Agenda item 2 is further consideration of the financial memorandum to the Water Services etc (Scotland) Bill. Last Thursday, we took evidence from the water industry commissioner and from Scottish Water. Today, we will hear from Scottish Executive officials: Andrew Scott, who is head of the water services division of the Environment and Rural Affairs Department; Clare Morley, who is the bill team leader; and Tom Harvie-Clark, who is an economist in the department's analytical services division.
Briefly, we believe that the benefits of the bill will substantially outweigh its costs. Important public health benefits will be gained by safeguarding against the diluted accountability that would result from common carriage. Important environmental benefits will be safeguarded by, for example, the prevention of sewer flooding. The bill will also safeguard important social inclusion benefits, such as the harmonised charge throughout Scotland and the system of discounts that are worth a great deal to vulnerable households across Scotland. Finally, the bill will enable us to ensure that we can continue to provide discounted finance to Scottish Water from the public purse. We believe that the benefits of the bill substantially outweigh the costs.
The financial memorandum says that advice was received from the water industry commissioner on the cost of setting up the licensing regime. A cynic might say that the water industry commissioner would be unlikely to suggest a low cost—although the commissioner said in his evidence that it was a bottom-up exercise. Was advice sought from other regulators in Scotland or the UK on the potential cost of setting up a licensing regime? For example, was advice sought from the Office of Gas and Electricity Markets?
I know that Alan Sutherland consulted other regulators in coming to his estimates. He also set up a project to examine the costs in some detail. Clare Morley can explain how the costs were arrived at.
The costs that the water industry commissioner gave were the best estimate that was available at the time. He continues to work on costs and, I understand, he will publish a scoping study in the next couple of months. The figures that he has provided to date confirm those in the financial memorandum. The financial memorandum breaks down the £5 million costs into five categories. Would it be helpful if I talked more about each of those categories?
I would be happy to get more details. My reason for asking is that Ofgem is changing the licensing regime through the British electricity trading and transmission arrangements, the legislation for which is proceeding through Westminster. The work that has been done on that should give us a direct parallel for the costs of this process. It would be useful to have more details on the licensing regime costs.
I presume that we can get that information in writing.
The current situation in Scotland is that the industry is entirely unprotected from the effects of the Competition Act 1998. The Water Act 2003 protects the industry in England and Wales from the effects of the Competition Act. In Scotland, we are taking a similar precautionary step, although in a slightly different way.
Yes.
That £40 million difference is for Scottish Water's entire loan stock. It is difficult to model that risk, but it is potentially quite substantial.
How effective will the bill's provisions be in deterring large-scale industrial operators from going to a supplier other than Scottish Water? What inhibitions does the bill provide?
Such companies can already go to other suppliers and it is not the bill's intention to deter them from doing so where that is in their interests. However, the bill makes various provisions for handling special circumstances so that industrial operators that take steps to reduce the costs that they place on the public network can get a discount on their bill. That is the principal step to ensure that large users remain on the network where it is economic for them to do so.
I thought that the bill also imposed requirements on operators who enter the market so that they cannot simply pick and choose.
The bill will set a national harmonised charge, which will be segmented according to the circumstances of different users, such as large and small users. The principle of the national harmonised charge is not to keep large users on the network everywhere—for example, they might sink boreholes in areas where they have ready access to low-cost water—but you are right in so far as the harmonised charge will maintain a level playing field across Scotland.
Is it your argument that the costs that are entailed in the bill are justified, at least in part, by having a controlled market that does not create sudden incentives for large water users to bail out of the system and leave other consumers to pay for a network that has to be there anyway?
That is right. Widespread, unregulated common carriage would result in regional de-averaging of price.
The financial memorandum provides figures for the operation of a competitive retail market, but Scottish Water's independent consultant—IBM Consulting, which has done similar work in other parts of the world—came up with figures that were rather higher than those provided by the Scottish Executive. Are you aware of that work? Have you had a chance to examine those figures? We asked Scottish Water whether IBM could divulge the results of its research to us. Have you had an opportunity to discuss that work with Scottish Water? How robust are the Executive's figures, given that IBM has provided very different figures?
