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.
This blog first appeared as a guest blog for Utility Week on 12 March 2013.
At Water UK's recent City Conference there was, understandably, considerable debate about how competition in water might work. In my presentation to the conference, I sought to explain how the policy gap, which, it seems to me, exists between the Government's White Paper and the Draft Bill, could be addressed. The required steps are not complicated or difficult. But they would change the apparent policy intent of the Draft Bill (however strenuously this is denied).
Our interest is, of course, quite parochial - we do not want to see the benefits that have already flowed to customers and the environment in Scotland from retail competition being undermined. Such is our statutory duty.
However, we do believe that the interests of customers and the environment in England are not wholly dissimilar to those of customers in Scotland. We cannot see how de-averaging of non-household tariffs can be in the interests of household customers, or indeed the smaller and/or more rural non-household customers.
Some may argue that the total benefits from new entry (facilitated by "improved price signals", otherwise known as de-averaging) could be greater than the costs. This could be true, but it does not mean that at least some customers won't end up paying more (perhaps a lot more) than they otherwise would have done.
Any allocation of cost is, to some degree, a matter of judgement. But in Scotland there are nine self-standing PFI contracts and they are quite instructive about the potential impact of de-averaging. To give one example: the fully loaded unit costs of the Moray Coast Waste Water PFI are about four times those of the Aberdeen Contract and this is, by no means the extremes of geography that exist in Great Britain.
To have non-household customers pay on this basis would surely not help build the customer legitimacy that the Government seeks and the industry needs if it is to continue to finance its investment cheaply.
To allow de-averaging would, of course, mean that some customers who are lower cost to serve would benefit - but for every £1 of benefit received by one customer, an extra £1 has to be paid by the other customers.
Any potential benefits of new entry to the upstream water and waste-water markets could be substantially reduced if assets could be stranded and the industry's costs of borrowing were to increase. Similarly, the losers from any de-averaging of regional costs would similarly see the effect on their charges exacerbated by an increase in the cost of capital.
So the Government appears intent on pursuing an upstream policy, which relies on market forces to increase innovation and identify new water sources without fully considering the social or economic impacts on communities and individual businesses. But its commitment to market forces does not stretch to the retail area - despite "in the market" competition having been proven to work in Scotland. Does everything really need to be re-invented?
Not allowing a retailer to exit the market will increase the unit costs of those who are less successful and could be expected relatively to increase the cost of capital. This is not to suggest that the Government should mandate separation - the policy should simply be to allow the owners of a water company the option of divesting their retail activity. Such a divestment may well be in the interests of both their current retail customers and their shareholders!
Returning from the City Conference, I began to wonder whether the apparent change in Government policy (from White Paper to Draft Bill) reflects its downstream and upstream impact assessments. These suggest that the net benefits from the upstream reforms are some 10 times greater than the downstream reform. If correct, then a focus on upstream would indeed be reasonable.
But our assessment of the actual cash savings achieved from retail competition in Scotland (without allowing for dynamic efficiency) is almost as high as that suggested for retail competition across the whole of England with dynamic efficiency. And our assessment does not value any of the level of service improvements we have seen. Given that Scotland is a tenth of the size in population terms, this does not seem very realistic.
Applying apparently reasonable assumptions, based on the Scottish experience, would conservatively suggest an NPV around four times greater than that contained in Defra's impact assessment. As such, taking the upstream assessment at face value, the benefits of retail could actually be greater than those of upstream reform under certain scenarios. Given the risks to customers, investors and the environment in pursuing the upstream reform as set out in the Draft Bill, this would suggest that the EFRA Select Committee's caution is well warranted.
It is easy to suggest some sensible changes to the Draft Bill:
- rule out any de-averaging of charges at the wholesale level;
- make it clear the levels of resilience that the industry should achieve and when this should be achieved; and
- require companies to procure new capacity (whether water or waste water) in the most efficient way possible. This could be through water efficiency, recycling water, better storage or by means of bulk transfers between regions.
But these changes would take us back to the universally welcomed White Paper and to a different policy to that implied in the Draft Bill. And that would not be altogether a bad thing!
This blog first appeared as a guest blog for Utility Week on 28 January 2013
It is now more than a year since the Water White Paper was published. It is more than six months since we saw Defra's draft Water Bill. In that time there has been a lot of talk about what needs to be done, how it should be done, and when customers in England might be able to choose supplier.
Some commentators have recently started to speculate that there will be a delay in introducing the Bill to Parliament and that this would inevitably delay market opening beyond April 2017. It need not! What will be required, however, is a proper focus on implementing a retail market - doing not talking.
Our experience in Scotland was that passing the relevant legislation was not a particular pinch point on the road to implementing a retail market. For us, the first step was to have a clear and agreed vision of what the retail market should look like. So, which activities are retail? Who talks to whom? How does the money flow? How much profit is at stake? Who assumes working capital and bad debt risks?
Until a regulated company has a clear understanding of these things it is unlikely to be willing, or indeed able, to take any real steps in preparing for market opening. To do so could result in a series of false starts and much higher implementation costs.
Once consensus has been reached about what the retail market should look like, the next step is to finalise (at the price review) the wholesale and retail revenues that will be available to the current incumbents. The retail revenue would, no doubt, reflect an assumption that a company has 100% of its current customer base.
At the same time as this is going on, consideration also needs to be given to the development of appropriate market rules and procedures (or 'codes') that are critical to market opening. Only once these codes are in place can the benefits that flow from setting separate wholesale and retail charge caps be realised. (Incidentally these codes can be statutory or non-statutory - in Scotland we chose the latter.)
The initial focus should be on the two codes covering the key areas of operations and governance. The Operations Code should set out how the new retail function (and its competitors) will interact with the wholesale business (in essence how the two bits will be glued back together). The Governance Code sets out how a new entrant or customer can be sure that the incumbent retailer is not able to benefit at his expense.
The outcome of the price review will allow a company to begin work in earnest on how it plans to convert wholesale revenue into wholesale tariffs. This is not easy! Indeed it shouldn't be underestimated just how difficult this is likely to be - requiring the correct allocation of bad debt, working capital and indirect costs (such as the customer-facing costs of incidents) to different classes of customer. If a company gets these sums wrong it could make some of its customers unduly attractive to its competitors. This could result in the loss of profitable customers, the retention of unprofitable ones and losses in the retail business. Clearly this is not an attractive outcome (especially as companies are not able to exit the retail space).
A third code, the Market Code, will also then need to be put in place. It has three broad functions: to define the procedures for registering customers to a supplier, to calculate how much market participants owe to the wholesaler, and to set out the rules for the overall governance of the market (as well as how these can be changed). The first two of these functions are carried out by the CMA in Scotland. Their systems cannot be finalised until the wholesale tariff structure has been designed.
So is legal change a major constraint? Almost certainly not! Most, if not all, of what needs doing this side of the price review could be done (and have real value) as a regulatory initiative.
As to what might be required in actual legislation, key is losing the cost principle and ensuring that multi-lateral arrangements are possible. But the constraint is simply that these elements are commenced in the year or so before market opening. Indeed that is what happened in Scotland!