The Success of the Water Industry in Scotland, 2002-2022
By Professor David Simpson
Introduction
The common theme of the papers published by the Bottom Line is that when a community takes control of its own affairs, the outcomes include measurable improvements in the wellbeing of that community, as well as improvements in its output and wealth. These propositions are supported with an abundance of statistical evidence.
Small independent states have been able to use their agency to outperform the UK. The chances of the UK matching the economic and social performance of advanced small states in the future are very small. The gap in performance of the UK in comparison with other advanced economies has been steadily widening for many years, with the UK increasingly left behind. By being dependent upon a failing UK, Scotland is hugely disadvantaged, lacking the agency that would become available with independence.
There are examples of success in Scotland that show what would be possible with independence. One of our biggest industries, the water industry, has flourished in comparison to its counterparts south of the border. The reasons for this, which are connected to questions of agency and political culture, are explored in this paper.
This paper has been written by Professor David Simpson who was a non-executive member of the Board of the Water Industry Commission for Scotland (WICS) from 2005 to 2012. He claims no credit for what took place, but he was lucky enough to have a ringside seat.
Background
Discussions about the performance of an economy often focus on the birth rate and growth of new businesses. But at any moment in time an economy depends on large and medium-sized businesses for the continuing provision of secure and well-paid job opportunities, as well as for tax revenues. In this respect the Scottish economy is no different. But within the last two decades it has experienced the failure of some of its largest and longest established indigenous companies[1].
It is therefore gratifying to be able to record the achievements of a large Scottish company that has made good progress since its formation in 2002. That company is Scottish Water, which has a monopoly of the supply of raw water and the disposal of waste water in Scotland, and employs around 4,200 people. It is one of the largest companies in Scotland by value of assets, since its pipelines, if laid end to end, would easily reach around the world. Readers may well ask: “If it’s so big and successful, how come we haven’t heard more about it?” There are probably three reasons for its low profile.
First, most of its assets are invisible. Apart from a few vans scurrying about, there is almost nothing to be seen. Its pipelines are buried underground, while its water treatment plants are usually hidden from view. Reservoirs often appear to be works of nature.
The second reason is that, unlike the water companies in England and Wales and other utilities such as gas, electricity and telecoms, whose performances and share prices are the subject of daily speculation in the media, Scottish Water is owned by the Scottish Government. Of course, Scottish Water produces an Annual Report, but there is little excitement to be found in its pages.
Finally, it is probably safe to say that the average citizen takes the supply of fresh water and the disposal of waste water for granted. So long as fresh water comes out of a tap whenever it’s turned on, and the toilet flushes on cue, they are untroubled by the continuing problems of procuring, treating and supplying fresh water to every household and business in the country, and the removal and treatment of waste water from the same premises. For households, even the cost of providing these services is not immediately obvious. Unlike in some other countries, houses in Scotland are typically not fitted with water meters; householders’ bills are just another line in their council tax statements. So, what is there to worry about?
The story begins at the turn of this century, when three important changes took place in the organisation of the supply of water. In 1999 the role of Water Industry Commissioner for Scotland was established. The Commissioner identified the scope for substantial improvements in efficiency and service through the merger of the three existing regional water authorities. In 2002 the authorities, representing the North, East and West of the country, were amalgamated into a single company called Scottish Water. In 2005 a regulatory body, the Water Industry Commission for Scotland (WICS), was set up to monitor the performance of Scottish Water[2]. The change was part of a move to strengthen regulatory independence by clarifying the regulator’s role as decision maker, rather than as Government advisor.
Working in tandem, these two organisations began to improve performance standards in three major areas: operating efficiency (i.e. costs and prices), investment delivery and levels of service. After twenty years, it is possible to measure the improvements that have been achieved. From the point of view of the ordinary citizen, perhaps the stand-out achievement is that, whereas before 2002 the average household water bill in Scotland was higher than the average in England and Wales, today it is lower.
Achievements and Benefits
The first achievement was to get the new integrated company Scottish Water up and running. It inherited a dire situation: operating costs were twice as high as the best performing English company, investment per head of population was low, customer satisfaction was poor, while drinking water quality, environmental water standards and levels of service were all below comparable English levels.
To measure levels of service, water companies use a composite index called the Overall Performance Assessment (OPA). It includes things like leakages, unplanned sewage discharges and customer complaints. On this measure in 2002, Scottish Water was 30% below the leading company south of the border (Dwr Cymru). Twenty years later, in 2022, the picture had completely changed. Despite its geographical disadvantages, not only had Scottish Water caught up with the English companies, it had surpassed them in several key areas. The first graph shows that leakages of fresh water from pipelines have fallen steadily each year from 2003 to 2021. The second graph shows that, after a steep decline in the early years, the number of sewage pollution incidents has continued to decline each year.
