Finance Committee, 22 Jun 2004

Meeting date: Tuesday, June 22, 2004

Official Report 330KB pdf

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Scottish Water

Agenda item 3 is consideration of the Executive's response to the committee's report on Scottish Water. Members have received a copy of that response, which came out last week.

We welcome our next panel of witnesses. We have with us Ross Finnie, the Minister for Environment and Rural Development, who is accompanied by officials from the water services division: Andrew Scott, who is head of the division; Janet Egdell, who is team leader in operations and institutional governance; William Fleming, who is team leader for strategic review of charges; Andrew Fleming, who is team leader for capital, regulatory protocols and off-network supplies; and Clare Morley, who is team leader for the Water Services etc (Scotland) Bill. You are well supported, minister.

I invite the minister to make an opening statement before we proceed to questioning.

Thank you, convener. I am grateful for this opportunity to address the committee and discuss the Executive's response to your report into the water industry. I am pleased that the committee agreed that the financial sustainability of the industry is key to its success, and I am pleased that a majority on the committee found that the allegations that were made by Analytical Consulting Ltd were wrong. I am also pleased that the committee felt that more detailed examination of the industry's investment needs was needed; that consultation on the principles of charging is essential; and that robust and transparent economic regulation has a crucial role to play in ensuring that the water industry becomes more efficient.

I agree with the committee that a number of changes to the current regulatory regime are necessary. As I have indicated to the committee in my letter, we propose to make changes through the forthcoming Water Services etc (Scotland) Bill. I have several changes in mind. I want to give ministers clear statutory duties to set publicly the standards and objectives that Scottish Water should achieve; I want to transfer the function of the water industry commissioner from an individual to a commission with a small board of non-executive experts and a chief executive; I want to empower the new commission to set limits on Scottish Water's charges; and I want to set out in statute a transparent process by which the commission will consult publicly on proposed charge limits.

In these opening remarks, I do not intend to revisit my response to the committee, but I will say that it included a letter on the next strategic review of water charges—a letter that was sent to the water industry commissioner and to Scottish Water at the end of May. It might be helpful if I draw the committee's attention to the main points of that letter.

We will require the water industry commissioner and Scottish Water to proceed on the basis of the provisions in the Water Services etc (Scotland) Bill, which was published on 14 June. Subject to Parliament's approval of the bill, that means that final decisions on water charges in the period from 2006 to 2010 will be made by the new water industry commission, rather than by ministers acting on the advice of the water industry commissioner.

The commission will reach its decisions by the end of November 2005, on the basis of a clear process in which the public and all stakeholder groups will have had the opportunity to be involved. Crucially, the commission will consult on all charge limits before reaching its final decision. Decisions will be made in the light of two clear policy statements from the Executive, which will reflect the outcome of the public consultation. One statement will set out what we require Scottish Water to deliver by way of water quality, environment protection and customer service standards during the period from 2006 to 2010. It will reflect public responses to the consultation process that we will launch shortly. The other statement will set out how the costs of the programme should be shared among different customer groups. It will reflect public responses to another consultation process, which will also be launched soon.

Under those arrangements, ministers will become accountable for decisions on policy for the water industry and the commission will be responsible for ensuring that Scottish Water delivers the objectives at the lowest cost and the highest quality. The outcome will be charge limits for each year of the 2006 to 2010 period. As a further strengthening of the regulatory regime, the commission's decisions will be open to scrutiny by the Competition Commission.

In terms of the context of the inquiry, we should not lose sight of how far we have come in the two short years of the life of Scottish Water, which was set up against a background of doubts about whether the existing companies could continue to deliver. While the industry has a long way to go, it is in a much better situation than it was. The merger of the three organisations, which was difficult and complicated, is resulting in efficiencies. Customers are paying more than £1 million a week less in operating costs than they were when the three organisations were involved and Scottish Water is on track to double that saving in the next two years.

I realise that the committee's discussion focused on the period from the creation of Scottish Water until now. That was a thorough examination, but I believe that we have to start moving forward and to build on the improvements and changes that Scottish Water has made and which this committee recommended. My response indicates that we are taking up much of what the committee has put to us.

Our report was extremely strong in the sense that it probed this area in considerable depth. Although there were disagreements in the committee about certain aspects, there was a great deal of unanimity about the core recommendations.

One issue that we highlighted was capital slippage. That came up again in a new form in relation to the end-year flexibility figure that was announced a week ago. Could you say something about the Executive's attitude to the huge sum of money that is now being freed up in borrowing terms?

Again, members of the committee will be entirely familiar with the reports that were published in 1998, I think—certainly, they predate the creation of Scottish Water. One of the many harsh criticisms of the three existing companies related to their capital procurement programmes and capital management programmes. One of the tasks that Scottish Water was charged with was to treat seriously the need to improve that position. You will be aware that the new non-executive directors, recognising the substantial investment programme that Scottish Water had to undertake, took seriously the need to improve radically the way in which capital procurement and capital management programmes were being addressed. That is what led the board of Scottish Water to go into partnership with Scottish Water Solutions Ltd, which gave it access to people with a much wider range of building construction, scheduling and managing expertise.

I have no doubt that the committee was as disappointed as I was with the speed with which that progressed and with which Scottish Water Solutions finally got under way. However, I have had conversations recently with Scottish Water and, in particular, with Ian McMillan, who is a non-executive director. He takes a lot of responsibility for this matter because of his background in power construction and he has been taking an overview of the process from a non-executive point of view. He and the board make it clear that, although the previous water companies signed up for a £1.8 billion capital programme, there is no evidence that they had any capacity to deliver that programme. We will not know for sure until we see the reports that will be produced in September, but the board is as confident as it can be that it has capacity to commit capital expenditure, in a way that a quantity surveyor would sign off, at a run rate of around £40 million a month. That would get Scottish Water to the £480 million to £500 million a year that it has to reach if it is to deliver the programme.

I am extremely disappointed that the process has taken as long as it has done, although it is difficult for me or you to be wholly critical of non-executive directors for taking their fiduciary responsibility seriously. We are beginning to show signs of getting to the point that we want to get to. There are timing differences in relation to when the money will be spent but, for the first time ever, I am confident that we are building at a run rate that approaches £40 million a month. That is the level at which Scottish Water must remain. We must ensure that the non-executive directors keep the executive directors on target to deliver that.

I am sure that members will want to probe the issues surrounding the financial management arrangements, but I would like to raise the issue of the planning regime, which Scottish Water and other witnesses have suggested is a barrier to the commitment to investment. We have been told about the difficulty of bringing together a series of planning applications for a vast variety of projects throughout Scotland. Is there a case for having a fast-track planning system for dealing with major infrastructure projects? If so, should that system be linked with a mechanism that would allow Scottish Water to purchase the necessary land in advance of having to submit a final plan for an investment as a way of cutting through the time barriers that have prevented the timeous commitment of capital?

I am reluctant to intrude into the territory of my fellow minister, Margaret Curran, but I would say that I do not greatly favour the principle that you mention. There are procedures in place already and, in matters of law, it is difficult to obviate a due process in terms of the Town and Country Planning (Scotland) Act 1997, so I suspect that it would be necessary to have some sort of different procedure.

In the past, there has been a tendency to accept that the water industry's priorities should be ordered in relation to a situation that was largely determined by regulatory concerns to do with whether a specific water plant or sewage plant met the current regulations. I understand that the experience that has been brought into Scottish Water via Scottish Water Solutions and new non-executives has caused the issue of how such programmes are managed in other utilities to be reflected upon. Other utilities have similar problems with planning permissions and so on and they tend to work in a way that ensures that they have a broad range of projects being worked up simultaneously. That means that, if a project hits a planning or engineering hurdle, they are in a better position to move forward with other proposals. I understand that Scottish Water is giving that a lot of thought.

It is for others to determine whether there is a need for change in the planning regime, but I would point out that, if Scottish Water were working up other proposals, it would get a little bit ahead of the game when it was applying for planning permissions rather than waiting until the only project on the go was the one that was awaiting planning approval, which would leave Scottish Water exposed if there were any difficulty.

I read, with as much care as I was capable of, the minister's letter and the Executive's reply to the committee's report. I want to raise an issue that seems to me to go to the heart of one of the recommendations that the committee as a whole made. The Scottish Water submission in annex C shows that, for the most recent available accounts, for the year ending 31 March 2003, of the £969 million total funding that was available to Scottish Water, no less than £895 million was funded from the customer and only £51 million was funded from borrowing; other charges included working capital of £23 million.

