I have recently written an article for the Oxera magazine, Agenda. In it, I explain the substantial savings that have been achieved by Scottish Water’s retail business, Business Stream, since it was first legally separated. They are now saving over £9 million a year. A full audit trail for these savings is available on our website. These savings are after having taken account of the new costs of operating the retail framework in Scotland.
Our analysis shows that customers in Scotland are likely to benefit to the tune of over £300 million in present value terms.
Interestingly, even if savings are only two-thirds of what could reasonably be thought possible from a review of relative costs in Scotland and in England and Wales, the benefit to customers and to investors could potentially reach £2.5 billion!
A separation along the lines implemented in Scotland would benefit investors: the key is the commitment to do no detriment to the wholesale business. Under this approach, investors would see improved performance by both the wholesale and retail sides of the business and the financeability of the wholesale business would improve.
- No adjustment was made to the regulatory capital value;
- The retailer pre-paid wholesale charges and bore all the bad debt risks;
- There was no change to the allowed for cost of capital in the wholesale business; and
- And again, I should emphasise, we had a statutory duty not to do detriment to the core business of Scottish Water.
And let’s not lose sight of my earlier point about capturing economies of scale. The capital markets would seem likely to exploit the economies of scale within retailing that would likely be offered up if the same retail framework were introduced down here.
So investors see the opportunity for real value creation and at the same time, customers begin to benefit from improved service, lower costs and more tailored offerings. And this could reasonably be expected to improve willingness to pay, which, in turn reduces costs. A virtuous circle indeed!
There should be significant economies of scale in establishing a retail competition framework in England and Wales. In order to try and understand the potential benefits, we need first to consider the set-up and on-going costs of the framework.
If I assume that there is nothing that can be learned from Scottish Water’s experience in separating its retail activities and the same effort is required to develop the industry codes and contracts, we could say that the companies will spend - on a per customer basis - broadly the same amount as Scottish Water.
I further assume that the Scottish CMA could be made fit for purpose for a pan-GB market for around £10 million (around four times what was spent originally). And lets further assume that Ofwat spends 1.5x as much as the Commission in setting up the framework. This may not seem like much extra but approaching 70% of what the Commission spent was on the legal costs of drafting codes and contracts from a zero base. The market structures work in Scotland and so the incremental legal work should be relatively modest.
As to ongoing costs: I have assumed that Ofwat would incur an additional £2 million costs in managing the framework, an additional cost of capital of £6 million a year and a CMA operating cost increase of £7.5 million a year.
I assume that the companies south of the border can achieve only two-thirds of the savings realised by Business Stream - despite the fact that Business Stream’s costs at separation were lower than the average in England and Wales as a percentage of non-household revenue.
This gives a potential net present value of over £750 million without any dynamic efficiencies and nearly £2.5 billion if dynamic efficiency is included. We have published an audit trail for these numbers, which is available here.