Source: Water Industry Commission for Scotland (WICS)
Source: Water Industry Commission for Scotland (WICS)
The differences in OPA scores recorded in 2002 can be traced to earlier low levels of investment. The merger of the three authorities led to a significant increase. Between 2002 and 2020 the annual average investment per head of population in Scotland was £135 (in constant 2019/20 prices) whereas the average for England and Wales was £102 [3]. With this concerted increase in investment, Scottish Water’s OPA scores now match or exceed the best performing companies in England and Wales.
During the same period Scottish Water reduced its operating costs by over 30% in constant prices. As a result, between 2002/03 and 2020/21 average household bills in Scotland fell by 10% in real terms. The comparable figure for England and Wales was an increase of 4% [4]. Londoners, who were unfortunate enough to be served by the worst performing company, Thames, found that their water bills had on average increased by 19% over the same period.
How was this remarkable turnaround in Scotland achieved?
These improvements were largely the result of a sequence of innovations devised by the regulator, WICS, and implemented by Scottish Water in collaboration with the other stakeholders in the sector, notably the environmental and drinking water quality regulators, the Scottish Environment Protection Agency (SEPA) and the Drinking Water Quality Regulator for Scotland (DWQR), and the customer representative bodies. The innovations included new methods of price regulation, the creation of a competitive market for the supply of water to businesses and public sector organisations like hospitals and schools, and the introduction of customer involvement into the regulatory process.
Building on the work undertaken since 1999, WICS set out to devise a new regulatory procedure. While regulation of the water industry in England and Wales had been in operation since 1989, it was designed for a constellation of ten[5] privately owned, profit-seeking water and sewerage companies and some smaller regional ‘water only’ companies. There was no precedent for regulating a single publicly-owned water company. (The nearest parallel is with the regulation of the Post Office, an experience that has proved to be an unhappy one.)
The basic design was for there to be a regulatory control period, initially of four years, from 2002 to 2006, with WICS providing advice to Scottish Minsters about the level of charges necessary to finance an environmentally and financially sustainable service. So began a sequence of regulatory periods, for each of which a fresh determination by the regulator was made. At each subsequent review Scottish Ministers lay down broad principles and objectives, and the task of WICS is to determine a scheme of prices (charges) that will finance the investment and other objectives laid down by Ministers at the lowest reasonable overall cost.
A very large part of the success of the water industry in Scotland in the last two decades has been due to the willingness of the principal parties, WICS and Scottish Water, to learn the lessons of the experience of each successive regulatory period, to find out what had worked and what hadn’t, and therefrom to fashion a series of improvements in subsequent periods.
The current regulatory period runs from 2021 to 2027, and there has been no let-up in the pace of innovation. On the contrary, it has been described as a greater challenge for Scottish Water to meet its new objectives than anything it has faced before, including coping with the original merger or managing the catch-up. This is because the regulator WICS has asked Scottish Water to undergo a corporate cultural “transformation”, without which, it says, the objectives agreed for 2027 will not be achieved.
The present regulatory settlement has been decided in the context of the longer run challenge that the water industry in Scotland should achieve net zero operational and embodied greenhouse gas emissions by 2040. The major element of this challenge is to increase the rate of investment to maintain and replace Scottish Water’s ageing asset base. For that purpose an expenditure of £4.5 billion over the period has been agreed. This is an increase of 30% on the previous regulatory period. To pay for it, prices will need to increase at an average annual rate of CPI+2% for the six years up to 2027. And it appears, given the challenges currently foreseen from asset replacement needs and achieving net zero emission, that prices are likely to have to continue to rise by a similar amount over future regulatory periods if the water industry in Scotland is to become sustainable over the long term.
While economic regulation has traditionally focused on financial costs and benefits, WICS has this time included in its determination an allowance of an extra £133 million to cover “externalities” such as carbon, natural and social benefits.
As well as factoring non-financial benefits into its calculation WICS is putting into practice the conceptual principles encompassed by ‘Ethical Business Regulation’ (EBR). WICS explains that EBR is not about being ‘nice to people’ but rather about achieving high levels of candour and transparency, including being clear about what you thought and why you thought it. It has offered transparency and accessibility to its own decision-making processes; it says it has conducted “frank dialogues” with Scottish Water, and has asked for Ethical Business Practice (EBP) in return.
