Some thoughts for a government implementing Cunliffe

Steve Gummer provides an in depth explanation of the impact that the Cunliffe Report will have, and shares how the report is not quite what it first seems.

It’s been a heck of a week for water regulation. The Cunliffe report, published on Monday, lit a fuse that could fundamentally change how the UK regulates its water sector. Yet, as we noted earlier this week, Cunliffe might not be exactly what it first appears:

1. The potentially revolutionary aspect of Cunliffe isn’t the abolition of Ofwat. Interestingly, the report doesn’t actually use the word “abolish” regarding Ofwat at all. Instead, the truly significant shift is the move from an incentive-based economic regulation model towards a supervisory model characterised by close scrutiny. This represents a potential paradigm shift, marking the end of more than three decades of regulatory thinking.
2. Cunliffe isn’t itself a solution. Rather, it raises numerous critical questions. It’s around fifty separate consultations may be required to fully unpack its implications. Notably, there’s uncertainty about its practical implementation, its impact during transitional periods (such as AMP 8 and AMP 9), and how to handle the residual functions of the Environment Agency (EA) not transferred to the proposed “super-regulator.” Additionally, there are unanswered questions regarding regional planning responsibilities.

This week, I’ve been fortunate enough to engage in many insightful off-the-record conversations with experts deeply embedded in the water industry. Below, I’ve shared some of the most intriguing insights. To respect privacy, I’ve avoided naming individuals, and I certainly can’t claim credit for much of what follows.

Cunliffe signals a shift – but it’s not as revolutionary as it seems

Cunliffe explicitly moves away from the incentive-driven regulation that has dominated the UK water industry since privatisation in 1989. Under the current model, based on a foundational RPI–X price-cap approach, companies have significant autonomy, incentivised via five-year price reviews aimed at rewarding cost-efficiency and innovation. This system simulates market competition, allowing companies to keep profits gained by exceeding efficiency targets, thus driving infrastructure investment and improvements in water quality.

By contrast, the US operates a direct rate-of-return regulatory model for utilities, where regulators explicitly control allowable profits. Companies must justify all expenses and investments beforehand, with customer charges set to recover these pre-approved costs plus a predetermined profit margin. While this tightly controls profitability, critics argue it lacks incentives for efficiency and innovation.

The UK’s incentive-based approach has increasingly faced criticism since the 2010s. Critics argue that it allowed excessive prioritisation of shareholder returns at the expense of infrastructure and environmental performance. High-profile issues like sewage pollution, leaks, and rising customer bills had already led Ofwat to adopt stricter controls, such as tighter financial oversight during PR19, enhanced dividend scrutiny, and financial ring-fencing rules. Cunliffe marks the final departure from the pure incentive-driven approach… a journey the sector had already begun.

Transitioning towards supervisory regulation

What replaces incentives? Cunliffe suggests an intensive supervisory model inspired partly by US banking regulation. American bank regulators, such as the Federal Reserve, conduct continuous on-site monitoring and impose stringent financial rules. Similarly, UK water could see a regulator closely overseeing companies’ operations, enforcing conservative financial management, and intervening when needed. This would represent a substantial shift in regulatory mindset.

However, practical delivery of this scrutiny poses challenges. Cunliffe proposes creating eight regional water system planning authorities in England, plus one national authority for Wales, echoing pre-1989 Regional Water Authorities. These bodies would produce integrated water investment plans reflecting local priorities and environmental conditions, aiming to streamline current fragmented planning processes. Yet questions remain around their authority and separation from water companies responsible for actual delivery. Structurally, these planners might evolve into localised regulators, balancing national oversight with regional accountability and tailored solutions.

What happens to the Environment Agency?

Cunliffe proposes creating a single integrated water regulator absorbing Ofwat, the Drinking Water Inspectorate (DWI), and all “water-related functions” from the EA and Natural England. Although logical in theory, the report doesn’t fully clarify the complex implications. “Water-environment related functions” presumably include water quality regulation, abstraction licensing, and enforcement, but it explicitly leaves flood management and waste regulation with the EA.

This structural split could create challenges. Many EA roles are multidisciplinary, combining water and non-water duties. Disentangling these roles could disrupt existing workflows, requiring careful management to avoid duplication or gaps in expertise. For instance, integrated environmental permits currently covering water, waste, and air emissions could become fragmented, increasing complexity rather than streamlining regulation. There’s a legitimate concern over whether the residual EA would remain effective after such a significant restructure. A clear governmental strategy ensuring coherence in both the water regulator and the reshaped EA will be essential.

Government pressure and an alternative idea beyond Cunliffe

Publishing Cunliffe doesn’t guarantee government acceptance, especially given growing public pressure on issues like sewage pollution and customer bills. Calls for nationalisation are intensifying, exemplified by headlines like that in the I declaring “The Cunliffe report proves it: water must be nationalised.” However, Cunliffe itself resists ideological extremes. There is no doubt though that the clock is ticking and government faces pressure to “do something big”! The report suggests substantial regulatory reform and significant investment, rather than changing ownership labels.

To the government hell-bent on something big, one significant possibility not directly mentioned by Cunliffe (but Cunliffe compatible) is merging several regional water companies. Currently, England and Wales have 11 major regional companies and several smaller entities. Reducing this number through mergers could streamline planning, facilitate investment, and ease regulatory oversight. Fewer, larger companies might achieve economies of scale and simplify regional infrastructure planning, potentially negating the need for additional bureaucracy. It could also reduce projects contingent on complex bulk supply arrangements and do away with some of the historic water companies that have developed unhappy brand recognition. This could potentially be coupled with larger scale infrastructure providers, they would deliver regional major infrastructure safeguarding balance sheets of heavily leveraged companies.

Ultimately, Cunliffe opens critical discussions, laying groundwork for a major transformation in water regulation. How effectively these recommendations are implemented will dictate the future success of UK water governance. More conversations are needed.