The second item on our agenda today is more of the committee's investigation into issues surrounding Scottish Water. In particular, we wish to explore the technical issues around borrowing limits that have arisen as a result of a paper that has been produced by Analytical Consulting Ltd.
I thank the committee very much for the invitation to appear before you and explain our concerns about the strategic review of charges. Perhaps first we should establish our bona fides and say a little bit about our background. I was an academic originally, but I spent the bulk of my career working as a civil servant and latterly I was the chief statistician in the Scottish Office. A relevant part of my career was spent as an official in the general expenditure policy division of the Treasury, when I was responsible for setting cash limits for half of voted expenditure and for monitoring that expenditure. The other point that I should mention is that over the past seven years we have between us published more than 20 papers, mainly on the Scottish economy, monitoring devolution and Scottish public finances. The bulk of those papers are published under our joint authorship, because we work as a team.
As far as my qualifications on the subject go, I was responsible for the piece on public expenditure in "The Laws of Scotland: Stair Memorial Encyclopaedia", and I have edited and contributed to a book on public expenditure.
It is important to remember that although it was not controlled directly at the time of the strategic review, borrowing has been extremely important throughout. If we want to fund a given level of expenditure in the water industry, there are only two sources of funding: charges and borrowing. If we squeeze borrowing, charges must rise to compensate. That is why borrowing is of central importance, even though it was not controlled directly during the period of the strategic review.
As you can imagine, when that realisation hit us, we could not believe the size of the figures involved. We tried hard to understand the tables in the strategic review, which, as members probably know, is an incredibly large document. In working through it, we found it very hard to work out what the water industry commissioner for Scotland thought would be the absolute maximum that Scottish Water could borrow.
So, by this stage in our process, we had uncovered two things. First, there was a logical mistake in the simple relationship that holds in the strategic review between the RAB limit and borrowing. Secondly, that was reflected in an inconsistency in the published figures between the maximum amount of borrowing that was possible, given the arithmetic of the strategic review, and the borrowing figures that the Scottish Executive published in its annual expenditure report in which it identified the borrowing that it thought was consistent with the RAB controls. That inconsistency rises latterly to substantially more than £100 million per annum.
I must hurry you up, Jim. We asked for a brief opening statement, and members are anxious to ask questions.
Okay. That is not the end of the issue. We have undertaken further work to find out how that inconsistency arose. As far as we can see, it arose because of three specific mistakes in the commissioning letter. The discussion of this matter in the press and in the previous meeting of the committee has also highlighted a significant degree of confusion on the part of the water industry commissioner and the committee's adviser in relation to the other factors that should bear upon the appropriate level of borrowing for the water industry. I hope that we will have the opportunity later to outline how that confusion arises. In addition, there are other significant issues.
For example, we saw in the strategic review that, when the commissioner was asked to look at domestic harmonisation, he also brought in business harmonisation. This is a big problem for business in Scotland. We have also done some work on the fixed charges. The big problem that we found is that, when the capital expenditure programme is not followed—although it was the reason for the high charges in the first place—there is no system by which charges can be reduced while capital expenditure does not keep to its track. Finally, water is one of the major resources in Scotland, yet many decisions that we believe are vital to the Scottish economy have been left to the water industry commissioner.
Thanks very much for that. I welcome Alex Neil to the committee.
I have a couple of questions. The first is quite a stupid question, I suppose, but you might be able to answer it for me. I was surprised to find that interest payments are not included in RAB expenditure.
The logic of that is that RAB is concerned with the real operation of the industry—the amount of real resources that the industry is consuming. Sometimes, interest payments are an artefact of the history of borrowing and how capital was financed; however, interest payments in themselves do not say anything about how the industry is actually operating today.
But, as you pointed out, they make a significant difference to the amount of finance that is available for investment.
Absolutely.
That is why I was surprised. Interest payments are central to your calculation, and the fact that they are excluded from RAB expenditure seems to be a little bit strange.
I am glad that you asked that question. In fact, in looking through the figures, we are perplexed by the water industry commissioner's evidence. The figures show clearly that one could borrow up to almost £300 million per annum and still be within the golden rule. We are also perplexed by the fact that, when the water industry commissioner gave evidence to the committee, he pointed out that the water companies in England and Wales were not in a borrowing position and that Scotland was unusual. Evidence from the Office of Water Services—Ofwat—shows clearly that, over the past six years, on only two occasions were two separate water authorities in a positive position and not borrowing heavily. The level of borrowing in England and Wales is substantially higher than it is here.