We know that, in essence, Scottish Water is funded from two sources: borrowing and the customer. However, for the most recent accounts, the amount of funding from the customer is 95 per cent and the amount from borrowing is 5 per cent. The committee expressed concern that the regime resulted in over-tight borrowing controls. We know that the water industry commissioner got to the root of the matter in his evidence when he was asked why the borrowing controls are so tightly set and why he thinks that that is necessary. His answer is clearly available to us from his evidence to the committee:

"We were trying to bring cash-flow cover of interest payments to a ratio of 1."—[Official Report, Finance Committee, 2 December 2003; c 668.]

The water industry commissioner's basis for doing that was comparisons with English water companies. We dealt with those important issues in paragraph 129 of our report, which was answered in paragraph 20 of the Executive's response. I raise the matter now because nothing in your introductory statement to the committee this morning or in your letter to us—which described correctly the Water Services etc (Scotland) Bill, two consultations and all the rest of it—touches on the central flaw. The committee agreed that the WIC was wrong to compare the financial ratio targets in Scotland with those in England, particularly the interest-cover ratio.

"There were very considerable differences between the bases on which these targets were calculated."

That is the exact wording of paragraph 129 of the committee's report, which the committee agreed unanimously.

What would have happened had the WIC applied the correct ratio? The Cuthberts argue that, instead of revenue being raised by £150 million, there would have been a cut in Scottish Water's annual revenue of £286 million. Therefore, the error's magnitude, according to the Cuthberts' analysis at least, is £400 million a year. I appreciate that that general point is complicated, but I have tried to put it as simply as possible. The committee agreed that the water industry commissioner compared apples with pears and that that was wrong.

If that error had serious financial consequences—I challenge anyone to differ on that point—why, in responding to that serious criticism of the WIC's methodology, do you simply say that it is for the water industry commissioner to answer? First, if the error had the consequence of a price tab of £400 million a year—or even £300 million or £200 million a year—how could the Scottish Executive, in exercising its scrutiny role, not detect an error of that magnitude? Secondly, what will be done about that in future?

Perhaps we could have shorter questions in future.

There were two questions. I think that Fergus Ewing's opening question is related.

The ratio that is brought out in the accounts is absolutely factual. I am not attempting to dispute that. Clearly, there is an issue when borrowing is available to a company and a stream of revenue income comes in week by week and month by month, and there is a serious slippage in the company's financial capital spend. Unless the company does something differently—you may be suggesting that Scottish Water should have done so; perhaps it should have, but it is too late now—it inevitably uses up the revenue that is available on a monthly basis and does not draw down its borrowing. Therefore, it ends up with a figure at the end of the year in which it is way behind in its capital spend. The net consequence of that is that the company has used up the revenue and not the borrowing.

It is my hope and expectation that getting to the £40 million a month run rate will have consequences for Scottish Water's spend rate—the two are not exactly the same, because of timing differences. I think and hope that it is highly unlikely that the ratio will be repeated. That is the ratio that is brought out in the accounts, but it is not the ratio that will occur if Scottish Water's build rate, run rate and spend rate are in the region of £40 million a month.

I turn to the error in the methodology and the committee's view of the comparison. In the first instance, it is for the commissioner to respond. If we intend to do the work in house, we do the work in house. The committee took the view that the comparison needs to be clarified, and it is very proper that the commissioner should clarify it. If he agrees with your proposition, I will be very interested in the matter. However, it is proper that when a committee queries methodology that has been adopted by the commissioner, he should be the one to respond to that query, rather than I. We are still awaiting a response, so I do not know what the financial consequences of the issue are.

I understand that the commissioner wrote to the committee recently clarifying his position.

I have not seen that letter. If members have not seen it either, we are at a bit of a loss. I apologise for that, convener.

Water rate payers are paying 95 per cent of the total costs. It seems that the balance between what is borrowed and what is funded by water rate payers is wrong. You have admitted that there has been slippage under investment and that the capital investment achieved has been hugely disappointing. However, the upshot is that year after year water rate payers are paying far more than was planned and anticipated. When there is substantial EYF, it is not returned to the water rate payer. That is a general statement with which you may disagree in part or in whole. However, if we set that aside, it is undeniable that the committee has identified an error by the water industry commissioner.

You have said today that it is for the WIC to say whether he has made a mistake. Surely, before the WIC was reappointed it should have been ascertained whether he had made a serious error that goes to the root of determining how much funding is borrowed and how much is provided by water rate payers. The failure to come to a view on whether the WIC has made a mistake, as the committee has concluded, is serious. That issue should have been considered before the WIC was reappointed—not to mention the fact that the WIC has overspent his office budget by £140,000. It is extremely ironic that you should have reappointed a regulator who cannot properly run his office, never mind the water industry. Given the huge numbers that are involved elsewhere, that could be described as a sideshow. Before reappointing the WIC, why did you not check this matter and satisfy yourself as to whether we are right or the WIC is right? That is the issue of principle.

I am not entirely sure that Fergus Ewing and I are addressing the same point. In the first part of his question, he seemed to merge two aspects of the total financial consequences of the way in which Scottish Water's finances were run. The member believes—no doubt sincerely—in the conclusions of the minority report concerning the way in which the calculations are made. I understand that.

I am referring not to the minority report, but to paragraph 129 of the committee's report.

Yes, I understand that. However, the total financial consequences that you have drawn seem to me to meld two issues, one of which is the total costs of running Scottish Water. That cannot be seen over a number of years.

The fundamental question relates to the timing differences of the spend. At that point, there is an issue about whether a company should continue to draw down its borrowings. I am not quite sure how we do it, but I do not want a repeat of the backlog of capital expenditure.

As far as EYF is concerned, it is being maintained because it will be made available to Scottish Water. We hope that the timing differences will be eliminated over the medium to longer term and that Scottish Water will be able to access the money that is required for its major capital investment programme. I agree that, because Scottish Water did not draw down borrowing and was behind in its capital spending, the figures that came out at the end of the year to which you refer gave rise to the conclusions that you have drawn. However, as I have said, I do not think that that will be the case over the next two years because Scottish Water must invest at a rate that will deliver a £40 million a month run rate.

I want to pick up on a couple of points that the minister has just made. Although Scottish Water is behind in its capital investment programme, it is not that far behind. The real issue that emerges from the underuse of borrowing is faulty projections about operational efficiencies. Might the WIC have miscalculated the efficiencies that could be achieved and the interest aspects that have driven down borrowing from an expected £240 million to about £42 million?

I suppose that Scottish Water has proved to be relatively more efficient than the WIC or anyone else gave it credit for. It is up to the WIC to answer that question. However, he based his estimate of the level of efficiencies that Scottish Water might have achieved on the track record that was available when he was preparing the reports in question. Things move on, and the WIC will have to acknowledge the very real improvements that have been made within Scottish Water. As I have said, when the WIC was setting most of the targets, all that he had available was evidence about the operations of the three previous authorities.

Although I agree that that causes difficulties about how the industry should be run, I am bound to say that the targets that the WIC set demanded more of the three water authorities than they were prepared to demand of themselves. As a result, we are a caught bit between the devil and the deep blue sea. Although the WIC's initial reports set targets that were much higher than those that the three individual authorities were prepared to buy into, Scottish Water itself delivered a better result than the WIC had expected. It seems to me that those efficiencies will prove in the long term to be in the best interests of Scottish Water customers.

I want to discuss Scottish Water Solutions, which the minister mentioned in his remarks. Minister, you will have seen from our report that the committee shares your disappointment at the speed with which the company was established. Nevertheless, it is now under way, and we are past the 50 per cent mark in the four-year capital programme that will be delivered between 2002 and 2006. In its first two years of operation—that is, in 2002-03 and 2003-04—what was the forecast investment for and actual investment in Scottish Water Solutions? In fairness, I think that that question is for the officials, although my follow-up question will be for the minister

As Scottish Water Solutions did not exist in 2002-03, there was no forecast investment for it.

I cannot recall the amount of investment that was initially predicted for 2003-04, but I will write to you on that matter. The amount was subject to various revisions because of the process by which Scottish Water Solutions was established; that took longer than we thought it would take, so people's expectations of what it might have delivered in 2003-04 reduced over time.

Do we know what it delivered at the close of the financial year 2003-04, which was its first year of operation?

