Unexploded Policy Bomb in Water Commission Report

The key water industry question is how much the companies, and their customers, should be forced to spend to improve its infrastructure and so reduce leaks and sewage discharges.

This is not a question that can be left to the regulator. It is a major political decision.

Minsters did not duck the question following privatisation. The regulator prioritised efficiency and forced down real prices using the standard RPI-X formula. But environmental standards and spending were simultaneously driven up as a result of ambitious EU Directives, often encouraged by UK Environment Ministers. Ofwat then had no choice but to pass the associated costs on to consumers, including by adding a '+K' factor to the RPI-X formula. Here's the net result from 1990 to 2009:

But then, to quote Water Commission Chair Jon Cunliffe earlier this week:

"For much of the last 20 years, Ofwat was encouraged to regulate with a lighter touch and to focus on keeping bills down".

He also made the point that …

"It is clear that the Environment Agency has not had the resources, the people, skills, technology to hold the water industry and other sectors that impact the water environment to account".

Here's the result. Water charges have fallen in real terms whilst environmental standards have tanked.

Cue public consternation at sewage spills etc. etc., accompanied by impressive political energy devoted to deflecting blame onto companies' dividend policies etc.

Let's take step back:

Water companies are classic monopolies (apart from when they supply business consumers). They have guaranteed revenues and zero competition. Their regulator is legally required to set its prices so that they can cover their 'efficient¹' costs, make sensible investments in infrastructure and make a reasonable profit for their shareholders. It follows that it takes an impressive amount of mismanagement for water companies to have financial problems - although Thames, at least, has succeeded as a result of some crazy financial engineering. I have discussed this previously, here.

To be clear, Thames' dividend policy may have coincided with insufficient environmental spending, but it did not cause it - and the company has recently been fined £104m for sewage spills. Its salary and bonus policy is even less relevant to its environmental performance. A million quid here or there makes little difference when its total revenue is £2.7 billion!

So, ministers and civil servants, what help does Jon Cunliffe give you in addressing the fundamental trade-off between water bills and the environment? The good news? He addresses it in his very first recommendation ... which is that:

"The UK and Welsh governments should each bring forward a new, long-term, cross-sectoral, and systems-focused National Water Strategy for England and Wales, respectively. The Strategy should set out a clear framework for how regulators should manage the trade-offs between priorities, including how to deliver the investment needed to meet environmental standards and future demands while keeping customer bills affordable."

But that's pretty much it! You need to decide, ministers, how much to annoy voters by increasing their water bills v. how much to annoy them by increasing environmental damage. But this little unexploded policy bomb doesn't need to be detonated for several years as Ofwat's current draft price controls will cause bills to rise in real terms by an average of 36% over next five years. Good luck, after that!

As for the rest of the recent report:

Recommendation 16 has attracted more media attention:

The UK government should establish a new integrated regulator in England. This should combine the functions of Ofwat, DWI, and water functions from the Environment Agency and Natural England.

Large combined regulators that deal with a wide variety of 'industries' seldom work well - think Ofsted and the CQC. But the water industry has four distinct regulators, all with very different statutory responsibilities, attempting to control the performance of one industry. So the recommendation is sensible, although I do not envy those policy officials and lawyers who will need to design a combined system.

Recommendation 18 is "interesting".

The regulator should adopt a more ‘supervisory approach’ to regulating individual companies. This applies to England and Wales.

The Commission is recommending giving the new regulator the power where necessary to block changes of ownership, to set gearing levels and, in certain circumstances, to give direction to the ultimate controller of the company. ... We are also recommending making the public purpose of companies clear in the licence condition, bringing company governance in line with the governance code for listed companies and bringing in a statutory [duty] for the very senior management cadre, drawing on the experience of the senior managers regime in the financial sector.

It is perhaps no surprise that ex-financial regulator Jon Cunliffe believes that the regulatory culture in this industry "has become too adversarial on both sides". (Some would argue that it has not been adversarial enough!) He wants Ofwat v.2 to adopt an intimate, City of London-style, regulatory culture where each company interacts with its own dedicated regulatory team. As noted above, I think it would have been better for Ofwat to say that corporate behaviour was "nothing to do with us!". But the Water Commission, rather than choosing to tell Ofwat to focus on its main job, are instead determined to turn Ofwat into a water version of the Financial Conduct Authority - presumably with salaries to match.

What about vulnerable customers? Again, the Commission tells ministers to make their own minds up, against the background of ever-increasing charges:

Recommendation 42 (England): The UK government should consult on the introduction of a national social tariffs with consistent eligibility criteria and levels of support.

"We have to recognise that the cost of producing water and wastewater services is likely to increase over the medium and longer term as the industry has to replace ageing assets, respond to higher environmental and public health standards and continue to adapt to the challenges of rising population growth and climate change. Against that likely background of rising costs and rising bills, there is a need for a stronger safety net for the most vulnerable who are exposed to water poverty. ... It is for government to decide whether and how far to equalise support for the vulnerable in different parts of the country and it is for government to decide to what extent this should be done through water bills as part of a national social tariff, or through other means of support such as the social security system. It is of course for elected government rather than the Commission to decide between those options. ... However, we make no recommendation on the design, the level of support and the degree to which there should be cross subsidy between customers of different water companies. These are highly distributional decisions, and such decisions are not for technocrats but for government to make.

There are loads of other worthwhile planning and other recommendations in the 464 page(!) report. But, if ministers thought that Sir Jon would help them find a way through the current and forthcoming political water battles, I fear they will have been disappointed.

Notes:

It was arguably unwise of ministers to pledge, just before the report was published, that ‘households will never again see inflation-busting increases in their water bills’. (The Times 19 July 2025)

Simon Carne published an interesting and complementary analysis of water regulation policy almost simultaneously with this one. You can read it here.

A gentle introduction to utility regulation may be found in Part 8.5.3 of my How to be a Senior Civil Servant.

Martin Stanley

1. The word ‘efficient’ is important. The convention in economic regulation is that the regulator focuses on the financeability of a notionally efficient company (sometimes referred to in shorthand as the ‘notional’ firm) and pays limited or no attention to the position that the actual firm finds itself in. This means that cost inefficiency and the consequences of excessive real-life borrowing are treated as problems that shareholders have to deal with, without recourse to any special favours from customers. [Copied from John Earwaker’s Substack]