It is early days in what will obviously be a long journey, but WICS believes that if Scottish Water is being appropriately open and candid in the information it provides and uses robust analysis to underpin the decisions it makes, this will engender confidence that it is delivering the best outcomes for current and future generations of customers.
Another important innovation introduced by WICS has been in the area of customer engagement. One of the essential functions of any competitive market is that it reveals to potential suppliers what customers actually want and how badly they want it, i.e. how much they are willing to pay. The problem with a monopoly, whether private or public, is that this function cannot exist. Left to its own devices, a private monopolist would probably choose to supply whatever amount would maximise its profits. However altruistic a public monopolist might wish to be, it would still not know exactly what its customers wanted. In the case of Scottish Water, this means discovering what its customers’ expectations are in terms of levels of charges, and what their priorities might be for service level improvements, e.g. reductions in levels of leakage, improvements in water quality or in waste water disposal.
To find this out, in 2011 WICS worked with Scottish Water and the Scottish Consumer Council[6] to set up a Customer Forum to carry out customer research, with the results feeding into the Determination made in March 2014 for the regulatory period 2015-2021. The remit of the Forum was defined quite loosely so that its functions could evolve. Whereas initially customer views were introduced as an add-on to a business plan that was infrastructure-driven with subsidiary involvement of social and environmental considerations, the regulatory process moved to a negotiated settlement from which the regulator has stepped back, allowing Scottish Water to negotiate directly with customer representatives. It was more satisfactory for Scottish Water to justify itself to its customers rather than against a set of benchmarks, which were in any case becoming less and less relevant as Scottish Water caught up with the English water companies[7].
The role of the Customer Forum has evolved further towards taking part in creating Scottish Water’s strategic planning process. That has helped to change the dynamic from adversarial negotiation to “seeking a balance and avoiding tension”. The official WICS view is that “Scottish Water has got to have the trust of its customers, and negotiation per se is not a good way of achieving that” [8]. This rolling engagement programme led to Scottish Water committing to the principle that “every decision is the one it would take if the customer were in the room”. WICS has described this as being “EBP to an A* standard: it’s holding yourself to an accountability standard that’s really, really high.” [9]
After an intensive review of the whole customer involvement process within the water industry in Scotland, Stephen Littlechild, the doyen of British regulators, wrote:
“In my view, the Customer Forum process has been one of the most innovative, successful and encouraging developments in UK utility regulation.”
Stephen Littlechild, the doyen of British regulators [10]
To emphasise that the current regulatory period marks the start of a transformative journey for Scottish Water, rather than being an end in itself, WICS has published a series of charts showing that if the 2040 net zero target is to be met along with maintaining service levels and delivering other improvements, annual average investment levels will have to rise to around £ 1 billion by that year; revenues and thus prices will have to rise correspondingly over the next two decades.
Creating a Competitive Market for Water
By far the boldest of the many innovations undertaken by the Scottish water industry in the last two decades has been the creation of a competitive market for large users of water, i.e. businesses, charities and public sector organisations. Together there are some 160,000 such users; they account for around £350 million in annual revenues. The remaining 70% of the supply of water is used by households.
After several years’ planning, the market was opened in April 2008. So far as is known, it was a world first: no other such market existed anywhere else in the world. Nine years later, the English water regulator Ofwat followed in the footsteps of WICS and introduced a similar market for England Wales.
Today there are 20 licensed retail providers of water in Scotland that offer different levels of service, payment terms and prices after buying the water wholesale from Scottish Water. The benefits of the market include:
Lower prices: Consolidated and electronic billing has resulted in savings and reduced administration costs for non-household customers. For example, NHS Highland cut its annual water bill by £400,000 in just three years from 2011. That figure equates to a third of what the health board was previously spending per year on its water services, a total of £1.2 million.
Tailored services: Some licensed providers have developed additional services to meet the wishes of their customers by offering different methods of payment, automatic meter readers and advice on how to improve water efficiency or reduce wastewater discharges. Customers can now pay for the combination of services that best suits their needs. In some cases this means paying more than they did previously while in others it has led to a reduction in costs.
Environmental benefits: Water consumption has decreased by around 20% since market opening, reducing the operational carbon footprint of the industry.
Prices and Costs: The opening of the market required WICS and Scottish Water to work closely together to develop cost-reflective wholesale and retail tariffs. It has also allowed Scottish Water to improve its understanding of its own costs.