I am afraid that I do not have that figure to hand.

We will have to write to you about that.

You mentioned fiduciary duty, and I concur absolutely with what you said. I refer you to paragraph 5 of the Executive's response. We expressed concern about whether Scottish Water Solutions will meet its ambitious targets because the partnering agreement is a first in the UK water industry. In paragraph 5, you conclude:

"we should allow both Scottish Water and Scottish Water Solutions the four year period before making any assessment on their performance."

You might want to revisit that sentence, which strikes me as being extraordinary. There is annual reporting in the commercial sector and, more frequently, there are quarterly results that reveal figures such as that which I have just asked for. How far behind are we? I am not even asking for quarterly results; I am saying simply that this is a British first. The company did not even get set up in year 1 and it underperformed in year 2. Are we going to leave it for four years before we assess its performance? I am sure that that was not your intention.

I was thinking more of the expenditure period in relation to reviewing whether it should be done differently. We are very demanding in respect of performance assessment. I am due a response from the board about how the arrangements are proceeding and I will get clear assurances on the run rate and on the commitments. The response will address the problems that I mentioned in my opening answer to the convener about trying to have other projects in a better state of readiness, and the need for a much clearer view of the abilities of Scottish Water Solutions as it is constructed at present in its partnership with Scottish Water.

It may be that there will have to be refinements because of the delay in discovering that the massive programme could not have been delivered due to the way in which it was being managed. If there are to be fundamental changes, we might have to part company, but I was hinting that we might have to adjust the balance of skills and expertise. I was taken aback by the genuine view of the board of directors that it had taken on a job for which it did not have the capacity to deliver. That vexes the board members very much, and I am pleased that they feel that way. They think that there might have to be adjustments. However, there is a contractual relationship and if it is fundamentally not working, the failure of specific performance will apply.

I add one final observation. We all know that one of the main reasons why water was retained in the public sector in Scotland is that that would, notionally, give greater accountability. Irrespective of Scottish Water's performance, the minimum that the Scottish public deserve is transparency. The reporting requirements for Scottish Water Solutions should at least mirror the requirements that we find in the much-derided private sector, which would include—as a minimum—speedy annual public reporting of forecast and actual investment requirements. The Executive has an obligation to enforce that at an early stage because in the past two years there has been less transparency than corporate governance demands in the commercial sector. It is clear that that was not anybody's intention when we embarked on the project, especially as there is no alternative provider of such services for most of the poor housing associations and developers out there.

I certainly agree with that. There is no question about it. On the point about corporate governance and the financial arrangements of Scottish Water, the financial memorandum to the Water Services etc (Scotland) Bill makes it absolutely clear that the company must meet the same requirements as the private sector. We will bear down on the company on the matter: no doubt you will, too. It is a major company—by turnover, it is the fifth largest operation in Scotland. It has huge public and non-public interests, so we must do that.

I have read the minister's report to Des McNulty and the Executive's response to the recommendations of the Finance Committee. I am, to be frank, appalled at the cavalier manner in which the minister dismisses one quarter of the Scottish population. 1,250,000 pensioners live in Scotland and water charges have disadvantaged them. The increase in charges for a pensioner household is 5.1 per cent, but the pension went up only by marginally more than 2 per cent. Small businesses' water charges increased by 2 per cent, so you are looking after their interests. What about the quarter of the Scottish population whom you coldly ignore? You are very good at setting up quangos and if you do not watch what you are doing, Scottish Water will go down the same road as the national health service, in which there are too many chiefs and not enough Indians. There will be water rates that pensioners will be unable to pay. I could never append my name to your document when there are so many disadvantaged people in Scotland of whom there is no mention in any of your responses, which is despicable. Do you agree with that?

No I do not. The document does not mention any specific group. The committee did not ask me that question and I do not think that that was what the committee was focusing on.

On the setting up of quangos, I say with all due respect that I have reduced the number of water companies from three to one and although I do not dispute that there has been considerable disquiet about the increase in charges, the fact is that those charges would have been 10, 12 or 15 per cent higher if we had not created Scottish Water. The previous companies would not have achieved any of the savings that have been achieved; the reports of the water industry commissioner confirm that.

On pensioners, there is no doubt that sections of the pensioner community have financial difficulties and we have to consider that as a separate exercise. I do not see that as being an integral part of running Scottish Water, but it is an integral part of the Scottish Executive's and the UK Government's responses to dealing with people in low-income brackets. However, in terms of the day-to-day running of Scottish Water, we can deal with an industry that is increasingly competitive and has a huge burden of regulations on water quality and sewage disposal only by its being run by people who have genuine business expertise and who can deliver what we are looking for.

There are in Dumfries and Galloway 49 waste water treatment works at full capacity and another 35 works that are nearing capacity. You can probably, therefore, understand that there is a great deal of frustration when we see that Scottish Water and Scottish Water Solutions have not been able to use the borrowing consent that is available to them. I have been lobbied for additional borrowing consent, but I do not see much point in that if you are not spending what is available to you.

I concur with Wendy Alexander's suggestion that the performance of those organisations and their investment programmes need to be monitored. Customers and businesses whose water rates have gone up might resent that less if they felt that there was going to be investment and that some of the problems were being faced. Dumfries and Galloway is not unique; I know that there are similar situations throughout the Scottish Borders and in parts of the Lothians. It is a major issue throughout Scotland and it must be addressed.

I suppose I should ask a question instead of delivering a diatribe. You say that quality and standards III will be the subject of public consultation and will seek to identify Scottish Water's investment priorities. Will you also consult on the total level of required investment? I am reassured when you say that Scottish Water is not using its EYF this year; it was handed over to the health service to help with waiting lists, but the promise was given that Scottish Water would get the money in future years. It looks as though Scottish Water will not need it this year, but you say that that money will still be available in future years.

Once Scottish Water Solutions is up and running properly, how much consultation will there be on future levels of investment to tackle the serious infrastructure problems that face Scotland plc, and which were identified partly by the Institution of Civil Engineers? Will you also consult on the likely levels of investment over the period and on what the priorities should be?

Indeed. I do not think that you meant to do so, but you suggested that borrowing constraint was the issue. However, it has never been the issue; the issue has been the company's physical capacity to deliver.

The issue is interesting, because it focuses our minds on how we as the Executive, you as a committee and the public generally will respond to the consultation exercise that I am about to launch. If you go back and read some of the documentation that brought together the programme for the £1.8 billion spend between 2002 and 2006, you will be staggered to find—no matter whose evidence you look at—that no overwhelming body of evidence suggested that there were going to be major development constraints. That is frightening. Back in 1999-2000 we did not even say, "These are our priorities, but that is not."

The forthcoming consultation will be comprehensive. Indeed, the Executive, in conjunction with Scottish Water, has already done preliminary work to ensure that when we consult, everybody will be aware that they will have their own priorities; we must ensure that we get all those priorities on the table and that the public understand how much—in a perfect world—people would wish to spend on water.

We will then go back to the difficulties. At the end of the day, the Executive will face the difficulty of making choices. We will still be faced with the imperative to meet drinking water quality regulatory standards. We will still be faced with the need to meet ever-higher bathing water standards. If proposals on bathing water standards are approved, I will be at the environment council in Luxembourg next Monday. We will have flood water schemes that are linked to sewage infrastructure, then we will have development constraints. You can box those around in any order you like, but they will have to go on the deck.

As part of the consultation, we will examine the Office of Water Services model in respect of new-build constraints in order to establish whether we should change the ground rules so that developers pay a greater proportion of the costs. That would require adjustments to what developers pay for land, which would reflect the cost of infrastructure. There is an issue and a debate to be had around that.

In terms of the central question, Scottish Water Solutions exists only to deliver answers. Scottish Water, the Scottish Parliament and the public consultation will decide the priorities, but we will be constrained by regulatory requirements.

I did not intend to imply that borrowing consent is the problem. It was not news that borrowing consent was not needed because of capacity issues and because of not being able to get the work under way, as you said. Who does the work? One part of the equation is about what is needed, but the other part is about what is possible in terms of capacity. Obviously, what could be delivered was miscalculated in the past. Who is responsible for assessing what is possible?

The Scottish Water Solutions partnership is an attempt to bring more expertise to the construction planning process and civil engineering delivery of those projects, because we and the public will undoubtedly produce wish lists. There are other constraints that are being examined closely.

