatory capital value, will allow us to make direct comparisons going forward, but we are not in a position to make exact like-for-like comparisons along the lines that you described.

Would going along the lines that I suggested present a truer and fairer view?

It would do so for a comparison of the businesses as a whole, but it would make no difference in respect of efficiency.

Has Scottish Water recalculated the figures to deal with an assumption that the water boards down south applied a similar ratio of capital expenditure from charges and therefore did not borrow as much, for example? Has it reworked the numbers to show its numbers in a proper and fairer light?

I will let Scottish Water answer that question, but I am anxious to draw us back to the bill and the financial memorandum, which is what we are meant to discuss.

At the moment, we are concerned primarily with planning for the next regulatory period. We are due to submit our first draft business plan to the water industry commissioner at the end of October—obviously, part of that will depend on his draft methodology, which he will publish later this month for consultation. In submitting our business plan, our main aim will be to give the commissioner all the information we believe we have, which he needs to ensure that he can undertake proper like-for-like comparisons and that the draft determination that he will publish in June next year is comparable with that of Ofwat for the companies in England and Wales.

As always, I have sat and listened to beautiful rhetoric and must try to separate the wheat from the chaff and, as usual, there is more chaff than wheat.

Alan Sutherland said that the budget is

"tight, but it is manageable".

The budget of the people whom I represent is tight, but totally unmanageable, and pensioners found out that in the last tranche of increases, the increase was 5 per cent. Mr Ian McMillan made a lovely statement that boosted my confidence. He said that part of the remit was to ensure that customers do not suffer disadvantage. How can you reconcile that with the fact that every senior citizen in the country has been disadvantaged by a 5 per cent increase while their pensions have increased by only 2.5 per cent? You have disadvantaged every senior citizen with that little increase. I suppose that that will continue next year and in the future and the £1.87 increase—or whatever it is—will go up and up.

No one ever seems to think about the people at the bottom of the scale. The Executive, in conjunction with you, came up with a beautiful deal of 2 per cent for small businesses. What about senior citizens who are on a fixed income? You people have got to get real.

I am not sure that we are getting to the bill.

I wonder whether I missed something. Dr Simpson read out a series of statistics that justified his conclusion that there is a 43 per cent gap in efficiency between Scottish Water and the most efficient English or Welsh water company. Have we received an explanation of how those figures were arrived at?

Yes. We published—

Has the committee received a submission from you?

Do you mean the figures on the financial memorandum or the pounds and pence that I described?

I think that the problem is that the committee has not received a written submission from your organisation. I have asked for the figures to be provided to us, perhaps with an explanation. I am sure that that is what Mr Ewing is suggesting.

Yes. The figures are obviously important and underlie many of the assumptions that make the bill necessary, in your view. The bill will involve £10 million of initial set-up costs—money that I, like Mr Swinburne, believe would be better used to cut water rates. It is unfortunate that we have not received a submission that shows how you calculated those figures.

I will move on and raise two matters that arise from the figures that you gave this morning. First, Scottish Water began life with accumulated debt of about £2 billion. Senior citizens face swingeing water charges, as John Swinburne rightly said, partly because the customer has to pay back that debt through the interest element that must be met each year. The WIC compares Scottish Water with the 10 privatised companies south of the border, but is not the debt that the Scottish water-rates payer must pay back much greater than the debt of the English and Welsh water companies? I recall that those companies received a green dowry as part of the privatisation package, when their debts were written off. Are you not therefore comparing apples with pears?

It might be more appropriate to put that question to Mr Finnie when he comes before the committee. I have been very specific; I said that we are concerned with the financial memorandum to the Water Services etc (Scotland) Bill. Members should direct their questions accordingly.