Recently WICS undertook a root and branch review of the market to make sure that it continues to work well for customers. As part of the outcome of this it is now starting the process of introducing ‘health checks’ for licensed providers. The aim of the health checks is to improve customer outcomes and promote compliance and overall effectiveness of the market. So innovation continues.
Such innovative practices in the water industry have not gone unnoticed. WICS has been asked to share its experience with numerous countries around the world, including Greece, China, Romania and New Zealand. This international work supports the Scottish Government’s ‘Hydro Nation’ initiative which seeks to build partnerships and share expertise.
One of the earliest projects was in Greece, where WICS provided training support for the new economic regulatory body for water, working with the EU Special Task Force.
In Romania, analysts from WICS adapted the information framework used for regulation in Scotland to serve the needs of three regional water companies and the Public Services Regulatory Authority.
In China, the Chief Executive of WICS delivered a training course on the water industry in relation to the Chinese South-North water diversion project for the Chinese Institute of Water Resources and Hydropower Research.
In New Zealand, WICS analysed the performance of two water companies serving respectively Wellington and Auckland. Supporting the implementation of reforms to the water sector in New Zealand, they introduced the same collaborative approach developed in Scotland. The companies were helped to better understand their costs, their potential for efficiency gains and their future investment needs. More recently WICS has supported the Department of Internal Affairs (DIA) in New Zealand, undertaking strategic analysis of the economic benefits from aggregating 67 separate water service delivery entities. WICS has also used detailed data provided by the entities to estimate the likely scale of investment that would be required in the future, along with the impact on customer bills.
Economic Lessons of the Scottish Water Experience
To what should we attribute the observed success of the Scottish water industry since 2002?
The primary lesson to be drawn from that experience is surely that it bears out the common sense notion that success in business depends on entrepreneurship[11].
There are many definitions of entrepreneurship, but a good working one is that entrepreneurs bring about change, where change is the finding and undertaking of new ways of doing things. Since, as we have seen, the success of the water industry in Scotland has been founded on a sequence of innovations, then it seems as if the regulator and the company demonstrated what might be called entrepreneurial leadership.
Until about a hundred years ago, those economists[12] who emphasised entrepreneurship as the principal factor in a growing economy were thinking primarily of individuals who risked their own capital in new productive ventures. But today, the most striking examples of entrepreneurial success are to be found in such giant corporations as Facebook, Amazon, Google and Netflix, albeit that the origins of each of these companies can easily be identified with particular individuals. So we might use the term ‘entrepreneurial leadership’ to refer to the manifestation of entrepreneurial qualities at the corporate level.
What are these distinctive entrepreneurial qualities? At the individual level, the attributes that are frequently invoked to describe entrepreneurship include flair, vision, and an appetite for risk as well alertness to profitable opportunities. It may seem surprising to suggest that entrepreneurial qualities are to be found in the Scottish water industry, for three reasons.
First, the water industry is not like one of those digital industries whose products and technologies are subject to incessant change. On the contrary, its functions are fairly repetitive, even routine. Secondly, in Scotland, as in many other countries (although not England), the water industry is not a profit-seeking entity: it is owned by the Government. Although public sector entrepreneurs may not live such an exciting life as their private sector cousins, they share the need to make decisions at all times in an environment of radical uncertainty, looking towards an unknowable future. They must have a capacity for imagination, innovation and adaptability, as well as being possessed of a vision of the direction in which the organisation for which they are responsible should travel, how it is to get there and how the wholehearted support of its crew might be enlisted.
Finally, the water industry is typically not competitive; it is a natural monopoly, also known as a utility. Left to their own devices, the managers of a natural monopoly, whether publicly or privately owned, would be tempted to put their own interests, viz. high salaries, job security and a quiet life, above the public interest. The benefits to customers that in the case of other goods and services are secured by competitive markets can only be extracted from a monopoly by regulation. Indeed, there can be opportunities in good regulation beyond being a surrogate for competition – for example, it may be possible to achieve greater levels of openness, candour and trust in the regulated model – to the benefit of all customers and stakeholders.
Public sector monopolies can be made to work by thoughtful regulation, at least in circumstances where accurate and consistent information is available and where there is an ability to compare costs and performance with similar entities. But what the experience of the water industry in Scotland has shown is that a really successful public sector monopoly depends on the quality of its entrepreneurial leadership. For the last two decades the industry has been lucky enough that both the company and its regulator have been led by two exceptional individuals.