You will be aware that in purely statistical terms—although it has never quite worked out this way—delivering the £1.8 billion programme, which amounts to a run rate of £41 million a month, will account for 50 per cent of the civil engineering contracts that are placed in Scotland. There are serious constraints, I suppose, in terms of the fiscal ability in the whole of Scotland to engage. I was going to use a terrible metaphor and say that we cannot just turn on a tap of capital projects; however, my mental processes got slightly ahead of me and stopped that.

There are big issues. We all sit on other committees and in Parliament and we know that there are other capital commitments—the private sector has its own capital commitments. To have a single industry contributing that proportion of the civil engineering requirement in Scotland is significant. It might also be an issue of constraint in terms of what the industry can physically manage to build and the cost of that.

Going back to the free-cash ratio error that the water industry commissioner made in both his strategic review and the evidence that he gave to the committee on 2 December, I am interested to know how the Scottish Executive did not, in exercising scrutiny, detect that error—the magnitude of which was described by Fergus Ewing—particularly given that Cuthbert pointed out, immediately after the WIC gave oral evidence, that his evidence was inconsistent with the published information on the net borrowing of the English water and sewage companies. How can a mistake of that size in the water industry commissioner's logic be uncovered without its having any apparent effect on the recommended revenue caps and charges that are emerging from the strategic review?

Let us be clear. Are you talking about the allegation of the Cuthberts' error?

No, I am talking about the free-cash ratio error as enunciated by the water industry commissioner when he attended the committee on 2 December. He said:

"We were trying to bring cash-flow cover of interest payments to a ratio of 1. To put that in perspective, in the past five years only two companies in the industry—in one year each—have had cash-flow cover of less than 1."—[Official Report, Finance Committee, 2 December 2003;
c 668.]

That was subsequently proven to be an apples-with-pears comparison in that the Scottish free-cash ratio included capital expenditure, but the English one did not. That was the subject of Fergus Ewing's earlier question about what would have happened to achieve that ratio that would have meant not a raising of charges by £150 million but a reduction by £286 million.

Could you help me with the question, Jim? I would like to give a more intelligent response to it. There is some confusion. You are not talking about the Cuthberts' error on the borrowing, are you?

No, I am talking about what the water industry commissioner said. When the water industry commissioner gave lengthy evidence to the committee on 2 December, that was what he opened up with. It was his defence—his fig leaf. It was the argument that he put forward for the charges' being as they are.

Could you point me to that evidence?

Jim Mather is referring to paragraph 129 in the Finance Committee's report. It is the precursor to the committee's conclusion about broad financial ratio analysis. I am not sure how the question that Jim Mather is asking differs from the question that Fergus Ewing asked.

I am, in fact, looking for an answer to the question that Fergus Ewing asked. Why did not the Scottish Executive spot an error of that magnitude and how could such an error—which has huge implications for the revenue of Scottish Water—not have an implication for the revenue caps and charges?

For clarification, it might be worth separating out the issues. The committee's comments were about the mechanism of the analysis that was used—as Jim Mather has said, the apples-and-pears aspect of the comparison that was used. However, I am not sure that that was necessarily the basis for the financial profile, as Jim is trying to suggest in the context of talking about errors.

I am obliged to you, convener. I was in slight difficulty because I had a note from my colleagues on a slightly different matter.

The conclusion of the committee's report does not go on to make the point that Jim Mather makes, although he is entitled to his view. He draws the conclusion that there is a huge financial consequence and he asks why we did not detect something; there is no particular reason why. We do not try to second-guess Scottish Water—we have a supervisory role and we take it in good faith that people are doing their jobs. It is perfectly reasonable for the committee to ask whether the use of non-comparable bases can be misleading, which was the committee's conclusion. However, Jim Mather goes further than that and draws the conclusion that people could have had money back from their charges. I have not seen the evidence on that and the commissioner is entitled to respond first on that. Jim Mather and Fergus Ewing make the separate allegation that there must have been financial consequences if that evidence was correct, but that was not what the committee reported.

My argument is a logical extension of the defence that the water industry commissioner offered us.

I will go further. You and I have private sector experience. If you had come across a situation in which a key figure—let us say a finance director—gave evidence to an annual general meeting or to internal auditors that perpetuated an error, but that director did not subsequently admit to the error once that balloon was up, what would have been that finance director's future in the organisation? How can we justify continuing the appointment of the water industry commissioner?

It is interesting that you came to a conclusion before you asked the question—you have already drawn a conclusion about the amount. However, the amount does not form part of the committee's report—it is not one of the conclusions that the committee reached. We are back into the territory of allegations. You are entitled to make allegations but, using the same source, you made another allegation about an error in the accounting basis of Scottish Water's financial statement. It was found by a majority that that was not the case and neither the Executive nor HM Treasury shares your view. To draw a conclusion about the total quantum without having an answer to the question that was properly put by the committee is, to be frank, to go a little too far.

You talk about allegations and you say that the majority of committee members have not signed up to our claim, but that is something that will give them long-term discomfort. Neither I nor the Chancellor of the Exchequer would dissent from the well-established principle of accounting prudence that, in normal circumstances, an organisation should be run so that it covers, from revenue, the amount of resources that it consumes, including current resources and the amount of capital that is used up. That translates into the principle that revenue should cover operating costs plus depreciation plus interest payments. In the strategic review of charges, the planned revenue for the period 2002-06 exceeded the total operating cost plus depreciation plus interest payments by no less than £300 million.

When you approved the revenue caps that were proposed in the strategic review, did you ask why the planned revenue was so much higher than would be required by a conventional view of prudence, with the charges to water users being potentially several hundred million pounds too high? We all knew that that was happening because we received phone calls from business users. Why did that not suggest to you that something must have gone disastrously wrong with the arithmetic in the strategic review?

I will make a couple of points before the minister responds, one of which is about an error on my part. I received a letter from the water industry commissioner that should probably have gone to the clerks and been circulated to members—I thought that I had done that. I will circulate that information immediately after the meeting to ensure that members have the benefit of the water industry commissioner's response.

What was the date of that letter?

It was received last week. As I said, it was an error on my part not to have sent it round.

Jim Mather raised resource accounting and budgeting. The committee dealt with that and took a view on it, so I am not sure—given that the minister is here to respond to the committee's report—that it is necessarily helpful to go back over that ground. I will let the minister respond, but I want to channel the discussion.

It would be deeply embarrassing for the whole Parliament if the question was left hanging in the air unanswered.

The question is not hanging in the air unanswered. It is an interesting device to take your interpretation—to which you are entitled—and claim that it is the majority position, that position having been previously addressed and the error not having been found. Paragraph 129 of the committee's report does not make that allegation. You are making a private allegation, as you are perfectly entitled to do. I will not stop you making it, but does not accord with the committee's conclusions nor does it accord with the question that was addressed to the water industry commissioner. If you have a separate allegation, I will be happy to deal with it. However, I say with all due respect that you are trying to raise the matter as if it had been raised and adjudicated on by the committee, which found that £400 million-odd was to be handed back to Scottish Water consumers. That was not what the committee found. If you want to make that allegation, you are entitled to do so and I will answer it. However, I would like to see that calculation, as it is not contained in the committee's report.

I think that I am entitled to a response—

I will call Wendy Alexander to speak first, in the interests of clarification. I will call you to speak after that, Jim.

It is a matter for the convener to clarify. There are two issues.

The committee rejected the wider question of whether the water industry commissioner had the right to treat depreciation, and to reach views about borrowing, as he did. The questions today have focused on a much narrower issue on which there was unanimity in the committee. The WIC addressed the matter of financial ratios in answer to a question that I asked. I exonerate the minister completely from the minutiae of this, as he had other things on his mind at the time. The committee did not share the view that the water industry commissioner had no powers to act as he did; however—Jim Mather makes a fair point—we were concerned that he had not used a comparable financial ratio analysis. Although, in broad terms, such an analysis was appropriate, the WIC did not conduct his analysis on a like-for-like basis.

It has been pretty graceless that there has been no admission of that—if there had been, the issue would have gone away. In that context it is surprising that the Executive went ahead and reappointed the commissioner without an admission that the analysis was not conducted on a like-for-like basis and that an inadvertent remark had been made in the committee. You might want to clarify the two distinct issues, convener.

You are quite right, Wendy. That has helped to clarify the two distinct issues. I was concerned that Jim Mather was going into a different area. The issue in paragraph 129 of our report is exactly as you have set out: the committee was concerned that comparisons that were being used to provide justification for the arrangements for a specific regime were being made on the basis of a different analysis.