With respect, convener, I understand from the Scottish Parliament information centre's briefing paper that the Executive's figures are based on information from the WIC. However, the WIC has not given us a computation of the figures that he brought to this meeting. It is highly relevant to request an answer to a simple question: is there a comparison of apples with pears, because Scottish Water began life with a massive debt of £2 billion, which was not the case south of the border? Any comparison must surely take account of that fact and make it explicit. Has that been done in relation to your figures?

I will make three points in response. First, there is an account of how the figure of £1.87 was derived. Secondly, the debt in England and Wales currently stands at about £20 billion—I do not have the exact figure to hand—so we in Scotland are not out of kilter in relation to the debt borrowing by water and sewerage businesses in England and Wales.

There are one or two myths about the green dowry. In our costs and performance report, we explained the amount of debt that was commuted when the industry was privatised in 1989, which was just short of £5 billion. The Treasury provided a cash injection—the green dowry—of about £1.6 billion. The total cost of the transaction was therefore about £6.5 billion, which is equivalent to £275 for each household in England and Wales. Privatisation raised £5.2 billion as proceeds, so the net cost to the Treasury was £1.3 billion. The net cost per household was approximately £55. Tax losses were also transferred by the Treasury.

In Scotland, £700 million of debt was commuted when the three water authorities were set up, leaving £1 billion debt on the books. The cost to the Treasury of that transaction was £700 million, which equates to £330 per household in Scotland. The cost to the Treasury in Scotland was about six times greater than that which was incurred by the privatisation arrangements in England and Wales. As it happened, there were also transfers of tax losses as in England and Wales.

Thank you for that explanation. If Fergus Ewing has another question, I would prefer it to relate specifically to the financial memorandum.

I have a question that relates specifically to the memorandum. I have read before the figures that Dr Simpson cited, and I believe that they are being examined by experts to determine whether the conclusions that have just been expressed are challengeable.

I raise a specific concern that BP and Unison have expressed about the requirement that Scottish Water set up a subsidiary. BP and Unison are not the most traditional of partnerships, but they have argued that the requirement to set up a subsidiary, which obviously has huge cost implications, would detract from the main task of meeting efficiency targets. I agree with BP and Unison. Attention is drawn specifically to one concern which is, namely, that in Scotland the market will be open; any customers will be open to competition. However, in England only customers who use 50 million litres of water a year—which would probably exclude most householders—will be open to competition.

At the beginning of the meeting, we heard both Scottish Water and the WIC say that we need to spend the £10 million because we must have open competition and if we do not set up a subsidiary we may be sued and face swingeing charges. However, we do not have open competition. Again, apples are being compared with pears. I understand that, in England, only the biggest customers—those who consume 50 million litres a year—will be open to competition. In Scotland, everyone's water supply is open to competition. In England, there will be common carriage. In Scotland, common carriage—that is to say, use of the water pipes by more than one company—is prohibited. Do we not again have different situations in Scotland and England? Are we not comparing apples with pears? Why do we need to spend all this money?

The bill will allow for competition for all non-domestic customers. It will not allow competition for household customers. We are talking about between 120,000 and 130,000 businesses in Scotland that could benefit from having a choice of supplier.

I understand from conversations with the Executive that the bill was designed as a precautionary bill. It will not introduce competition, but will put in place a framework that will protect the Government's social, environmental and public health policies. As I said in my opening remarks, there is a real possibility that a challenge under the Competition Act 1998 will impact on things that are the prerogative of the Parliament, and that would have consequences for customers. Therefore the costs would seem worth the benefits.

The concern was raised initially by Scottish Water, so it would be appropriate to give it an opportunity to comment.

On the setting up of the subsidiary, which was the first part of your question, there is a timing issue: when should we do that? Competition comes into being in 2008, so clearly it needs to be done before then. There is no doubt that creating a subsidiary—taking people who work in one part of the business and dividing up call centres and billing staff—will be disruptive to the business. Will that inhibit Scottish Water driving out more efficiencies? In the past two years, Scottish Water has delivered more efficiencies than any other water company in a two-year period. It will continue to drive out efficiencies, but will creating a subsidiary stop us continuing with that trend? The answer to that must be no. Ministers and the Parliament will expect Scottish Water to manage both activities at the same time.