We discussed with Scottish Water the costs in the financial memorandum, but it was unable to provide us with alternative figures. Our view is that the financial memorandum's figures are reasonably robust. That is largely because what will be set up will be a simple sort of market. Tom Harvie-Clark will elaborate.
The figures in the financial memorandum were based on advice from the WIC, whose estimates were informed by previous research that had been done for him. The proposed water market will be a much simpler market than the electricity and gas markets because there will be no multiple generators, nor common carriage. There will also be no storage issue such as there is with the electricity market, in which half-hourly balancing must be undertaken. That means measuring every customer's usage every half hour each day of the year, which is over 17,500 usage figures each year for each customer. The water market will need just one annual figure, so it will be a simpler market to operate. That is why we think that the cost of the switching engine will be modest compared with that of other utility markets.
I believe that the attitude to common carriage south of the border is different to what the Scottish Executive proposes. Is it part of your rationale that common carriage would make it simpler to operate the market? Is that a financial consideration for you?
No. The reason why we are not proposing common carriage is that we think that it poses a risk to public health and the environment. We do not have reasonable grounds for setting a policy objective that would eliminate retail competition within the business market. That is why we are allowing it.
The bill will allow new ministerial powers of direction, but I am not sure what they would be. You claim in the financial memorandum that it is not possible to predict what costs might arise in complying with a direction. Why is that? Are you not able to get into scenarios that might estimate costs?
Which direction are you referring to?
It is under "Charge determination". The bill will allow for new ministerial powers of direction, but the financial memorandum says that it is not possible to predict what the costs might be of complying with such ministerial direction.
I think that what you are referring to is the process by which the ministers will set objectives for the industry as part of the strategic review.
Sorry—I am still not sure why you are not able to guesstimate how much it might cost to comply with ministerial directions.
What will happen is the strategic review process. Ministers will publish in January guidance or directions on what the industry must achieve. The commissioner will go away and do his sums. He will come back in the summer and say, "Well, ministers, if you really want all these things delivered for the water industry and you want the water and the environment to be this clean, and you want this to be tackled by way of odour and this to be tackled by way of development constraints, and you have told me how much public expenditure you are prepared to give the industry, then bills will have to go up by this much to pay for it; and because you've set principles of charging which will require subsidies to run from here to there, which means that the price caps will vary for different types of customer."
So it has not been possible to create economic models for differing scenarios and try to come up with some kind of costing for them.
There are broad hints in the quality and standards consultation document. If you have a chance to read it, you will see that some very large figures are posited for future investment requirements. To fund those figures we would need to increase water bills substantially. Inevitably, other factors will come into play—for example, affordability and deliverability. There is no point in raising water charges to such a point that people cannot afford them and there is no point in specifying a capital programme that cannot be delivered—or that cannot be delivered efficiently. Ministers will take all those matters into account at the end of this year, when considering their response to the public consultation. They will publish their deliberations at the beginning of next year.
I did not hear you make much mention of economic impact in your opening statement. Do you envisage the bill having an economic impact?
I think that the best way to regard the bill is to see it as a precautionary measure; if we do not enact the bill, bad things will happen. That is the first point. The second point is that some of the most important aspects of the bill are not directly addressed in the financial memorandum because no novel costs are associated with them. Undoubtedly, the move to independent regulation will bring substantial additional efficiency incentives to bear upon the industry, which can only be good for taxpayers and charge payers.
My concern is that the bill could create an acceleration of larger businesses opting out of Scottish Water service provision and that that might blow back on the generality of domestic users and the poorer users that you mentioned at the outset. Has anything been done to evaluate that risk and to take steps to prevent it?