I will leave the question that I have just posed on the table and if I do not get an answer to it today, I will take it up in writing. We are not talking here about an allegation. To call it an allegation is grotesquely discourteous to people who have worked pro bono with me and others to open the matter up. It is a hypothesis. The term "allegation" carries pejorative overtones that are totally unworthy in that the hypothesis has so far been handled only by assertion. My concern is that, if that remains the case, then the committee, the Environment and Rural Affairs Department and the Parliament will be embarrassed when the Auditor General takes a look at the figures and agrees with the hypothesis.

I think that we have managed to exchange pejoratives. That is not your fault, convener. The question that Wendy Alexander posed, which is set out in paragraph 129 of the committee's report, leads logically to Jim Mather's question, which would have less or more force or effect depending on the answer to the question in paragraph 129.

Logically, this point falls to be clarified, following the contributions of Jim Mather and Wendy Alexander. There are two main criticisms here. First, resource accounting and budgeting has been misapplied. There was no agreement on that in the committee. Secondly, there was agreement in the committee on the interest cover ratio. The WIC made a mistake, as is set out in paragraph 129 of the committee's report. I have read from that report. Wendy Alexander has, I think, concurred, as has the convener.

It has emerged from this morning's meeting, and from what Mr Andrew Scott has said, that the committee has received a letter from the WIC. I did not know that. I asked the convener if that was the case, and he said yes. The convener has graciously said that he has not yet had the opportunity to pass on that letter to the committee, which I entirely accept. He tells me that, in that letter, the WIC denies that he has made any mistake regarding the interest cover ratio. We will want to study the text of that letter. I do not expect the minister to provide an answer to this question this morning, but it is a matter on which the committee has expressed a unanimous view: the WIC erred. The consequence of his error determined his approach to prudent levels of borrowing. If the WIC was wrong, that has serious consequences, although we might disagree about whether the extra revenue is £400 million a year or another amount. Will the minister come back to the committee to let us know whether he agrees with the committee on the interest cover ratio, or with the WIC? Whatever the minister's answer, what consequences will there be for the future arrangements for setting the appropriate level of borrowing?

I cannot remember the exact terms of the WIC's letter. I do not have its details in my head. We need to be clear about the extent to which the interest cover ratio was the basis on which decisions were made. That is not clear at the moment. A comparative analysis was produced, and the WIC may not have given it the weight that Fergus Ewing is implying that it should have been given. There is an issue there.

I have a final point to leave with the minister. I will try to deal with the reason why confusion has arisen over the calculations and with the lack of transparency. The reason for having water services in the public sector is, nominally, because that offers greater accountability. The exercise that has been undertaken shows an absence of transparency around financial reporting and an absence of accessibility to members of the committee.

It would be unthinkable for a public water company's accounts for the past year to be in front of us now, with details of how much of its capital investment programme had taken place. As the minister will know better than anyone, there are very clear bases for establishing ratios, including—when it comes to financial reports—reading the notes. All that will become possible if there is transparent financial reporting, which has not so far characterised the public corporation of Scottish Water. The minister has given us a clear indication that he will put in place a regime of transparency around financial reporting that will be sufficient to prevent the difficulties that have been experienced arising again.

I am grateful to Wendy Alexander for that contribution. The fundamental issue was the prospect of making a misleading comparison. The committee formed a clear view about that, in particular with regard to the use of the financial ratio analysis. We will simply have to come back to the committee on the matter—Fergus Ewing has invited me to do so. I am not sure how we will handle it. I could have a discussion with my officials and with the clerk to the committee as to the most satisfactory way of doing that. The WIC's opening sentence in response to the point in the committee's report includes the words:

"I would agree that I should have been clearer about the basis of calculation".

It might be that the commissioner has reflected on his answer. There are three and a half pages in response to that single point.

I accept that I must come to a view on the matter as well, Fergus. However, before we start to extrapolate forward as to the consequences of the application of the ratio in that instance, particularly given the fact that the committee was uncomfortable—to say the least—on the issue, the committee should have the benefit of the commissioner's response to its deeply-felt concern about how the ratios were applied.

The matter should be dealt with in that way.

I could not agree more with Wendy Alexander's analysis of the situation. We are talking about what I think is the fifth biggest industry in Scotland. Scottish Water should be examined at least as carefully as a private company would be. I think that that is something on which we all would agree. Certainly, coming from my political position, it is something in which I believe.

I welcome your pledge of more transparency, minister. I neither agree nor disagree with the tone of the comments that have been made about the WIC and his performance. However, in the interest of transparency, would you share your thoughts on how you came to the decision to extend the WIC's term of appointment? I am thinking in particular of your comments about the cost of the WIC's office and so on. Will you spell out for the committee why you felt that "on balance"—for those are the words that you used—the WIC's contract should be extended?

Yes. In operating as a stand-alone commissioner, the present WIC has made a contribution in terms of his analysis of the industry as a whole. With all due respect, as none of us was elected when the general public happily thought that the three public water companies were doing very well, we thought that there were no real problems and that the three companies should be allowed to continue as they were. Without the rigorous analysis that the WIC brought to bear on the issue, no serious question marks would have been raised about the companies' performances in a regulatory sense or their performance in a financial or any other sense.

The WIC's analysis provided a benchmark for the proposition of bringing the three companies together. The pressure with which he has borne down on the water industry has been hugely beneficial. However, it is unfortunate that, coincidental with that pressure, the water industry found that the state of play in the three companies was poorer than had been envisaged. The decision was made on balance. Although there are issues about how the present WIC communicates and deals with things, they do not relate to his performance as a stand-alone regulator.

The reason that I was able to respond so swiftly to the committee's helpful and constructive recommendation in this respect was that I had it already in mind. Having seen how things have worked out over the past few years, I thought that it would be better if we were talking not about an individual and a clash of personalities, but about putting the singular position and view of the industry against quite a powerful board.

The question remains whether the person under discussion has demonstrated an ability to understand the industry and its operation and whether he has borne down on the inefficiencies within it. On balance, one would have to conclude that he has done so. However, the appointment procedures to the new commission mean that the WIC's full appointment as chief executive of the new commission will require the approval of the chairman of the new commission, when they are appointed. In broad terms, that is how I reached my conclusion.

Will the extra tenure of the WIC last at least until such time as the decision is made on who the new chief executive of the commission should be?

Indeed. I do not want it to be a long period of time. I share entirely the committee's conclusion that the office of a water industry commissioner would hugely improve the process. I am anxious that we should proceed as quickly as possible on the issue.

Just for the record, I am not sure whether Jim Mather was referring to the Cuthberts when he mentioned people who have worked pro bono with him and others. I was the other reporter on the inquiry and I treated them in the same way as all the other witnesses, having received questions, speaking notes or anything else that I might choose to use in meetings.

As a reporter, I am grateful for the Executive's full and extremely progressive response to the committee's report. On capital spending, we heard throughout the inquiry about individual circumstances, such as those of registered social landlords or companies that wish to invest, and about the development constraints that exist. My question is about an inherent difficulty that might become evident in the roll-out. You mentioned practical considerations in relation to the capital programme and paragraph 8.1 of your written submission mentions that the Executive, the commissioner, Scottish Environmental Protection Agency and others are working to identify the priorities. Is there not a potential difficulty with SWS being the delivery arm? If SWS has efficiency targets under the private sector model, will it not seek the efficiencies that are easiest and quickest? If it does so, it might perform well, but the investment that we seek for the benefit of Scotland's economy or local areas might not match with the priorities of what is, in effect, a commercial enterprise.

I do not think that that is the case. We have to get the structure clear. Scottish Water Solutions will be there to deliver as efficiently as it possibly can, but it will be there to deliver a programme that has been agreed by Scottish Water and approved by the minister after the consultation process. Decisions about what goes into the programme are not in the hands of Scottish Water Solutions, which is there to deliver the efficiency. After the consultation process, we will have a pile of requests from everybody and it will be for us to determine the priorities. It will not be for Scottish Water Solutions to say, "Actually, we would rather take projects 1, 152 and 166 because they are easier for us to do." That is not how the process will work and that it is not how it is laid down either statutorily or in the regulations.

