Involving customers in water regulation

Change seems to be afoot in the Cayman water sector.  

There has been discussion about a revised form of regulation of Cayman Water Company. One proposal involves a rate cap adjustment mechanism (RCAM) and other models have been suggested. Another proposal is to sell off or lease the Cayman Water Authority, leaving its regulatory function with the government.  

It is all rather reminiscent of the 1989 water privatization in the U.K.

The purpose of this article is not to take sides on any of the proposals just mentioned, but rather to throw another hat into the ring. This hat is consistent with any of the methods of price regulation under discussion, and with public or private ownership. It is an approach that is gaining favor in several countries across the world, in utility sectors generally, including water.

The essence of this approach is the greater involvement of customers in regulation. The regulated company and customer representatives discuss, negotiate and, where possible, agree on certain proposals to put to the regulator. These proposals may relate to investment, quality of service, prices, profits, the company’s business plan as a whole – whatever is of mutual concern.

The discussions may be informed by regulatory precedent or regulatory guidance – for example, on cost of capital and efficiency. Ultimately it is for the regulator to decide whether to accept any proposals put forward, so there is no loss of regulatory control. But the focus of regulation is changed: the regulator facilitates discussion and agreement between market participants, rather than taking all the decisions itself.

What benefits does this bring? Greater mutual understanding and satisfaction, because regulation is geared more closely to the preferences of the customers and the needs of the business.
Taken in historical and international context, I sense a continually evolving and developing customer role in utility regulation generally. The rest of this article looks briefly at the past, the present and the future, so that Cayman can consider whether this approach might have a useful role to play in the regulation of the water sector there.

The past

In the early 1960s, the Federal Power Commission (FPC), faced with a sudden and enormous new caseload, invited gas pipelines and their customers to negotiate and agree on pipeline tariffs. Many indeed did so, which reduced cost, delay and uncertainty. Subsequently, the FPC’s successor body the Federal Energy Regulatory Commission (FERC) has actively encouraged settlements between gas and electricity transmission networks and their users.

From the mid-1980s onwards, the Public Counsel in Florida negotiated many settlements with telecom and electric utilities as a means of securing quicker, more substantial and more certain price cuts for customers than the Florida Public Utilities Commission was likely to offer. Utilities and customers both found attractive the certainty of fixed-price fixed-period agreements.

Since the mid-1990s, the National Energy Board in Canada has facilitated settlements between oil and gas pipelines and their customers. At one time it set out the formula it would use for calculating cost of capital, thereby removing the main barrier to productive and successful negotiation between the parties.

In all these industries, settlements brought better deals for customers. The agreements better reflected what the customers themselves wanted rather than what regulators thought they wanted or ought to have. In the process of negotiation, all parties came to better understand the needs and preferences of other parties. Relationships improved and trust began to be established. In general, this brought the prospect of ever more fruitful negotiation in future.

In the U.K., utility regulation did not begin until 1984, with the privatization of British Telecom. U.K. regulators have always listened to what customers have to say, but regulators have generally felt that it was their duty to make all the decisions themselves. Amongst other things, this has led to an ever-increasing burden of price control reviews, throughout the U.K.-regulated utility sector generally.

The Civil Aviation Authority (CAA) was the first U.K. regulator to propose a greater role for users. In 2004, conscious of the problems of the previous price control review, it proposed what it called constructive engagement. It invited each price controlled airport and its airline customers to try to agree some central parameters of the price control review, notably traffic forecasts, capital investment and quality of service. The CAA would determine the remaining parameters such as operating cost efficiency and cost of capital, and set the price control. There was widespread skepticism among the parties, but the process worked at Heathrow and Gatwick. Once the heavily-disputed new runway at Stansted was taken off the table, constructive engagement worked at Stansted too.

The present

So much for the past, what has been happening recently? The CAA has successfully used constructive engagement and related approaches in other contexts, including in setting rates for national air traffic control and in its latest airport price control review. Ofgem, the Office of Gas and Electricity Markets, has involved customer groups in setting price controls for gas and electricity transmission and distribution networks. Regulated companies that get the support of their customers for their business plans have been eligible for “fast-tracking” through the price control reviews.

Ofwat, the Water Services Regulation Authority, has allowed a greater role for customer challenge groups in setting price controls for companies in the water sector in England and Wales. WICS, the Water Industry Commission for Scotland, has gone furthest.

Together with Scottish Water and Consumer Focus Scotland it set up a Customer Forum. The functions of the Forum were to research customer priorities and to represent the interests of customers to Scottish Water and to WICS; to seek the most appropriate outcome for customers in the strategic review of charges; and, later, to seek to agree on a business plan with Scottish Water.

I had some limited involvement in the WICS process, but mostly my position has been as observer on the sidelines, rather than as a participant. I am impressed with several features common to all these customer processes. There has been a remarkable degree of enthusiasm and commitment by all parties involved, not least the companies and their customer groups.

