This blog first appeared as a guest blog for Utility Week on 16 April 2013.

Competition has become a very emotional issue for the water industry. But what exactly is it we are arguing about?

Competition is already used by, and brings benefits to, the industry. This includes market testing the substantial capital programme, and using competition to secure the best prices from the energy markets. Water companies also compete for skills in the labour market.

Yet there was a time - not so long ago - when the companies in England and Wales resisted retail competition for non-household customers. Was this because there was insufficient evidence that the retail function could be separate from the wholesale activities?

Well no - there was already strong evidence that the retail function could be managed separately. In Wales, Glas Cymru let a separate contract for customer service to Thames Water while operations went to United Utilities. And in England, Wessex and Bristol Water were pioneers in establishing their separate joint billing company.

Scotland merely built on this experience and went a step further: not competition 'for the market' but allowing different licensed companies to compete in offering water services to non-household customers.
Was there a fear about asset stranding? Perhaps, but, as has now become clear, if retail competition is implemented sensibly there is no risk of this happening.

So turning now to potential concerns about upstream competition. Perhaps there could be none! It depends...

In a world where there is 'in the market' competition it is right to be concerned; in such a world there is a real potential issue that assets might be stranded, and a real risk that the regionally averaged prices that benefit both households and non-households could be sacrificed.

By contrast, when fixed costs are high (and represent a substantial proportion of total costs) competition 'for the market' is likely to be an efficient way to procure the services or products that are required. Just as the industry already does when it needs a new water treatment works! If it were better to have had two water treatment works competing with each other, would those who held the purse strings not have pursued, or at least trialled, such an option?

But, in looking forward, there is no reason why water companies should seek to deliver all of the solutions to all of their problems by themselves (in the same way that they no longer deliver all of their own capital expenditure).

So what is the best way forward? Is it to have companies competing with each other to develop resources or treatment assets and increase the risk that assets could be stranded? Or is it to recognise that there are substantial upfront costs and that best value is likely to be had when there is genuine competition to supply the available market. This should allow the innovative and efficient to thrive and for the benefits to be available to customers and the environment.

This is, of course, easier to say than to implement. The current companies would need to be rewarded for managing the procurement process. New entrants upstream would have to contract with the local network operator (this would prevent them from taking advantage of regional cost differentials) but would benefit from the efficient procurement obligation placed on that network operator. The playing field would not just be level - it would be seen to be level.

This is a vision worth pursuing. It would reduce the risk of financing the regional water and sewerage company. It would increase the opportunity for innovative solutions and for best use to be made of all of our available resources. In short, it would lead to an industry that is both more resilient in what it does and more legitimate in what it charges its customers.

I attended the Water UK infrastructure conference this week. As usual the event was well organised and well supported.

There was a lot of talk about how badly the industry procures and delivers capital projects. But before we go criticising others, it seems to me that we, as economic regulator, should think hard about what we can do to facilitate effective asset management. In my view there are five steps that we could take that may help:

• Set prices with a real eye to the very long term.
• Set prices that take account of the annualised resources that are likely to be required to deliver this longer term plan.
• Focus on outcomes and costs for delivery of outcomes rather than an overly prescriptive list of capital projects (thereby encouraging greater innovation and creativity).
• Recognise that optimal capital planning and paybacks do not fit neatly into five-year regulatory price setting cycles and give a regulatory commitment for longer than five years when this could improve the efficiency and effectiveness of asset management.
• Allow flexibility in timing of outcome delivery where this is agreed with customers and regulators.

A longer term approach to asset management is likely to become increasingly important over the coming years. Replacing assets on a like-for-like basis will, almost certainly, become prohibitively expensive. We will need to find more innovative and/or more strategic solutions. Understanding the extent of this capital maintenance challenge will tell us a lot about the improvements in service levels that customers may be able to afford in the future. 

Historically, our approach has been to set prices based on an (overly) defined investment programme to which we have applied challenges both with regard to scope and efficiency. It seems to me that this approach has likely encouraged risk aversion on the part of Scottish Water. Our approach has reinforced the consideration of capital expenditure in a silo when, arguably, alternative approaches were becoming more desirable as we look to reduce carbon footprints, for example.

