How a regulatory system works in practice
A Water Services Association case study

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Page 4: Review

Water Services Association 3 Image 6It is against this background that the Director General of Water Services must plan for and conduct his periodic reviews, which he does every five years. His review is part of what is called a medium-term incentivised regulatory system. This means that the Director General sets price limits which he believes will provide a strong incentive to the water companies to increase their efficiency and improve their performance. He does this after gathering a huge amount of detailed information about the companies’ operations, their current and historic performance, the work they have to do and the amount they have to invest to meet quality and environmental standards, as well as what their customers think should be the companies’ priorities.

Theoretically, the way the system works is that if the companies perform better than the Director General expected and earn higher profits than the price limits were set to allow, then the benefits of that ‘out-performance’ can be kept by the companies and their shareholders until the next periodic review. At which time the Director General sets new, lower price limits, which then transfer the benefits of the out-performance to customers.

Forecasting

In practice, where water companies have been able to perform substantially better than expected, they have voluntarily shared the benefits with their customers even before a periodic review has required them to do so. Forecasting what is likely to happen over five years is not a precise science and the Director General has suggested that he might like to have periodic reviews more often, perhaps every four years. His problem will be to allow sufficient time, in what is essentially a very long-term industry in which investment decisions can influence events for 100 years or more, to give greater benefit to customers - which is his motive - without reducing the incentives to water companies to improve performance.

In reaching his decisions, he has to juggle with an amazing complex number of variables. What is reasonable profit? How much should companies borrow to invest and how much should come from customers bills? What is the right ‘gearing’ for a company’s balance sheet - that is to say, what should the right balance be between debt and equity? What is a reasonable return on capital invested? What criteria should be laid down for efficiency? etc.

All this involves not just the regulator, but the companies too, in a large amount of managerial and administrative work, the results of most of which must be put into the public arena. This is another reason for the Director General to be cautious in how frequently he conducts his reviews.

Water Services Association | How a regulatory system works in practice
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