There has been substantial learning about the preferences of customers, and exploration of alternative means of meeting these preferences. Companies have demonstrated willingness to change and to innovate in order to satisfy customers. Business plans have been modified in many respects. The extent of ultimate agreement between companies and customer groups has been notable. In all these respects, the new customer engagement processes have been more successful than might have been expected at the outset. Regulators themselves have testified to this.

Yet the regulators have had significant reservations about other aspects of the latest price control reviews, particularly about the options offered by most companies. While encouraging companies and customers to engage, and in different degrees to negotiate over business plans, the regulators have emphasized that the final decisions about price controls remain for themselves. In a sense, agreement between companies and customers is a necessary but not sufficient condition for a business plan to obtain regulatory approval.

Regulation still plays a central role. Although the CAA acknowledged that agreement between Stansted and its airlines was a justification for no longer regulating Stansted, at the other airports it set central parameters of Heathrow’s price control and indicated what kind of price undertaking it would accepted from Gatwick in lieu of a price control. 
In the water and energy sectors, many business plans proposed by companies and supported by customers have not been approved. Ofwat and Ofgem fast-tracked only a handful of company business plans and required significant revisions to the business plans of other companies. In contrast WICS accepted the business plan negotiated by Scottish Water and the Customer Forum as the basis of the price control.

The future

Why did the CAA determine or require changes in the price controls of Heathrow and Gatwick? Why did Ofwat and Ofgem not accept business plans supported by customer groups? Primarily because company plans embodied what the regulator regarded as too high costs of capital and projected operating costs. It is of course the duty of the regulators to be satisfied on such matters. But it would be unfortunate if this jeopardized an increasing role for customer engagement, by leading companies and customers to conclude that negotiation and agreement were not worthwhile.

What then might be done to facilitate customer engagement that would meet the requirements of the regulators too? I have written elsewhere about the successful experience in Scotland. Two aspects of the policy adopted by WICS seem to have been helpful. First, through the price control review process, WICS issued a series of guidance notes exploring the issues and indicating its own view.

This included on cost of capital and operating costs. Increasingly, these guidance notes identified a range of parameters within which Scottish Water and the Customer Forum could fruitfully negotiate, with the prospect that an agreed business plan would indeed provide the basis on which WICS could and would set a price control. Second, WICS suggested that, in the event of outcomes varying significantly from the agreed upon business plan, the parties would together consider remedial action, including the sharing of any unexpected gains and losses. This gave the parties more confidence in committing themselves to agreement, and encouragement to work together over time.

The success of the approach in Scotland may – or may not – have been facilitated by the fact that Scottish Water is a monopoly and publicly owned supplier. Nevertheless, whether and how far such approaches would be effective and appropriate in the England and Wales water and energy sectors deserves careful consideration. Would it not be possible for regulators in England and Wales to indicate their views on cost of capital, future operating costs and other significant issues before or during, rather than after, the process of customer engagement with companies?

It might be argued that the cost of capital and efficient operating costs will depend upon the precise nature of the business plan to which companies and customer groups agree. But could not regulators give guidance on some basic issues and leave the detailed adjustments to companies and customer groups?

This may result in some inconsistencies, less neatness than the regulator would like. But the competitive market is full of inconsistencies. And neatness, as I know from setting some 50 price controls, is a regulatory artificiality imposed upon a diversity of efficient cost projections that are embarrassingly inconsistent.

If we wish to discover new ways of reducing costs and of improving quality of service, and of finding what works best for customers, we must allow companies and their customers to explore and adopt new and different approaches. Over time, companies and customers and regulators will learn from these different experiences. U.K. regulators have been moving in this direction, with good results.

The next round of price control reviews will provide the opportunity to go further. I would be surprised if there were not scope to involve customers in water regulation in Cayman too.

 

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Stephen Littlechild

Dr Littlechild was a member of the Monopolies and Mergers Commission from 1983 to 1988 and Director General of Electricity Supply from 1989 to 1998. Since 1999 he has been an international consultant on privatisation, regulation and competition, especially in the electricity, telecommunications, airport and water sectors, and an economic adviser to several regulatory bodies.
 

Dr Stephen Littlechild
Fellow
Cambridge Judge Business School
University of Cambridge
Trumpington Street
Cambridge CB2 1AGUK

T: +44 (0)1223 339700
E: s.littlechild@jbs.cam.ac.uk
W: jbs.cam.ac.uk

 
 

 

Cambridge JBS

Cambridge Judge Business School is in the business of transformation - of individuals, of organisations and society. What does that mean in practice? It means we work with every student and organisation at a deep level, identifying important problems and questions, challenging and coaching people to find answers, and creating new knowledge. This combination of the latest thinking from academia and professional practice, in turn, enables us to develop greater knowledge and better methods in order to have an impact on the world in which we live and work.
 

 

 

Cambridge Judge Business School
University of Cambridge
Trumpington Street
Cambridge CB2 1AGUK

T: +44 (0)1223 339700
E: s.littlechild@jbs.cam.ac.uk
W: jbs.cam.ac.uk