I think that the water industry commissioner was trying to impress on us the fact that, at the time of privatisation, the debts of the water companies in England and Wales were written off and that the fact that the debt was not written off in Scotland has made a significant difference to our historical mode of interest payment.
No, he said:
My main point is that, had the water industry commissioner decided to borrow more—we do not know whether he decided not do so on the basis of a mistake or on the basis of his decision that he did not want to incur additional debt—he would not have been able to use that borrowing to reduce the charges that are paid by either domestic or business customers.
I think that that is a red herring. If you are thinking purely in terms of the golden rule, you are talking about funding a capital expenditure programme of £1.8 billion over four years. Within that there is infrastructure renewal expenditure, which is not the acquisition of new capital assets. However, even knocking off infrastructure renewal expenditure, that leaves a maximum ceiling of roughly £300 million per annum that the industry could borrow up to, which is quite consistent with the golden rule. That figure is not a million miles away from—it is very close to—the sort of borrowing figures that the Scottish Executive has published. The golden rule says only that the ceiling is around the £300 million limit: that is a very long way from the type of statement about borrowing that was made by the commissioner. It is also a long way from the comments of the adviser to the Finance Committee, which were quoted in the Sunday Herald, that the golden rule implies "Thou shalt not borrow at all", or words to that effect.
I understood the golden rule to mean that borrowing was used only for investment.
That is right. That is exactly what we are saying.
We are saying that, even if we exclude the infrastructure renewal expenditure, enough investment was taking place to justify £300 million of borrowing. However, we are not saying that £300 million ought to be the right level. That is a matter for other people.
I congratulate you both on the eloquent way in which you have brought high finance down to my terms. I assure you that there are pensioners all over Scotland who will look at their water rates and say, "Thank goodness someone has come up with a logical explanation for this attack on our income."
That is a statement rather than a question.
I make statements. I do not ask questions.
My only comment is that Mr Swinburne's view has been repeated by people inside the industry.
On this complex issue, the Cuthberts have done us a great service by elucidating a fundamental policy issue surrounding the change in the water industry. Clearly, it is possible—and they make a strong case for this—that the strategic review contained a logical mistake that, in the old days, would have led to permissible expenditure's being lower than it should have been, given that permissible spending was what drove borrowing in the old days.
I will deal with the point about the determination of the appropriate level of borrowing. As we said earlier, we are not proposing that any particular level of borrowing is right. Rather, we hope that we are highlighting the four major inconsistencies in the statements that have been made.
On Jim Cuthbert's first three points, which all directly relate to what the strategic review says about the character of the new regime in Scotland and to the water industry commissioner's evidence on that, we should write to the water industry commissioner for clarification. Those are anodyne and technical points but, nevertheless, they elucidate the changing character of the governance of the water industry.
Following a previous meeting, I wrote to the water industry commissioner. I will check the terms of my letter to ensure that we captured the precise points that have been raised today. We have not yet received a response from the commissioner, but we hope to get that clarification.
Wendy Alexander's second point was about the outturns. Like her, we are slightly baffled by the way in which people have used outturns to justify the position that was taken in the strategic review.
That takes us to the heart of the political problem that water has created for everyone. It is clear that, under the old regime, in which the total permissible expenditure was spent, we would have been spending in excess of £300 million in return for the high water charges. I presume that, following the hikes in charges, people would at least have seen the beginnings of some improvement for their £300 million of expenditure. After a hike in charges and the setting of a more restrictive financial target, which was perhaps appropriate, we have seen that the industry has proved capable of spending £51 million out of £199 million—a quarter of what was available. That critical question about the operational efficiency of Scottish Water is a matter for the Environment and Rural Development Committee, not the Finance Committee.
I, too, think that that points to a failure in mechanism. In effect, in the strategic review, high charges were set to fund a large capital programme on a relatively small level of borrowing. If it turns out that all the financial resources available are not needed because the capital programme falls short, equity says that that bonus should be used to offset the high charges. What actually happened was that the bonus was used to further reduce the level of borrowing and to reduce the RAB limit at the end of the year by about £114 million. Surely there is a need for a mechanism that feeds such underspends back to the people who have been penalised—the people who are paying the high charges—instead of using them to offset the RAB limit or to reduce borrowing.