An alternative would be to adopt a simpler price cap approach, recognising the need for investors to earn a fair return irrespective of how the required outcomes are achieved. Under this model, it would be for Scottish Water to justify to its customers (who could, if they wanted, seek the views of both the regulator and the industry assessor) the outcomes that it would deliver within the resources available. Such an approach would likely also require Scottish Water to be empowered to negotiate with both SEPA and the DWQR about what outcomes they wanted and in what timeframe.

Scottish Water's hand would be strengthened both by the involvement of customers but more particularly by the longer term visibility on resources that is central to this approach. This still allows the space for Ministers to set high-level objectives which set the context for the outcomes to be achieved.

There has been a lot of debate about the length of regulatory control periods. Should they be five years, or perhaps 10 years as originally intended? Ofgem recently opted for eight years but allowed the possibility of a reopening after four years. The pessimists focused on the latter rather than the former!

But are we asking the right question? It is clearly good to give a degree of certainty to a regulated business about the level of resources to which it will have access. This is essential to the effective operational and financial management of the business. But such defined periods are unlikely, it seems to me, to fit neatly with an optimally planned programme of service enhancements.

Would it not be better to have a defined level of resources that takes account of the operating environment that we expect over the next 25 or so years? This would allow the regulated company to plan larger capital interventions as effectively as possible within this framework and allow other initiatives to be phased appropriately, taking full account of the views of customers and other stakeholders, as and when resources are available?

My final thought is that, as regulators, we may have regarded all changes to the sequencing of capital expenditure to be a ‘bad’ thing, worthy of criticism. Clearly, there will have been cases when criticism was probably warranted but there will be others where unexpected bottlenecks may have appeared and some re-jigging was appropriate to deliver the overall programme as timeously and efficiently as possible.

There may be other circumstances where the priorities of customers or the environmental regulators may change and an alteration to the capital programme is appropriate. On reflection, and subject to proper evidencing to the Commission and the Customer Forum, it would seem entirely reasonable that Scottish Water should phase its service improvement expenditure in whichever way it calculates most likely to be best for customers.

If we were to adopt this approach, it would seem to me that capital procurement prices should fall, ceteris paribus, and there should be less need to ‘pad out’ a capital programme (whether by Scottish Water or a quality regulator) and consequently less need for the regulator to feel instinctively that the programme needs cutting back........

My previous blog about the United Utilities’ sponsored ICS Consulting report on vertical integration was quite negative about its approach to the question of separating retail and wholesale activities.
However, this report does make a number of good points: the importance of coordination (and thinking through system impacts of actions); the importance of time; and the impact of asset specificity.
In Scotland we have experience of the potential difficulty of managing wholesale fragmentation. This comes from the fact that some half of Scottish Water’s waste water treatment and 80% of its sludge treatment is done by PPP contractors. Odour problems at Seafield, performance issues at Dalmuir and the impact on asset strategy planning for the future are all real issues for which Scottish Water is responsible and for which their ability to ensure effective delivery is limited.
It could be argued that this results from the long-term nature of the contracts and the poor (an ex post judgement) specification of service levels and change protocols. But this ignores the fact that the water industry is as long a term business as there is. Traditionally, the expectation has been that assets will be replaced when they reach the end of their natural lives. Once built, there is always the concern that assets could be wholly or partially stranded – that is why such store has been placed on the RCV. Long-term contracts, such as the PPPs, were the alternative.
Looking forward, it is possible that assets may be required for shorter periods or revenue solutions may work for a temporary period. The industry will have to adjust to this. Some of the answer may lie in smarter regulation – moving to total expenditure regulation rather than separate treatment of operating and capital expenditure. Some may lie in encouraging trading between companies and more innovation. And encouraging innovation will require all of us to be more understanding if or when problems with innovative solutions arise.
But the key point is that there needs to be active consideration not just of the effects across the whole wholesale business, but also attention has to be paid to the marginal risk and payback of new approaches. Adding to the RCV may have been fine in the past – but it is unlikely to have the desired effect going forward. Unless, of course, we want to see future customers continue to pay for benefits that are no longer being received.
It is also important to think about the impact of assets already built and operating. It is not easy to change these and once built there is a significant cost in adapting or operating them at lower capacity than was planned. Such assets could also impact directly on other sectors that need access to raw water – but for whom the marginal cost of foregoing water may be lower in the short run even if potentially higher in the longer run.
These are complex issues. Clarity from Government and strategic and long-term planning of water and waste water assets by wholesale water businesses will both be vital.