It is very hard to put figures on that. Inevitably, when one talks to large users they always play up the threat of leaving the network, particularly when they have alternative supplies. However, we have introduced arrangements that enable large users to reduce their water bills when they have taken steps to reduce their calls on the public network. An example of that might be a whisky distillery that takes raw water rather than chlorinated water into its distillery. That imposes less cost on the public network, so the distillery will get a discount on its charge. Another example might be a large water user that installs storage tanks on its site to limit its peak consumption, which would qualify it for a discount on its bill. It is also the case that the national wholesale charge is in part a notional idea because charges will be set to be cost reflective and there will be categories of users. Because large users impose less cost on the system in various ways, they will still qualify for a discount. Therefore, the large-user tariff will continue, but it will be the same across Scotland.
You mentioned at one point that without the bill Scottish Water's ability to borrow at favourable rates would be limited.
It might be.
What are the implications of that in interest rate terms?
Scottish Water borrows from the Executive and gets Government borrowing terms, which gives it cheaper debt than any other company. Our estimate of that margin is that it is about 2 per cent. Scottish Water's debt is about £2.2 billion, so the benefit from cheaper debt comes to about £44 million a year.
With competition legislation bringing pressure to bear on Scottish Water, surely that is not the only change that you would expect to see.
If Scottish Water were to be challenged in the courts, anyone seeking access to its facilities or seeking to compete with its facilities would say that Scottish Water receives state aid, which distorts competition because no other company can compete so favourably. It would be argued that the interest rates—
I am sorry to interrupt you—I should have mentioned this earlier. We agreed that we would stand to observe a minute's silence at 11 o'clock in memory of the people of Beslan.
I did not want to dwell in particular on the matter, but I wanted to make the point that if the windows and doors were open to let in some fresh air on the issue and allow the scrutiny of Scottish Water in relation, for example, to borrowing and the prospect of state aid, there would be another side to the equation. In such circumstances Scottish Water might be forced to be more competitive about charging and perhaps borrow more and factor things over time. I wanted to put that on the record.
We are strengthening the provisions for independent regulation, to make them much more akin to the system that operates down south. There is very little competition down south; what has brought the huge efficiency gains is benchmarked, comparative competition. We are introducing that properly in Scotland and I expect that to bear down substantially on Scottish Water's costs.
At last Thursday's meeting the committee again heard concerns that we are not comparing like with like. I would be grateful if you would have a look at the Official Report of that meeting and give some thought to the matter.
First, I do not know about the cost of serving Campbeltown in particular, but I presume that it is one of the more expensive areas to serve. The bill would enable us to preserve a national approach to charging, which might benefit Campbeltown.
I return to the competition modelling that would be allowed under the bill. You made great play of the fact that there would be a national charging system, which would permit some measure of cross-subsidy between different parts of Scotland and different types of users. Although people might support the principle of cross-subsidy, I think that there will be much interest in its extent in different parts of Scotland. Do you anticipate that the competition mechanisms in the bill and the scrutiny process that would be associated with the role of the proposed water industry commission would allow the level of cross-subsidy to be carefully considered, not just on an on-off basis every four or six years, but as part of the process of considering investment, for example?
People are much more sensitive to the price of water than they have previously been and are much more mindful of what they are getting in return for their bills. As part of our preparations for advising ministers on how they should approach setting objectives for the period from 2006 to 2010, we have commissioned a project that will provide a model of current cross-subsidies in Scotland. The results of that project will be published in the new year at the same time that ministers publish their objectives for the industry. Indeed, one of the objectives that ministers will have to consider is whether they unwind any existing cross-subsidies in the business community and from business to domestic charge payers. As a result, subsidies will be thoroughly examined and decisions will be taken in December or January about what any future subsidies should be.
If one follows an argument based on social or environmental drivers, as opposed to an argument that is driven by economic growth, one will end up with different kinds of outcomes for investment. For example, if you argue that economic growth should be the prime driver, you will presumably try to deal first with the most serious constraints to development in Scotland. However, that approach will apply to the more industrialised parts of the country instead of to the more remote rural areas, which will argue that their needs are equally important. How do we deal with that? How will the mechanism that the proposed legislation seeks to put in place allow us to identify and balance the different factors such as rurality and urbanity, growth and social inclusion and so on that have to be taken into account in making such decisions?
