6 Dec 2011

Should water companies self-regulate their risks?

This white paper [PDF] from Ofwat proposes a move from output- to outcome-based regulation of water companies in England, i.e.,
The first change is to the current system of regulatory reporting. This would move Ofwat away from detailed regulatory monitoring of compliance. This change puts the companies firmly in charge of managing their risks, and redefines our role as holding them to account for the results, not the processes they adopt to ensure compliance.

Second, we propose that Ofwat itself adopts a risk-based framework. This will not only include a systematic assessment of risk and opportunity but will also allow us to focus the allocation of our own resources. This will demonstrate that we intend to conserve resources and target our efforts, so we have the capability to act swiftly and decisively where there is a real risk to outcomes for water consumers. And the companies and we would be freed from regulatory burden where there are no material risks to consumers.
This project, while admirable, suffers from three fatal flaws:

First is the emphasis on self-reporting and regulation of risk by companies that have little incentive to provide accurate reports on risk. Mistakes, after all, can be plausibly blamed on "unexpected, outside" factors beyond the companies' control, i.e., "can we increase our prices to fix the problem please?"

Second, "self regulation of risk" does not instill confidence in people after the fiasco of self regulation of risk by financial companies that have absorbed $ trillions in bail out money, world-wide.

Third, Ofwat faces information and incentive problems in terms of monitoring risk inside companies. What questions should be asked? Who wins or loses if the wrong questions are asked or the wrong weights (in terms of risk) are applied to the answers? How will outsiders know if Ofwat is doing a good job at monitoring one company, let alone 20+ companies with very different institutional and physical characteristics.

Luckily, I have an answer to these flaws:
  1. Rebrand this effort as "delivering sustainable services" instead of "managing risk." 
  2. Require that water companies take out performance insurance with companies that will compete for business (minimizing the cost of insurance), watch water companies (providing oversight), pay for accidents (relieving customers of higher bills for mistakes), and provide a transparent view on performance (facilitating comparisons and benchmarking). All of these ideas are spelled out in this paper.
Bottom Line: It's difficult to balance between over-investment that taxes customers and under-investment that puts their water services at risk, but regulators can facilitate that balance by importing a competitive industry that will take responsibility for failure while getting paid for success.