I appreciate that clarification. It might be my lack of understanding, but if the investment round takes place over a four-year period, there will obviously be priority areas for local communities, the economy or individual businesses. Will SWS be instructed to programme its work on that basis? I will outline one fear: that the implementation of work in some investment areas over the four-year programme has higher priority than others. That would be a concern in relation to building constraints for a particular local plan that has approval and is waiting to go, whereas other capital programmes might not have the same level of urgency.

As far as possible, that will be the second, or probably the final, stage. If, having agreed the priority issues for a four-year programme, we ask about the timing of the building programme, we get into a delicate issue. I agree that we do not want those decisions to be made on the basis of what is easy—perhaps we can agree on that. I am somewhat reluctant to be over-prescriptive because we might get into the difficulty of marshalling a number of programmes so that we actually get them delivered. I would not want suddenly to find that without all the information about civil engineering, planning and other conditions we are trying to second-guess people who are better qualified to deliver the programmes. I take your point, but I assure you that it is we, not Scottish Water Solutions, who will decide the balance of the programme. As I said to Elaine Murray, the consultation will have to involve serious consideration about what we do with new development constraints and whether we switch how they are financially structured.

I imagine that the work that is being carried out with local authorities and others, which we heard about during the inquiry, has led to a substantial list of identified areas of constraint and potential, which could give a much larger figure than what is affordable or what it would be prudent to borrow. Within the weighting or consideration of the capital programme, will consideration be given to the Executive's stated priority of economic development? In the first period, the quality of water was the main consideration—that obviously continues as the number 1 priority for you as environment minister—but where will the consideration of the economy come in decisions about the capital programme?

That debate will emerge. The economic development case is important. You are right that, although we are about to embark on consultation, we have a fair idea about the range of issues that local authorities will want to put on the table—one does not have to be Einstein to work that out. People with other perspectives will be concerned about capital development issues, which will also have to come on to the table. Alongside those, we will still be required to meet the drinking-water quality and discharge regulations. Of course, given that the Parliament approved the Water Environment and Water Services (Scotland) Act 2003, we will also have water-quality constraints across river beds. All those issues will have to be addressed.

In the middle of that debate, we will have to look within Scotland and at England and Wales and other European comparators to see what we can do about new build. If, to breach the economic restraints, we change to a regime whereby the vast proportion of the development costs are borne by the developer, that would have to be known in advance so that when developers acquire land, they pay a price for it that reflects the potential development cost. I have spoken to one or two developers and, in principle, they do not have a difficulty with that. We would have to be clear and open about the fact that we were considering such a regime. It is possible that such a regime might be a way of getting over the substantial economic constraints and at the same time allowing the Scottish Executive and the Scottish community to pursue improved quality of drinking water and improved sewage discharge. That is the equation. I want much greater openness and transparency in the process, much greater understanding by the Parliament and an improved ability of the Parliament to represent the community, which includes the 1.25 million people whom John Swinburne mentioned.

I remind the minister that, on 8 January, in response to a supplementary question from me, he said that he had

"asked Scottish Water to reassess completely the provision for underinvestment and development constraints."—[Official Report, 8 January 2004; c 4668.]

Where are we on that?

That was a horrific thing to do to Scottish Water, because it revealed that 80 or 90 per cent of the issues had apparently not been assessed. In parts of Scotland, Scottish Water has had serious discussions with the regulators—either in planning authorities or the Scottish Environment Protection Agency or elsewhere—who imposed standards that could not be met without a complete rebuild. Some of the constraints have been eased, but the figure that emerges is frightening and cannot be met. Of the £1.8 billion for investment, a lot of the new connections will assist, but only to the extent of about £200 million or £300 million of development constraints. Scottish Water simply does not have enough in its budget. That is the stark reality. Those priorities were determined by regulatory requirements. It is very difficult to say to Scottish Water that it should not be meeting the requirements of the drinking water quality regulator or the requirements on sewage discharge. That is a huge problem for Scottish Water.

Jeremy Purvis was kind enough to restate the pro bono work that the Cuthberts have done. In the main, that work has consisted of published papers, evidence to the Finance Committee, letters to the press and articles in newspapers, among which is an article in today's The Scotsman that is entitled, "How Labour created a new tax out of Scotland's water". I suspect that Labour was put in the frame because the phrase "Scottish Executive" was too big to fit in the space. They argue convincingly that mistakes were made in the application of RAB and in the calculation of the interest cover ratio. Those mistakes meant that the amount of borrowing that was available to the water industry under the strategic review was significantly less than had been indicated by the borrowing figures that the Executive published.

The major argument that was advanced against the Cuthberts' hypothesis in the Finance Committee's majority report depends on the existence of an extra £200 million in borrowing provision, which it appears was discovered by the committee's adviser, Professor Midwinter. Even if that extra borrowing provision had existed, it could not have been used within the RAB limit. There is another problem with the £200 million: it appears that there is no written record of it and that the water industry was not notified of its existence. Can the minister confirm whether the £200 million that Professor Midwinter discovered was referred to in any contemporaneous internal or external document that the Executive produced? Was the water industry ever notified of the existence of the £200 million, and if so, when, or was that figure entirely spurious?

The borrowing that is available to Scottish Water has always been within the limits that are approved by the Parliament. Therefore, that figure was in the public domain. Before the creation of Scottish Water, the Executive made it clear to the water industry commissioner that we had separate concerns that the merger of the three water companies might result in over-runs, under-runs or additional or unforeseen expenditure. As part of the process of setting up the strategic review of charges, we indicated that we would make available the £200 million separately, but within the limits that were set out. To us, that seemed to be a perfectly prudent thing to do. The water industry commissioner had a slightly different view on when he thought that all the efficiencies that he had calculated would arise from the merger would kick in.

Jim Mather has mentioned putting finance directors under scrutiny. When I was in the private sector, very few mergers that I observed went to plan, so it seemed prudent to set aside the £200 million. The two amounts were quite separate, but they did not appear from nowhere—they related to the levels that were suggested in the strategic review of charges.

How do you explain the fact that we have a letter from your department that says that none of the stakeholders was ever formally notified of the £200 million?

I think that the question was about whether stakeholders were ever notified of that £200 million separately. It was part of the overall figure. It was greater than the total amount of borrowing. The stakeholders knew what headroom they had when we notified them of the total amount of borrowing. They might have had to make a deduction, or to draw one figure from another. We did not make that available separately; it was to be part of their overall access to Government funding.

Given how things have panned out and the fact that, even in 2003-04, 89.7 per cent of the capital expenditure is being funded out of revenue, has it never crossed your mind to recast the charging regime, to put in place rebates and to stop penalising the current generation of water users?

That is not the issue. Essentially, we are talking about timing differences. The moneys will be required for Scottish Water's capital expenditure programme. The essential problem is that Scottish Water has had difficulties in getting the appropriate capital programme up and running. It would not have been a sensible arrangement to have taken away those moneys and thereby put at risk the future capital programme.

I am keen to reconcile two sentences that appear in paragraph 16 of the Executive's response to the committee's report. After stating that

"Scottish Water will not require in EYF any of the underspend that was generated in 2003-04",

two sentences later the minister states:

"As the committee is aware, we have an agreement for 100% End Year Flexibility (EYF) for water."

Which statement should we believe?

Both are absolutely accurate. Again, it will all be a matter of timing. Given Scottish Water's current projections, it is pretty clear that that EYF will not necessarily be required in the immediate future, but the full EYF is and will be available to Scottish Water when it requires it. The matter is one of timing. I am not cutting off those moneys, so there should never be any accusation that Scottish Water is unable to complete its capital programme as a consequence of our removing moneys from it.

Given that the timing of the expenditure is clearly going to be different, Scottish ministers collectively are entitled to use those moneys in the most effective way across the Executive's expenditure. However, that does not detract from the fact that the Minister for Finance and Public Services has undertaken to make the moneys available to Scottish Water when they are required so that the company can meet its capital expenditure.

I want to pursue that. Let us accept the argument that the borrowing provision should be rolled over so that it continues to be available to Scottish Water. Two years into the current cycle, we are now in a position in which we have more realistic projections about what efficiencies Scottish Water will make and what its interest payments are likely to be. Is there a realistic chance that the borrowing provision that is rolled over this year will be required next year? Is that likely to be used as part of an acceleration of the capital programme next year? Is not the reality that, as the process has progressed, a significantly increased proportion of the investment is being paid for through charges than was originally projected, when a different balance between funding from borrowing and funding from revenue was anticipated?