Our objective in preparing our report is to feed into the quality and standards III process. Wendy Alexander mentioned the Environment and Rural Development Committee; it is clear that what we report on underspend will be of interest to that committee and I would expect it to take up some of those issues.
I have read what is in your paper and it seems that you are talking about a clear factual error. Some of the responses that our adviser has given on the issue have added to our confusion. Do you have a response to the points that Arthur Midwinter has made to the committee and to the press on your paper and your work to date?
You should concentrate on what is before the committee, if possible.
Paragraph 7 of the adviser's paper for the committee mentions the announcement about the reallocation of the £188 million. We took that amount of money into consideration in the calculations in our paper—it was already thoroughly enmeshed in our paper. We subtracted that £188 million from the Scottish Executive figures over the three years, so we were comparing like with like at all times. We are not talking about £188 million in one year; we are talking about something that we believe is much more significant to the Scottish people than Holyrood. The actual size of the error compounds as the years go by; the error is per annum.
I would like to pick up some other points in the briefing paper that has been sent to the committee. We were surprised to get first sight of what was in the paper in an article in the Sunday Herald. That raises the constitutional issue of whether it the role of an adviser to the Finance Committee to float his points first in the Sunday Herald.
We have the whole commissioning letter.
The second page of the commissioning letter is labelled C in our handout. It is probably better to look at the version of the letter that is in our handout, because we have annotated some of the passages in it. We have marked the first paragraph of the second page of the letter with a 3. It says:
I am interested to know at what level you feel that borrowing should be. What are the implications of the error for water customers?
We would not like to comment on what the actual level should be. From examination of the history of Scottish Water, it was interesting to note that in 1989, for example—as Wendy Alexander said—the amount that we were able to borrow every year in Scotland was very large, relative to what was happening in England and Wales. We must take an holistic view of the way in which efficiency may have run in the past; we may have been borrowing an awful lot in the past. There must be a consideration of history, as well as of what we want to pay in the future. If we go right up to the Scottish Executive limits, we will be well within the golden rule. As the issue is of primary interest to Scottish industry, it must be debated at parliamentary level.
I had not finished going through your adviser's briefing. For the record, I would like briefly to pick up some further points. Paragraph 4 of the briefing says:
In paragraph 2, the adviser says:
I want to be clear about that. In a sense, there is a difference between what you are saying and not only the adviser's paper but, perhaps more significant, the minister's letter. The minister says that the Executive's figures are absolute figures that could not be breached, whereas the water industry commissioner's figures set targets for achieving financial sustainability. You say that the targets are akin to limits as far as Scottish Water is concerned.
Once the allowance for flexibility that the commissioner allowed is added in. We added that into our paper.
But the question that I am coming to is whether the water industry commissioner set the correct targets. The real issue is not the different limits, but whether the water industry commissioner, in choosing the figure to set for the financial sustainability target, made the right judgments. I would be interested to have your views on that.
Our view is that, when the commissioner set the target—despite the fact that he said that he was setting it in relation to the future sustainability of the industry—the target figure plus his flexibility figure added up exactly to the figure in the commissioning letter. We have to be absolutely clear that the commissioner used the entire amount of available public expenditure and yet, when the Scottish Executive did its calculations using the same figures, it came to a very different borrowing figure.
I think that you have established clearly in my mind that the water industry commissioner's statement about using all the available public expenditure was probably factually inaccurate.
He was accurate in one sense, in that he was following to the letter the instructions in the commissioning letter. It is absolutely true to say, from looking at the letter, that the £130 million was squeezed down because of the introduction of RAB. That is the double-counting point. Given that the commissioning letter said that the commissioner had to treat the public expenditure limits as limits, he had to allow a substantial margin for flexibility. In essence, the commissioning letter forced the water industry commissioner down the route that he took.
When the document went to the officials in the Scottish Executive who dealt with the water industry, why did they not go through the detail of the financial statement? Somebody should have said, "Hey, wait a minute. The figures that we provided to the water industry commissioner in the commissioning letter mean that it is impossible for him to have arrived at the borrowing limits that are included here."