What about ownership as an explanatory factor in the success of the water industry in Scotland? It is true that a publicly owned company may be less diverted by pressure to pay dividends to private shareholders. But whether a publicly owned company is thereby more oriented to customers, as opposed to other interest groups such as politicians or employees, is debatable. There have been too many examples of the failure of government-owned businesses for arguments in favour of the intrinsic superiority of public ownership to be convincing.
Earlier this year the Scottish Government announced that it was bringing another company “into public ownership”. This is the train operating company, ScotRail, a subsidiary of Abelio, a company owned by the Dutch Government. It is difficult to believe that the act of transferring the ownership of Scotrail from the Dutch Government to the Scottish Government will make any material difference to the company’s performance. An improvement will surely only come about if corresponding changes are made to the way the company is managed and the industry is regulated.
A final factor contributing to the success of the water industry in Scotland may have been the industry’s governance framework, in particular the clarity with which the responsibilities of the different stakeholders have been delineated.
The ultimate responsibility of all stakeholders is to the Scottish Parliament, which gives legislative consent to Government policy. The Government acts as owner, sets objectives and develops policy on charging, financing and levels of service. Scottish Water is responsible for meeting the Ministerial Objectives for the industry, and must live within the resources allowed for by the economic regulator WICS, that is responsible for setting charges. Scottish Water must also ensure that it meets the water and environmental standards set by its other regulators, SEPA and DWQR. Having no responsibility for policy decisions means there is less scope for conflict between the different regulators or for one regulator to hide behind another.
Are there any other activities in Scotland to which the economic lessons of the water industry may be transferable? The possible answers include the other utilities, gas, electricity and telecoms, as well perhaps as parts of the banking system and the NHS.
The experience of the Scottish water industry in the last two decades shows what can be achieved when there has been agency, or responsibility, in Scotland for decisions in every area of the industry: ownership, operational decision-making and regulation. The outcome has been the development of an approach that fitted Scotland’s political wishes rather than the preferences adopted in England. Whereas the regional water companies south of the border were privatised in 1989, in Scotland the industry remained in public ownership, and moved into the hands of the newly devolved administration after 1999.
By historical accident, the organisation, governance and operation of the water industry in Scotland since 2002 has been almost entirely free from Westminster control or even influence. Had things turned out differently, Scottish Water could easily have been privatised. Whether in private or public hands, it might have fallen under a GB-wide framework of regulation. But the Scottish Government, Scottish Water, its regulator WICS, and the other stakeholders have been able to pursue their courses of action within a political context indistinguishable from that which would have occurred had the country become fully independent.
The collaboration between the Scottish Government, company, and regulator that has been observed since 2002 has delivered outcomes that have surpassed the performance of the other water companies in Great Britain. Scottish Water has delivered lower bills and better services for households, businesses, schools and hospitals as well as superior environmental benefits for communities. WICS has developed a regulatory framework in Scotland that has distinguished itself from the rest of the UK, indeed from the rest of the world, in terms of innovation, process and spirit.
References
[1] Ewan Brown, Corporate Ego, Edinburgh 2021
[2] WICS employs a staff of 28 people, all of whom now work remotely. Since July 2021 the organisation has occupied no physical office space.
[3] WICS (2020), ‘Strategic Review of Charges 2021-27: Draft Determination, p.32.
[4] WICS (2020), ‘Strategic Review of Charges 2021-27: Draft Determination, p.36.
[5] There were originally 10 water and sewerage companies in England and Wales at privatisation; there are now 11 companies, with the creation in 2018 of Hafren Dyfrdwy, which operates in north east and mid Wales.
[6] When the Scottish Consumer Council was disbanded its water activities were transferred to Citizens’ Advice Scotland.
[7] While similar developments have been taking place elsewhere in other regulated industries in the UK and North America, not all have been successful. For example, the introduction of Customer Challenge Groups (CCG) in Ofwat’s Regulatory Period 2015–2020 fell short of expectations, insofar as most companies did not get an enhanced status for their business plans even though they had been ‘endorsed’ by the CCG.
[8] The Water Report, November 2020, p.7
[9] Ibid, p.8
[10] S. Littlechild, Studies in Regulation, Regulatory Policy Institute, Oxford 2014.
[11] This is a view that appears to be endorsed by the Scottish Government. In its National Strategy for Economic Transformation published on 1 March 2022 ‘Entrepreneurial people and Culture’ is assigned the First place in the Strategy’s list of ‘Programmes for Action’.
[12] Perhaps most notably Cantillon and Schumpeter amongst others