That is certainly possible. Essentially, the issue very much hangs on what happens with the capital programme. Two swallows do not make a summer. Scottish Water and Scottish Water Solutions have reported to me that they are hitting a run rate of £41 million a month—something that they failed to do in the past. I am happy that that has been reported, but I do not take it as proof positive of anything. Like the committee, I will want to see that level of activity being sustained. If that happens, the logical conclusion is that Scottish Water will be more likely to require a greater proportion of its borrowing requirement.

If that level of activity is not sustained, we clearly have two separate problems. One of those concerns the fact that Scottish Water will not be able to use that borrowing requirement. The other issue, as the convener has properly highlighted, concerns the balance of how that capital expenditure is funded. Crucially, we would also have the equally serious matter of being unable to deliver on the £1.8 billion programme. Going forward, that would have pretty serious consequences for the outcome of Q and S III. Some very serious issues hang on that capital delivery programme being put in place.

There was a serious underspend on capital commitment in the first year. The situation improved slightly in the second year, but there was still a gap because the level of capital that was invested was 15 per cent below the target.

From what you said, there is an extra £205 million of borrowing headroom that could be used in the latter two years of the period, but there does not seem to be any expectation that any part of the money could be spent on, for example, dealing with development constraints or accelerating investment, or perhaps even anticipating what could come in the period 2006-10.

There are two issues there. With all due respect, no other organisation has got anywhere close to committing £41 million of expenditure a month. Acceleration might increase a little, but it is not going to increase much. After a sustained period of managing what is a much more acceptable level of capital expenditure, Scottish Water might see if it can improve on that, but around £41 million a month spent on structure on the ground would be a reasonable achievement. We need that to run for a period to be satisfied that Scottish Water can deliver the quality that we require and to see whether there are ways to increase capacity. That is one of the crucial issues that will have to be discussed during quality and standards III, because—in response to Ted Brocklebank and Jeremy Purvis—there are issues about what the constraints are in delivering a revised programme.

In a sense, the money has been characterised as water EYF money that could be spent in the water industry in future. However, is there any possibility or likelihood that significant amounts of that money could be spent in the period 2005-06 in the water industry, based on what you know? If we cannot spend the money in that area, should we be calling it water EYF, or should we recognise that it is EYF—it is borrowing that has not been used in the water industry, which will now be devoted, as far as we can see, to uses outside the water industry?

That is a possibility. We have been reluctant to cut off the source. We are told that the £40 million figure is the one that Scottish Water can achieve but beyond which it might have difficulty in going, so as the months go on, your proposition may turn out to be the right one. If that becomes the case, this committee, the Minister for Finance and Public Services and I will be interested in seeing how things project forward.

We want there to be greater transparency in response to questions to us and to Scottish Water, and we want the run rate to be treated differently, in terms of what is being put in on the ground. The treasury functions of managing cash flow and of managing when commitments are likely to be realised impact hugely on the level of borrowing and, looking forward, the likely level of borrowing. As you rightly said, we are getting a much better picture of that. The Minister for Finance and Public Services, parliamentary committees and I will be concerned to get a better handle on those issues, which depend crucially on the run rate.

I want to pursue the issue one step further. There are two dimensions to this. The first is that, if borrowing is available and if the parameters of the regime under which Scottish Water operates—which you put in place and which the WIC supervises—are geared towards compliance, could some of the currently unused borrowing capacity be used over the next two years, and perhaps even be rolled forward after that period ends, to deal with development constraint issues?

Could borrowing capacity be diverted by means of a rebalancing of the regime, with money being targeted at some of the serious development constraints on businesses and local authorities in different parts of Scotland?

That would suggest that some water-type projects could be built.

I am sure that you will find plenty of people in Scotland who would argue that such projects could exist.

I am not saying that they could not exist. Scottish Water has a bundle of projects totalling £1.8 billion.

My argument is that those projects are largely compliance-driven projects. To pick up on Jeremy Purvis's point, there are probably other projects that have development constraints.

Your suggestion is not unhelpful, but if it were possible to build at a run rate that was higher than £40 million a month and to get rid of regulatory requirements, Scottish Water would be delighted. However, all that it has been able to do is to reach a point at which it can manage and operate a £40 million run rate. There are other constraints. If someone else could build more water infrastructure to get rid of some of the regulatory issues, I would be very pleased.

There may be two kinds of constraint: a construction capacity constraint, which puts a limit on what we can reasonably do and means that we can build only £40 million of projects a month; and a financial and regulatory constraint, which means that, within the current framework, we can spend the £40 million a month only on things that have already been agreed. If unused borrowing is available and if the capacity exists to build additional water infrastructure and to deal with development constraints, could a change in the regime under which Scottish Water operates allow at least some of those development constraints to be addressed?

The £1.8 billion was agreed by the Executive and the Parliament for a specific purpose. The answer to your question is that that would be possible. However, you are positing that money should be spent only on dealing with development constraints and I think that there could be a serious argument about whether that would be a priority for Executive expenditure. Other people might have something to contribute to that argument.

I agree, but £205 million has been allocated to water expenditure and, in effect, we are spending approximately only one fifth of it. If it is not physically possible to use it, the borrowing capacity should obviously be reallocated; but if it is physically possible to use it, we should be considering what constrains its use for the purpose for which it has been designated.

I was not disagreeing with the principle of what you said; I was simply saying that there might be other priorities. The nature of the expenditure would be crucial. We would have to consider whether it was different in any material way from the expenditure on construction that is in the existing programme. Our priority has to be dealing with the constraints on water quality and sewage discharge quality. There is a widespread misconception about water quality. The water is not of poor quality but, when we consider international comparisons, it needs to be a lot better.

I agree with the convener's two classifications for constraints—one that is financial and regulatory, and one that relates to the capacity of the industry to do more work than it is being asked to do at the moment. Following a meeting with a representative of civil engineering companies in Scotland—Mr Alan Watt—I understand that companies do not feel that they are at full capacity. Of course, many of those companies are not members of the consortium Scottish Water Solutions. Although I am no expert in this matter, it seems that there is unused capacity in the industry. Indeed, judging from the reaction of someone in the public gallery, I think that I might be right about that.

Given that we are primarily pursuing points that have arisen from our committee report, I want to pursue the issue of the £200 million. With great respect, I think that the issue, which was raised by the committee in paragraphs 94 and 95 of the report, is pretty serious. Wendy Alexander has already highlighted our concerns about transparency, but our problem was that the initial figures that we received in evidence—mostly from the WIC—indicated that there was a certain level of borrowing totalling £513.9 million. The committee sets that out in paragraph 94 of the report. However, I recall that, after we had concluded our evidence taking, we suddenly learned from our adviser in private session that—hey-presto—another £200 million was lurking around that the committee had not been told about.

As a result, the committee unanimously agreed to pursue the matter—I see the convener nodding—not just in our letter of 30 April, to which you replied in your formal response to us, but, as you know, in other correspondence. In those letters, the committee asked you to give us some more information. You have stated that the £200 million was made available following consideration in November 2001—before Scottish Water was set up—that the company might need more money. In the letter to us, it was stated that no "formal notification" was made in that respect. It does not state to whom there was a lack of "formal notification", but we take it that it was referring to Scottish Water and the WIC.

First, was any informal notification made to Scottish Water and/or to the WIC? Secondly, as the convener asked in his letter, can we please have the documentary evidence to back up your response? By asking for that, I am not alleging any mala fides; however, I have to point out that the information did not emerge until we had completed our evidence taking. We would all have liked to have had an answer to this question before today. Personally, I would have preferred not to have spent all this time raising the point, because many other points need to be raised. I repeat: was any informal notification made that a further £200 million of borrowing was to be made available to Scottish Water and the WIC? If so, will you please supply the documentary evidence to substantiate that?

We have already said that we did not refer specifically to the £200 million. Instead, we referred to the total amount of borrowing that was being made available to Scottish Water. As I said in response to an earlier question, that total amount of borrowing was still within the limits that Parliament had approved. Furthermore, Scottish Water was aware of the amounts that the WIC was calculating.

Why did the committee not receive that information before? Is the table set out in paragraph 94 of the committee's report wrong? I am referring specifically to the table headed

"Changing Decisions on Borrowing Provision",

which lists the WIC's provision, margin and totals. In 2002-03, that total was £199.3 million. The next line shows

"Additional Provision by Scottish Executive",

which, in 2002-03, was £60 million and, in 2003-04, which is the last complete financial year, was also £60 million. In the latter two years of the programme, the additional provision will be £40 million. That makes £200 million. If you are saying that the specific figure of £200 million was not made available, where did that figure of £200 million come from?

