In Scotland, the Commission has a duty to facilitate entry to the retail market but, in so doing, to do no detriment to the core (wholesale) business of Scottish Water. As the debate around market opening in England continues, I have frequently been asked what we mean by "no detriment". At first, I thought this was a trick question!

But the answer is actually quite simple in principle, if more difficult to implement effectively.

The rationale of having retail suppliers compete for business is essentially two-fold: to encourage suppliers to offer non-household customers the best price for appropriately tailored services and to have these retailers, who are closely focused on the needs of their customers, challenge Scottish Water to improve its performance in both levels of service and costs. This avoids the potential conflict of interest that can arise when the same management team make decisions about the levels of service provided to customers – particularly when what is best for customers may not immediately, and obviously, be good for the supplier.

But to ensure that the wholesaler acts objectively, it is important that they can count on there being no detriment to their underlying performance from the actions of the retailer. In an industry where there needs to be a long-term commitment to the financing and operation of assets, it is essential that additional risks associated with asset capacity utilisation are not created. The presence of an asset in the RCV of a company is not sufficient because this does not address changes in unit operating costs.

Our approach is to build on our closer dialogue with Scottish Water and discuss the impact of changes to wholesale services that arise from the changing profile of demand for services experienced from retailers. For example, a retailer may profitably sell water saving advice to a customer and this could have quite different effects on the wholesaler. If supplies in an area are limited there could be real benefits to the wholesaler and its costs could even be reduced! On the other hand, there could be plenty of water supply in a particular area and the only cost savings for the wholesaler could be the variable operating costs such as chemicals and energy. In this case, we would expect that there would only be a modest reduction in the revenue allowed to the wholesaler.

Our aim in making this commitment to do no detriment to the wholesale business is to encourage dialogue between the retailers (who will thrive only if they meet the needs of customers) and Scottish Water. This should ensure that, over time, services become increasingly aligned with what customers are prepared to pay for.

Establishing this dialogue between retailers and Scottish Water could also have a secondary benefit. It may make it easier to pursue innovation within the sector. Innovation to be sustainable needs to benefit all parties: wholesaler, retailer and customer. In my view, innovation is likely to be essential to delivering the improved services that customers will increasingly expect at a price that they are willing and able to pay.

I believe firmly that competitive forces lead to lower costs, better levels of service and increased innovation. Separating non-household retail and wholesale activities has benefitted all water customers in Scotland. But the question remains: How do we ensure that upstream activities become as innovative and focused on improving value for money?

The status quo is not an option. So the choice is clear – either we seek to introduce a competition framework for upstream activities or the regulatory framework needs to be adapted to encourage innovation and the pursuit of as many NPV-positive projects as possible.

Competition could be introduced by allowing participation in the market in direct competition with current incumbents or by letting periodic contracts for service delivery (for the whole of an appointed area or a subset of it). Such contracts are the norm in many parts of the world. I am not clear though that there is any evidence that such ‘for the market’ competition has led to better outcomes either in efficiency or in innovation from what exists already. And tendering for these contracts can be very expensive – with customers ultimately footing the bill!

Potentially, competition ‘in the market’ looks more attractive. New entrants would have to be lower cost and offer greater reliability and improved service in order to carve out a successful and sustainable niche. But when I look at the detail of how this might be implemented, I begin to have some real doubts:

• It is not immediately clear that there are naturally defined activities in upstream service delivery. For example, storage of treated water could be, in different circumstances, an abstraction or a network or a treatment activity.
• Assets tend to have extended asset lives. As such, it is marginal revenues and costs that are important for the incumbent (at least in the short to medium run), whereas average costs are immediately important for the new entrant.
• Any involvement in upstream activities has to be negotiated with the current service provider – even new connections on a greenfield site are the incumbents to refuse!

In different ways each of these factors could complicate the development of a robust framework for competition and may lead to increased costs – at least in the short to medium run.

There may be a better way of encouraging the innovation that would ultimately lead to lower prices and better levels of service to customers. There are five evolutionary changes we could make:

1. Allow Scottish Water to retain the benefits of pursuing lower cost or better levels of service for a sufficiently long period that the company has achieved payback at a reasonable investment hurdle rate.
2. Provide a framework for returns earned by Scottish Water, including the sharing of higher returns with customers.
3. Allow for a higher return to be earned on innovative approaches – provided the ultimate cost is lower to customers. These returns should be available for the duration of the proposed project.
4. Ensure that customers, their retailers, third parties and the incumbent can benefit from innovative approaches.
5. Involve customers in decision making. Customers will have a view on how services should or could be improved – including, for example, the trade-offs between lower carbon, less certain, lower price and higher return options and more conservative, traditional approaches.

These five changes are at the root of our changes to the regulatory framework in Scotland. So I am much encouraged by Scottish Water’s intention to increase further its dialogue with retailers about the opportunities that may exist to improve value for money to customers.