The commissioner has said, pretty consistently, that his judgments are made by his assessment of what is needed to produce a financially sustainable water industry rather than by borrowing limits. The driver in that situation is not borrowing limits, but the commissioner's economic judgments. I think that it would be hard to argue against that. If that is the case, what is your view of whether the commissioner made the right judgment?
We do not pretend to say what the right level of borrowing should be. We are saying that the justification that has been given, for a borrowing profile that goes down as steeply as that which is shown in the strategic review, does not look sound. As we have pointed out, that is because of the various contradictions in the rationale for the profile.
I am trying to get at whether we can work out what is the driver for the charge increases—that is what interests people. I want to return to two issues, one of which you highlighted in your paper. The first of those issues is the harmonisation of domestic and non-domestic water charges within a very short space of time. It is arguable that the harmonisation process was a political judgment. There is no doubt, however, that it led to significant increases across most of Scotland. Although there may have been a benefit to the north of Scotland, there is a sense that the east and west lost out. The fact that harmonisation was not phased in over a considerable period is a major factor in the increases in charges.
Yes.
I have something to add on your first point about harmonisation. When the three water boards—East of Scotland Water, North of Scotland Water and West of Scotland Water—were in operation, it seemed reasonable on social justice grounds to look at domestic harmonisation. However, the way in which harmonisation was introduced is much more open to comment.
I have nothing to add to that, other than to say that there seems to be a logical issue of fact and what we regard as a mistake. There is a question about the second mistake in the commissioning letter, setting an absolute limit, which further depressed borrowing. There also seem to be wider issues about fixed charges and harmonisation. Another issue that has been raised today is the lack of any mechanism to feed back to consumers, in immediately reduced charges, any underspend in capital expenditure.
There is a technical debate about limits and targets, but I am not convinced by what you have said about mistakes. There are some issues about what the water commissioner has said at different points in time; perhaps there are some inconsistencies there. What I am trying to say is that I see there being two major issues in relation to increased charging. The first is the precipitate decision, which affects businesses in particular, on the harmonisation of charges across Scotland. That has been a major financial driver for increased business charges. The second issue concerns decisions that were made on the way in which debt will be repaid. From a financial point of view, those two issues seem to be the two biggest packages of change in the system. Do you agree?
You said that you were not sold on the idea that an error had been made. That is a very simple, factual thing, which could be cleared up if the minister would answer the questions that we put to him. The water industry commissioner says that he used all the public expenditure, and he cites two ways in which that has been used up—on new borrowing and on the margin of flexibility that he allowed himself. It is clear from all the arithmetic in the review that those two things add up to what the commissioner has from the commissioning letter, and yet the figure produced by the Scottish Executive is £100 million more.
My view on that is that the water industry commissioner made a political judgment about borrowing, rather than a technical judgment.
That is not what the water industry commissioner says.
I agree that it is not what he says.
The commissioner said in his review that he used up all the public expenditure. We did not necessarily expect you to be convinced by what we said but, as Margaret said, the key question is whether the Scottish Executive can justify the logic of the simple relationship that holds in the strategic review, relating borrowing to RAB expenditure. Our view is that the Executive cannot possibly justify that, because it is logically incorrect. The second question is whether the Executive can produce figures that feed into that relationship and which relate the RAB expenditure limits in the commissioning letter to the borrowing figures that the Executive has published. Our view is that it cannot possibly do that.
We shall hear from the minister next week.
I am reluctant to enter the rarefied field of high economics. We have professional economists with us and they are much more qualified than I am. However, I suppose that ordinary observers such as me are entitled to ask why, despite the fact that you say you have had no response from the minister, the minister appears in his response to this committee totally to rebut any claim that customers are worse off. He says that
Let us look at the separate elements of the process. The Scottish Executive issues its public borrowing limits today. In fact, under RAB, it has had an idea all the time of what the borrowing limits would be. Scottish Water is the entity that does the borrowing, so all the time that the exercise has been going on, that level of borrowing has been available from the Scottish Executive. However, those were not the figures that went into the strategic review. The figures that were used in the strategic review were not the public borrowing figures as given by the Scottish Executive, but the ones that came out of the RAB process, which were considerably lower. It was those figures that fed first of all into revenue caps and then into charges. The line that the Scottish Executive had that was actually available for borrowing was not the line that fed into the determination of charges.