Under the table at paragraph 94 in the report, it says that there is a

"£610m agreed maximum for Scottish Water and £78m margin held by Scottish Executive."

If you look at the totals that we made available to Scottish Water, you will see that the margin for uncertainties and errors was £200 million. I do not think that there was any attempt by anybody to disguise anything. It was a question of advising Scottish Water of the total amounts that it could spend.

The WIC made it quite clear that he took a different view on any margins for uncertainty in relation to the mergers. We could not do anything about that if we went outwith the Parliament's stipulated level of borrowing, but we took the view that, because of uncertainties, it would be prudent for us to make an additional £200 million available to Scottish Water if the need arose. It was not a question of saying, "We want you to spend £200 million more." It was more a question of there being a prudent reserve available should that situation arise. There was no intention on our part to undermine the WIC's position by saying, "Thou shalt spend." Rather, there was a pragmatic recognition that, in those earlier years, there might be differences. We had also hoped, of course, that those differences would relate only to parts of the expenditure. We had not anticipated that there would be such an underspend in the capital programme. That was not something that we contemplated and we had no reason to assume that one would arise.

I take that point, but it is a slightly different point. You have stated that the £200 million was part of a larger figure, but that £200 million was the additional total that the committee adviser informed us about—a figure that had not appeared in any of the submissions from anyone, either from your department, from Scottish Water or from the WIC. In his letter to you, the convener asked whether documentary evidence could be provided. You have indicated that there was a larger figure of which the £200 million was part. Could we have sight of the relevant documentation, please? That would include the internal departmental decision plus any documentation that communicated the relevant information to Scottish Water and the WIC. If we could have that correspondence and other documentation, that might perhaps bring the issue to a close so that we could move on to consider other matters.

We shall have to discuss what further information we can provide and, if it can be provided, we shall happily provide it.

I raised the matter because I feel that the committee was not given the full information that we should have had in the course of our inquiry. We received it only after the inquiry was over. With great respect and without inferring any malice or mala fides, I think that that is an unanswered question. It will not go away and it is obviously a question that I shall invite the Auditor General to look at if the committee cannot get the information that most of us felt that we should have had, and could have had, at the beginning of the inquiry rather than at the end.

The minister has indicated that he will go away and have a look at the various bits of information. We have had a reasonably good crack at the issue, so unless there are any outstanding questions, we shall move on.

Some questions that I raised earlier are outstanding in that they have not been answered. I take it that I shall get a written response at some subsequent point.

I shall look at the Official Report. Your questions related to two separate issues. Some of them related to the unfortunate matter of our not starting today from the position that the water industry commissioner had outlined. I shall look at that matter and correspond with you and with the convener on that. There may be a need for us all to reflect on what the water industry commissioner says and to consider the consequences of that, and for the committee then to pursue the questions that members have raised, which might or might not be informed by that response.

That sounds reasonable.

It might be helpful to channel that through the clerks, so that we can conduct a proper correspondence.

And now for something completely different, minister. Paragraph 2 of your letter states that, as part of the general response to the issues that have been raised by the committee and others, a Water Services etc (Scotland) Bill has been introduced and paragraph 17 of annex B says that the bill

"will enable third parties under licence to provide retail services to non-household premises".

Put simply, that means allowing English water companies to bid for business customers in Scotland. My concern about that is twofold. Because Scottish Water has debts of between £2.1 billion and £2.7 billion and the English water companies do not—because their debts were written off at the time of privatisation and no comparable provision was made for Scottish Water's predecessors—Scottish Water has one hand tied behind its back in respect of competition for that business.

My second concern can be illustrated with an example. I have read that BP has considered getting a different supplier for Grangemouth because it wants to secure a cheaper service. Do you agree that, because Scottish Water is at a disadvantage to its likely competitors, there is a danger that—even with the Competition Commission providing a regulatory regime, which I do not think makes a jot of difference to the substance of my point—we will open the door for an exodus of business customers if the provision goes through? As John Swinburne said earlier, that would mean that the burden would pass to the domestic customers—including the senior citizens whom he was sent to represent—who would face the possibility of even higher domestic charges because Scottish Water's business customer income would be leaking massively.

I never cease to admire Fergus Ewing's ability to conclude a reasonable question with a line of gloom, doom and despair that can have been reached only because he has not thought about what the answer to his question might be.

We are responding proactively to the competition legislation and are invoking the provisions of that legislation to enable us to regulate a public service in a way that places quite severe limitations on the extent to which competition can take place. People will have to be licensed, which means that there will not be an entirely open door. There will be regulation. The licensing regime will ensure that people cannot simply cherry pick certain consumers because it is important that other industrial consumers and domestic consumers are not left to pick up the tab. That is why we want to have a licensing regime and will invoke the conditions that are provided in the competition legislation. If people are licensed to use the common carriage, they will have to pay an appropriate price. They will not be allowed simply to tap into the infrastructure and bleed it financially. The fundamental purpose of the bill is to place a severe constraint on free and open competition for the very reasons that Fergus Ewing outlined. However, the consequences that he saw as flowing from the bill are actually the possibilities that the bill seeks to avoid.

The issue of large industrial users does not relate only to Scottish Water. In relation to some users, there is an issue to do with whether they always need to have water supplied to them that has been through an expensive purification process. That is an issue throughout the United Kingdom and many articles on it have appeared in journals and the press. Scottish Water is fully aware of the issue and is in close contact with BP on a range of issues relating to its supply.

The Water Services etc (Scotland) Bill is designed to license and control competition, as we are allowed to do under the competition provisions, in order to prevent the situation from turning into a bit of a free-for-all.

Why was that provision included in the bill? Was it because of pressure from elsewhere?

Do you mean the licensing provision?

Yes.

It was the least that we could do. Under competition law, we cannot wholly exclude third parties, but we are entitled to place reasonable restrictions on a supplier dealing with domestic and non-domestic use. We have taken advantage of all the available provisions to prevent an entire free-for-all, which would have undermined the business of having a public water supplier.

If the granting of licences to allow English water companies to come into Scotland is the minimum that is required to comply with the law, does that not mean that the existing law is in breach of competition law?

Which law?

The existing law as set out in the water legislation that applies in Scotland.

Is the issue not when competition requirements come in?

No. The bill is our legitimate response within the timeframe to the competition requirements that were introduced by the Competition Act 1998. I know that that sounds like it was a long time ago, but we are still within the requirements of that act; we are not in breach of it, but we still have to act to bring ourselves within its ambit. The Competition Act 1998 allows us to carry things out in a fair and orderly manner and that is exactly what we will do.

So provisions of the Competition Act 1998 will just be coming into force at the intended commencement date of the Water Services etc (Scotland) Bill.

I am saying that we will certainly meet the requirements. We are not in breach of the Competition Act 1998; we considered that carefully when we produced the bill. We have been anxious to ensure that we have and can continue to have a publicly owned water company, but even though it is publicly owned, the company still has to respond to other legislative requirements. The Competition Act 1998 raised new issues to which we are responding with the Water Services etc (Scotland) Bill.

No doubt that is an issue that the lead committee for the bill will consider when it—

Can I ask one final—

Let me just finish my sentence.

The lead committee on the Water Services etc (Scotland) Bill will deal with that matter, but we will consider the financial memorandum that is associated with the bill.

I may have given the impression earlier that pensioners were freeloaders and that we were looking for something for nothing. We do not mind paying your increases, minister, but will you please keep them in line with the amount by which the Government increases our pensions? Unless your increases are linked to the ability to pay, you are further disadvantaging everyone of my generation.

I understand the point that you make and I am not dismissing it at all. I do not think that pensioners are freeloaders; people on fixed incomes are a matter of real concern to anyone in society. All that I was suggesting to you was that there are wider issues about the management and running of the water company and how Government interfaces with a water company that it owns to deal with matters of income and income distribution.

On behalf of the committee, I thank the witnesses for coming today. We will be in correspondence to deal with one or two of the outstanding issues that were raised.

The next item on our agenda is consideration of our draft report on the Prohibition of Smoking in Regulated Areas (Scotland) Bill, which we have agreed that we will take in private. I thank members of the public for attending.

Meeting continued in private until 12:55.