Sorry—I do not think either of the gentlemen has answered the question that I raised. Scottish Water has raised the specific concern that

"Scottish Water retail will not be treated equally with other retailers. This is due to the fact that the Scottish retail water market will be wholly open to other retailers, whereas the retail water market in other parts of the UK will not be wholly open because retailers will only be able to compete for non-domestic customers who use over 50 megalitres."

Why has the bill been framed in such a way that your concern has not been taken up?

We did not say that in our evidence, but I am happy to comment on the point. England and Wales have chosen, quite simply, to take a different route to achieve the same objective. The Scottish Executive has chosen—it is not Scottish Water's choice, but ultimately your choice, as Parliament—to take a different route. As I said earlier, although one quality regulator south of the border believes that common carriage is not a risk, the view of the Scottish regulator is that there is a residual risk. If an operator in the water industry can avoid putting two or three lots of water from different ownerships down the same pipe and still achieve its objective—as Alan Sutherland said, the objective is to prevent challenge—that is by definition a good thing to do. I am not saying that it is impossible.

England and Wales have chosen to go down a different route. They are trying to mirror what happened with electricity and gas and create the market gradually, that is at 50 megalitres. It is highly likely that that figure will reduce in future, but of course customers will get the benefit of either retail competition or common carriage. I question the English system—why do they believe that retail per se is not a good thing for their commercial customers?

I have one final question. We have heard the WIC argue that Scottish Water is massively less efficient than the most efficient water company in England. You will be exposed to competition from that company. If that company can supply water at 43 per cent of the cost—or anything remotely like that—it will be able to steal your customers. That will mean that the business customers will be the customers of the most efficient English company and you will be left with exactly the same costs. You will lose revenue massively to your more efficient competitors and the victims will be the remaining customers of Scottish Water who, instead of paying for part of the costs, will pay for all the costs.

I am trying to put this as clearly as possible. Does not the bill really represent a gigantic threat to the ordinary domestic water-rates payers in Scotland? If I am wrong, can you explain why I am wrong?

Central to the successful operation of the bill will be the clear setting of the price that Scottish Water will, in future, charge businesses for the wholesale supply of water. It is critical that the wholesale price that Scottish Water will charge retailers is properly set so that it fully covers—but no more than that—all Scottish Water's future costs of providing treatment and distribution activities. If those wholesale charges are set properly, there will be neither a benefit nor a disbenefit to household customers arising from the bill.

What is the point of the bill, then? If the price is going to be set artificially at a level that enables Scottish Water to supply the water, what is the point of the bill?

The water side of our business runs everything from raw water resource abstraction through treatment and distribution to the selling and delivery of services to customers. The bill proposes that companies will be able to obtain licences from the commission to undertake those aspects of activities that are not prohibited under the bill. Therefore, Scottish Water's future wholesale price will not be for the same service that it provides today; it will be for those elements of the service that remain with Scottish Water and that are not provided by newly licensed entrants.

I think that we are reaching the end of this process.

Can I just clarify something?

Fergus Ewing's points were on policy, not the financial memorandum. It is important that we confine—

My point is related to Water UK's apparent criticism of what is proposed in the bill.

Okay.

In its conclusions, Water UK basically says what Fergus Ewing has pointed out. If these issues are not addressed through legislation and regulation, competition in Scotland could encourage cherry picking and leave domestic customers alone to pay for the environmental and social objectives that are given to Scottish Water. Is that not a real danger? Water UK points that out in its submission.

Absolutely. That is why it is critical that the wholesale price is set correctly.

I thank our witnesses for coming along. We will have Executive officials at our next meeting, and you have given us food for thought and ammunition for questions to those witnesses. Thank you very much for coming along today.