Why does Allan Wilson say that there was no error in the application for public expenditure?
That comes back to something that we have already pointed out—a complete inconsistency in the commissioning letter. At one point, in what I shall call a white statement, the commissioning letter says:
I am now fully aware of why Wendy Alexander did not want ministerial responsibility for this matter. [Laughter.]
The Government made the decision that it was willing to invest in public sector borrowing, which is shown in the amounts in the spending review. Those amounts are all over £250 million per year. The Government gave its consent to that amount of spending and I presume, therefore, that it was quite happy about it. Subsequently, however, as those high charges come in, they are bound to have an effect on the competitiveness of Scottish business. That will have a long-term dynamic effect on the economy.
With the charges that are being levied on domestic and business customers, the investment programme that is under way, the reasons for the underspend and the efficiencies that the companies are putting in place, would the situation be quantifiably different today if the budgeting system had been different? Does rearranging figures on a bit of paper make a quantifiable and tangible difference to what is happening at the moment?
We suggest that, on average, bills would be 20 per cent less if the full amount of public sector borrowing had passed through in an efficient capital spend programme.
In other words, if the industry had decided—entirely consistently with any golden rule—to borrow up to the level that the Scottish Executive had said was acceptable and consistent with its limits, bills could have been 20 per cent lower. We are not saying that there should be a 20 per cent reduction in bills, because, as we have made clear, we are not arguing for what the exact profile of borrowing should have been.
Yes, but what I am trying to get at is that, if the Scottish Executive chose to borrow £300 million, £400 million or £500 million more for investment or to have reduced charges, it could do so. The point is that the political decision has been taken. Through advice from the water industry commissioner, the debt profile has been decided. If a different political decision had been taken, there would now be a different and considerably higher debt profile that could be paid off over a longer period.
We are suggesting that the political decision is as shown in the spending review, which highlights the fact that the Executive was willing for the industry to borrow up to between £200 million and £300 million per annum. The Scottish Executive does not lend or borrow the money; the industry itself is given permission to go out into the market and raise it. The Executive's own spending plans show that it was willing to give such a consent.
That is absolutely right. It is interesting that when our paper became public the Executive's initial response was that it had made available £200-odd million of borrowing a year. As Margaret said, that political decision had been made. However, the Executive had missed the fact that, because of an accounting error, it was not possible to make that level of borrowing available within the strategic review. As a result, ministers made no political decision that would justify the stringent borrowing profile in the strategic review, because they came out and said that their political decision had been much more generous.
Would the 20 per cent reduction in bills that you have estimated apply to domestic and business customers across the board?
We are not saying that that reduction should happen. Instead, we are saying that it could happen if, within the golden rule, the industry utilised all the borrowing that should have been available to it.
And the borrowing would be used to offset lower charges to customers instead of being vested in the infrastructure.
That statement is not meaningful. After all, there is one pot here. If the industry were fulfilling its investment programme, the new capital assets being created would amount to about £300 million a year. As a result, any level of borrowing that is lower than £300 million a year is entirely consistent with the golden rule that one should borrow only to fund the creation of new capital assets.
I call Alex Neil.
Thank you for allowing me to come to the table and for giving me the opportunity to ask a question.
Before you answer that, I would say that our inquiry has focused on all those issues. You may be at a disadvantage in coming along to this meeting without having been at previous meetings.
I have been following the discussions closely.
The committee has been discussing those issues. Our discussions have arisen not only from the Cuthberts' work but from our whole process. The Cuthberts have been given an open-ended invitation to set out the situation, but they may want to answer the particular factual points that Alex Neil has raised.
We are aware that the committee has done a lot of work. We have concentrated on a specific part but, in doing so, we have found difficulties in the relationships between the Scottish Executive, the water industry commissioner and Scottish Water as to who is taking responsibility. We have asked a simple question, but the buck has been passed backwards and forwards, and has gone all the way to the Treasury and back. We have found glaring difficulties at all stages in the strategic review of charges. We are being led into fixed charges and there have been long economic chapters on why charges should be fixed. However, the committee has comprehensively dealt with that point. We think that it is not just another strategic review that is required but an examination of the whole process.
