My last blog post concluded by asking whether or not customers have too wide a choice of retailers of water and waste water services. My view is that they will want real choice. This means tailored services, pro-actively offered, that really make non-household customer’s lives easier, especially when there is a growing expectation that suppliers will adopt a ‘green’ approach to service delivery wherever possible.

If the majority of retailers focus on limiting the damage to their bottom line, then by definition only a few may offer the sort of attentive service that really benefits customers (and the environment). There may be less pressure on those that have gained from scale economies (and perhaps added some scope economies by extending the range of products they offer) to continue to be as responsive to customers. They will want to be sure that they do not offer a way back in for their competitors by being much more expensive – even if for more and better services. I am not therefore convinced that they will pursue innovation as resolutely as they might have done were the relative winners and losers amongst retailers still to be decided.

The result is lower bills to customers. But are these bills sustainable in the medium term? And will customers really get the enhanced levels of service which, experience in Scotland suggests, is what they seem to want? It all feels as though we are in danger of getting a mite too close to the price, rather than service, dominated energy markets. For me, at least, this is nowhere close to the best outcome!

I have now read the draft Water Bill that Defra published last week. It is complex – even if I exclude the provisions relating to reform of the upstream supply of water or collection and treatment of sewage. There is no intrinsic problem with legal complexity providing the operation of the market is straightforward. Customers, retailers and wholesalers must understand the rules of the game and be able to develop strategies for participating in a market that meet their needs.
 
I understand why the companies argued against legal separation mandated by Government. I can also understand that some companies may opt not to separate their retail and wholesale activities even if there is a penalty in the form of a more restrictive Governance Code.
 
However, I cannot understand why any incumbent water company can be so certain of its success in the new market arrangements that it would want to cede the option to divest its retail activities. This is an option that is not time limited – even retailers who are successful in the early years of the market may decide that there is more value to their owners in divesting their retail activities than there would be in continuing to participate in the market. Options with unlimited time value are not to be given up lightly!
 
We should assume that the gross retail margin is sufficient at the opening of the market to run a business that earns a reasonable return in the capital it employs. (We would define gross retail margin as the retail revenue that may be charged to customers for the traditional water and sewerage service less the wholesale cost that will have to be passed on to the wholesaler.) However, each retail business will immediately face competition from both new entrants (including Business Stream, Scottish Water's retail subsidiary) and the retail arms of other incumbent businesses. 
 
If multi-site customers (including the public sector) do substantially opt to consolidate their supply relationships, most incumbent companies could find that they have lost, say, 30% of their retail revenue within the first year or so. Although they will face lower wholesale costs, they may find it difficult to reduce their retail costs (operating, capital and financial) by as much as the revenue they have lost. In a best case scenario they may be able to maintain their retail unit costs of serving customers but the retailers who won the extra business will achieve economies of scale and their retail unit costs are likely to be much lower.
 
Round two of the game is that the retailer that has been unsuccessful will have to work increasingly hard to defend its remaining customers from its newly turbo-charged competitors.  This is likely to mean reducing prices (either accepting a lower return on capital employed or finding ways further to reduce retail unit costs). 
 
I would not want to argue that this process is an inexorable slippery slope towards a market where some incumbents resort to contribution pricing. (This would fly in the face of our experience in Scotland where competition has been more about tailored services and innovation in the relationship with the customers than it has been about price per se.) There will inevitably be opportunities for retailers to differentiate their service offering and capture new or retain existing value. But this will have to be achieved against a background of new found financial pressures.
 
It is not at all clear to me why we would think that we need 22 water retailers and 11 sewerage retailers  (always assuming – somewhat heroically – that there is no new entry) when businesses enjoy far less choice of airline, communications provider, energy services provider etc. It would seem reasonable to conclude that market returns will be rather lower than any market participant would accept, given the choice.
 
So three questions:
 
•    How many new entrants will be longer term players in the market, given that they alone can exit?
•    What price that time unlimited option to exit the market that companies seem to have given up? and
•    Would such a situation really be in the interests of customers in the longer run?

Looking forward to how we explain the changes in the industry that will result from the Government's Water White Paper, it seems to me that we have to seek out the common interest. The interest of investors (whether public or private) are wholly aligned, except perhaps in the very short term, with the interests of customers.

Both customers and investors will want reassurance that when wholesale and retail prices are set, both the wholesale and retail arms of the previously single vertically integrated companies will be capable of standing alone and independently of each other. To do otherwise would make new entry difficult or impossible to the retail market or it would make investing in the wholesale business unattractive. This would, of course, be in none of our interests.

So as we set out to create an Anglo-Scottish market, we should learn from experience in Scotland. Whether it was luck or good judgement, we ensured that Business Stream and Scottish Water were financially sustainable businesses. We did this by thinking hard not just about activities and their direct and indirect costs but also the financial flows between the two arms of the business. These financial flows are very important. So too are asset allocations, depreciation and a consideration of the return that a retail business should be allowed to earn at market opening.

These are issues that the industry needs to work through as a matter of some urgency!