We have this wonderful thing called a minister who, if the bill is passed, will be obliged to set objectives for Scottish Water. That is the mechanism proposed. In support of that, we are currently carrying out two consultations. The consultation that deals with investment, called "Investing in Water Services 2006-2014", is quite a large project that has been running since January 2003. It comprises all the principal stakeholders of the industry, who have been systematically examining what we need to spend on infrastructure maintenance, drinking water quality, environmental compliance—there is a lot of money tied up in that—development constraints and odours. As a result, the consultation is a comprehensive examination of investment needs that is built from the bottom up. Rather depressingly, it has produced a very large figure. Ministers will simply have to make judgments on their priorities and make them explicitly clear. That was not the case when quality and standards II was established.
The process seems to have been driven largely by environmental compliance, particularly with European directives. How does the introduction of competition to the industry that we have been talking about link into an agenda of competitiveness or growth across Scotland? Has there been any consideration of that issue as part of this exercise or is it a separate matter? Will you examine competitiveness purely in the context of managing the balance within the industry and not necessarily in the context of managing the development and growth of Scotland?
The straight answer to your question is that the issues are separate. I do not think that a more competitive market will cause infrastructure to spring up in places where it does not exist. Nonetheless, ministers will have to make a judgment about the extent to which the network should be developed when they set objectives as the proposed legislation will require them to do. In January, ministers will have to make such judgments explicit. As a result, they will trade off bills against the extension of the network, the cleanliness of the environment and the quality of drinking water.
I have a question about the "eligible premises", where competition will apply. The intention is obviously for eligible premises to exclude domestic premises, so that retail competition will not apply to domestic billing procedures. Collection will remain with local authorities, hence the financial memorandum indicates no cost to local authorities through a loss of revenue because of their no longer having the charge to collect. Is consideration being given to the independent review of local government finance? If a recommendation that council tax should be replaced by another system comes out of that review, that would radically change some of the bill and the whole structure of the collection of charges through the council tax.
The bill does not attempt to pre-empt that in any way. It refers to charges being set by reference to council tax bands so as to ensure that that is a clear principle by which domestic charges may continue to be set. It does not require that, however. We will have to wait for the outcome of the review. The bill does not pre-empt such a recommendation, nor would it necessarily need to be rewritten should events unfold as you suggest.
It would, however, be quite a radical change to Scottish Water's financial role if its retail subsidiary contracted out to collecting agents or if it took over the collection role itself, dealing with all the administration for the discounts and so on that are currently linked with council tax.
The bill leaves the billing of domestic households with Scottish Water wholesale, as it prohibits competition for domestic households. That would not be an issue for Scottish Water retail to consider. At the moment, the local authority collection of domestic water charges is highly cost effective.
Therefore, it would not be cost effective for Scottish Water wholesale to—
It might result in increased costs if Scottish Water were to lose access to the existing mechanism.
Broadly speaking, it costs Scottish Water between £4 and £6 to issue a domestic bill. In England and Wales, where companies do not bill through local authorities, it costs several times that. Figures in the region of £15 to £20 have been used. Billing through local authorities not only enables us to achieve our social objectives, but it is pretty cost effective.
Is it the case that that does not open up liability under the Competition Act 1998? Is there not then a monopoly for the collection of tax? For electricity and other utilities, companies compete as collecting agencies.
The bill contains a prohibition of retail competition for domestic users on the grounds of protecting vulnerable households. As the policy memorandum says, that is the only way in which we think we can continue to deliver the current discounts, which are associated with council tax collection, including the banding and the single adult household discount. That will also be the key to any future discount package that might be associated with council tax benefit, as was suggested in the consultation on paying for water services.
If you were to do away with the discounts altogether and if you encouraged innovation around sending bills to households, it is quite possible that private companies might be able to serve Scotland a bit more cheaply than we think they might be able to do at the moment. The trouble is that they would have to go a very long way to be able to reduce their cost to the extent that local authorities can do now. Local authorities complain to us that they do not get paid enough for collecting each household's bill, and there is an issue about bad debt. However, broadly speaking, the arrangement commends itself on the grounds of cost.
I thank the witnesses very much for coming along and answering our questions.