I could not agree more. I do not have much to add other than to say how much we, as members of civil society, welcome the fact that the committee, as an organ of the Parliament, is there to scrutinise the somewhat murky dealings of the Executive. We trust, and we are confident, that the committee will deliver on its responsibilities as an organ of the Parliament to scrutinise the Executive. If it does that stringently, that will be a real step forward for the operation of devolution, which we very much welcome.
The committee is certainly minded to scrutinise things carefully.
The only question that I want to ask goes back to Alex Neil's point about significant levels of underspend. Are there comparable examples from other parts of the public sector where there is a mechanism for paying back rather than simply redistributing the underspend?
Local authorities used to give a rebate.
A related point is that if one looks at the documents produced by Ofwat—although I am afraid that I cannot give you a direct reference—one sees a standard feature that Ofwat has recognised in England, where equivalent strategic reviews tend to handicap the performance of the industry in delivering capital expenditure. That is no doubt built into the figures. One can have a mechanism post hoc, which would say, "We've got an emerging financial surplus; what are we going to do with it? We should pass it back to the consumers," or—or rather and/or, because the two are not inconsistent with each other—one can be wise enough to say that capital programmes tend to be underspent. Ofwat has recognised that they tend to be underspent when there is a periodic review mechanism. One should build that into one's figures in advance. We would suggest that both those things should be done: there should be a proactive mechanism that allows for the tendency of capital programmes to underspend and that allows for the abatement of charges; and there should be a proactive mechanism, if one has got the figures wrong and there are more financial resources available, for handing money back to consumers after the event.
But the prerequisite for both of those is the ring fencing of the resources arising from charging and the decisions made about capital spending. No ring-fencing mechanism of that kind exists at the moment, as has been evidenced by the way in which end-year flexibility is reallocated to other programmes.
Yes.
There is no doubt that the massive error—larger than Holyrood—that has been exposed by the Cuthberts' excellent work will affect everybody in Scotland directly. In Newtonmore and Kingussie, the community councils believe that no development at all will be possible for 10 years because of the lack of sewerage capacity. If Scottish Water had even spent the money that is available to it, instead of allowing the massive underspends that Wendy Alexander has correctly referred to, which amount to £148 million a year, at least my constituents would have been moved further up the queue if not to the head of the queue.
We have already covered that point, but I will restate our position. The minister's statement is factually correct when one looks at the part of the commissioning letter that says that the controls on resources and capital are kept separate. However, it is factually incorrect when one looks at the operational part of the commissioning letter, which sets a combined limit, combining resources and capital. I have taken you through the algebra in part B of our handout, which explains how that arises.
Although there was a mistake in the commissioning letter, with regard to that, had it been in respect of an industry in which depreciation is only on book values, it really would not have mattered; however, depreciation in the water industry has a cash element. It is a slightly unusual industry in that part of the depreciation is book-value stuff, which is all notional, and part of it is real cash going out. Because of the formula that was used, there was a double counting. Many people who are unfamiliar with the industry would not even have appreciated that such a terrible mistake had been made. It was bad because it was made in respect of the water industry.
To amplify what we have just said, I refer you to another part of our handout. Part D is the letter that we received from the Treasury, describing the operation of RAB. You will see that two parts of that letter are highlighted. The first part is a reflection that an element of capital expenditure appears within both the capital and resource budgets. The second is the key part. It says:
Fergus Ewing also asked about the second page of Allan Wilson's letter.
The second paragraph on that page is quite clear and true in stating that
In fact, the statement in the minister's letter is subject to two interpretations. Margaret is quite right to say that the level of public expenditure has not been a constraint on the industry. However, it has been a constraint on the level of charges that were set, because of the mistake. The fact that the level of public expenditure that was available fed into the incorrect formula that had been determined by the commissioning letter meant that, inevitably, charges would be increased more than they needed to be. As far as charges were concerned, public expenditure was a constraint. Ministers did not think that that was the case, because they had taken a political decision to make around £250 million-worth of borrowing available and they did not realise that it would not be possible to reach those levels of borrowing in the strategic review because of the mistake in the commissioning letter.
I want to raise one other aspect of your paper, which I do not think has been mentioned yet. On fixed charges, you refer to the paper by Sawkins and Dickie, which makes clear how high the fixed-cost burden is in Scotland relative to the position in England. You say that that is potentially severely damaging and you argue that the fact that small users pay particularly high average charges per unit of water consumed creates an entry barrier to setting up in business. Are you concerned that the water industry commissioner has conveyed proposals to Scottish Water and that, as we speak, the man whom you have identified as having made three errors in his evidence to the committee—which is quite extraordinary—is being permitted by the Executive to carry on regardless and set charges that, I presume, will not take account of your analysis and might well not deal with the problems of fixed charges that you have identified.
The problems of fixed charges and business harmonisation are, as the convener pointed out, the sharp problems that will affect the performance of the Scottish economy. That does not mean that the work that we have done is not fundamental, as it concerns the overall level of revenue gaps. The fixed charges and harmonisation determine where the burden then falls. We strongly believe that whereas the strategic review leads people along the path of believing that because there is a huge, fixed infrastructure, there must be a high element of fixed charge, that is not borne out in any economic textbook or thinking. It is an unbelievable view of economics to think that a fixed infrastructure means that individuals must pay fixed costs.
Do you think that the water industry commissioner can act differently within the parameters of his existing powers, or do you think that the WIC's role needs to be altered to bring in a real element of accountability, involving the Parliament, for example?
There is plenty of scope for the WIC to take different decisions within the current set-up. However, the current set-up may not be conducive to taking good decisions. It was very noticeable at the Finance Committee meeting on 2 December that responsibility was passed between Scottish Water, the commissioner and the Scottish Executive. That exactly mirrored what we found during our research. We asked people in the water industry commissioner's department about double counting and they said, "We were just following what the Scottish Executive told us to do." We spoke to the people in the Scottish Executive, who said, "We were just following what the Treasury told us to do."
I have a final suggestion, because obviously our inquiry will look at accountability and ways of improving the current system, which I think that we all—in different ways—think is a boorach. Would it be sensible to introduce a statutory power of direction, to enable the Executive to intervene, not just to take or leave a whole package, but to give directions, if so advised, to the WIC about how he exercises his powers? In the absence of such a power of direction, it seems to me that Scottish water ratepayers really are in the hands of the WIC. From what I have seen and heard of the WIC, I do not want to be in his hands.
I am not entirely sure that the Scottish Executive does not have that power at present.
It does not have a specific power of direction. As I understand the matter, the Executive has a general power to be consulted on the whole package, but it does not have a specific power to tell the WIC to take measures to reduce fixed charges. I am not aware of such a power and I have studied the Water Industry (Scotland) Act 2002. Would such a power be a sensible way in which we could increase accountability?
To our surprise, we found that there was nothing in the commissioning letter on, for example, business harmonisation. The decision on that matter was taken further down the line. Given the precariousness of some aspects of the Scottish economy, that issue might be better addressed and the Scottish Executive might give better guidance, within the limits of its power under the European Union. Water could give us a good competitive edge, but at present we are not looking at it strategically from the point of view of the economy. That must be an issue for Parliament.
The trouble with seeking to solve the matter by giving the Executive a positive power of direction is that the Executive made fundamental errors in the commissioning letter. If a criticism can be made of the commissioner, it is that he followed that mistaken advice too slavishly and did not question it. Neither of those problems would be solved by giving more powers to the Executive. The committee must consider the quality of the policy and technical advice from the Executive before it looks to the Executive for a solution.
We have had quite a lengthy evidence session. Two other members have questions, but I intend to bring this part of the meeting to a conclusion.
I want to ensure that I understand some of the additional information that you have given us today in your handout. As I understand it, the algebraic example that you gave really tells us that the capital budget is linked to the revenue so that one cannot outstrip the other by more than a certain amount. That is basically what the commissioning letter says.
Yes, but I would put a gloss on that. Profit is not the money coming in, because in RAB terms, profit is profit after allowing for certain non-cash items. To get back to borrowing, one must adjust it on a money basis, which leads one to the formula that I mentioned, that borrowing equals RAB expenditure, minus the notional items that are in RAB but that will not contribute to borrowing, plus the cash items that are not counted in RAB.
Right. The two are linked in that sense. What exactly is the mistake in the commissioning letter? There might have been a mistake in the way in which the letter was applied, but what is the error in the letter that went out in 2001? What should have been said in the letter?
There are three mistakes in the letter. The most important one is at sidenote 1 in our handout and amounts to a combined control on capital and resources.
It just says that they are linked together in a particular way. It does not mean that one goes up and the other goes down or whatever; it means that they cannot get out of step.
No. As our handout shows, the letter states that the sum of capital plus resources should be less than a fixed, pre-specified amount. That involves double counting infrastructure renewal expenditure because that is in both capital and resources. The fundamental mistake in the commissioning letter is to combine capital and resources in a single limit.
That is contrary to Treasury guidelines.
Yes.
The Scottish Executive's spending plans are meticulous in always showing capital and resources separately. In fact, when we started out, we could not see what the source of the error was. Our logic told us that there was an error, but when we looked at the spending plans, we could not see how one could possibly have arisen because everything was meticulously laid out. It was only when we got the commissioning letter, and saw for the first time ever that people had added the two separate limits together, that we realised that that was where the main problem lay.
That is helpful clarification, because the minister and officials are coming here next week.
I repeat that Margaret is absolutely right. What the Scottish Executive published in its annual expenditure report—although it is not clear—is a correct statement of separate resource and capital limits. What it fails to do is show the link between those and borrowing. It also gives a borrowing figure, but the borrowing figure is what we would expect in terms of the historic run of borrowing. The mistake is in the commissioning letter, where capital and resources were added together.
Yes.
The algebra then works out.
I am a scientist, not an economist. I am going through the calculations stage by stage.
I will inform the committee how I got to grips with the capital budget and what is wrong with it. I went back to, of all things—and I hope that this is not recorded—first year at school, when we were taught set theory. Is A plus B always the sum of all the items in A and the sum of all the items in B? If there is an intersection between the two, then that is double counting. When we explained about capital and resources, we said that the water industry is an industry in which infrastructure renewal is depreciating as a cash item but is also the capital spend. That is the bit that is double counting.
So one of the figures should not be here.
Exactly.
That is helpful clarification of your position.
My first question is on the power of direction. Paragraph 8 of the explanatory notes to the Water Industry (Scotland) Act 2002 states:
In that particular case, we did not have any information on the ministerial approval. If there has been ministerial approval, instead of saying that it was unfortunate that business harmonisation took place within the strategic review, the argument has to be moved further on to ask why the minister agreed to business harmonisation and what economic justification he used?
Those are the questions that we are asking.
Yes.
If only 21 per cent of funding is from the fixed-charge element, how does that have a massive effect on competitiveness within Scotland?
I think that that statement was made in the way that all statements about averages are made, which not only confuses everyone, but masks the variation involved and the effect that that has on enterprise and competitiveness. The fixed charge in relation to the marginal charge varies tremendously throughout the country. I am sure that many members are aware of that from constituents' letters in their mailbags. The principle of fixed charging, and its sensitivity, must be thoroughly investigated. Statements such as the fixed-charge element raising only 21 per cent of funding do not help.
The committee will consider that issue. I said that I would allow two more members to ask questions, but because I cut across Jim Mather earlier I will let him in as the final questioner.
In mitigation, I inform the committee that there are people in my constituency who pay 70, 80 and 90 per cent in fixed charges.
Absolutely—I agree with that. I would add a further requirement to a review, which is that it should be more open than existing procedures. At present, there is the opacity of the 600-page strategic review, which I am sure few people have read and fewer still have understood. The long stop for mistakes in the strategic review is the Executive's advice to ministers when they approve the review's recommendations. However, there should be a further stage that ensures that the public are better informed about what decisions are being made and on what basis, and that they are able to comment on that.
I want to ask the convener for guidance on a matter that has arisen from the oral evidence that the Cuthberts have given today. According to the Cuthberts, the committee's adviser—who unfortunately has not been with us yet this year—made comments to the Sunday Herald, which were reported on 28 December. Obviously, we will discuss the matter with Professor Midwinter when he returns, but I want to ask about a general principle rather than about the specific substance of his comments.
At one level, I think that any individual has the right to make any comments that they wish on an issue that they are asked about. As far as I am aware, there is no stipulation that committee advisers should not make comments. I am happy to seek guidance on Parliament's procedures on those issues and to communicate that to members.
Is that something that the Conveners Group might want to consider?
I will seek guidance from the relevant source. I thank the witnesses very much for attending what has been a fairly lengthy evidence session. It is not easy to be at the witness end of the table, particularly when we are dealing with technical matters.
May I excuse myself?
Yes.