This blog first appeared as a guest blog for Utility Week on 13 May 2013.
The speculation can finally end - the Queen's Speech confirms that there will be a Water Bill. But wait! Am I being too hasty? As always, the devil is in the detail: will the Water Bill facilitate competition or will it reinforce opportunities for cherry-picking?
From a Scottish perspective, my worry is about unintended consequences in England spilling over and changing the nature of our market. Our mantra when we implemented a competitive retail framework in Scotland was to "think big, but act small". It seems to me that, given the potential additional complexity of dealing with multiple vertically integrated companies, such an approach may also be appropriate in England.
If we are to maximize benefits to all customers on both sides of the border (in line with the policy direction set in the Water White Paper), there are four changes that we would like to see in an amended Water Bill. These suggestions are consistent with the EFRA Select Committee's detailed critique of the draft Water Bill.
1. Rule out de-averaging
We are concerned that de-averaging could materially disadvantage businesses (and, potentially, households) that are located in more rural areas. It also seems likely that it would disadvantage smaller businesses. We are sceptical too that the suggested benefits (ie that improved location signals will be offered to intensive water-using businesses) could outweigh these disadvantages. In our view, the costs of raw water are unlikely ever to be a major element of total water supply costs - especially given the capital intensity of water supply and waste water collection assets.
We have asked Oxera to carry out a detailed analysis of the potential impact of de-averaging in Scotland, and Scottish Water has agreed to make all of the necessary data available. We are hoping that Oxera's work will be reviewed, as it progresses, by a steering group that will comment on both the approach and conclusions. We will publish the results of this work and the method used on our website.
Although we are opposed to de-averaging, we do believe that it is important that Scottish Water understands its local costs of supply. This information would be helpful when considering the procurement of incremental capacity. It would also help Scottish Water to develop a clearer understanding of the circumstances in which it is beneficial to adopt innovative approaches where these are put forward by customers and suppliers. Which brings me to the next point...
2. Rule in incentives for innovation
Innovation could sensibly be encouraged by allowing customers to benefit from discounts if they have taken some action that reduces the water company's overall costs (the Section 29E procedure in Scotland). It also requires an acceptance by the regulator that the traditional regulatory framework has limited the scope for innovation and that, at least in theory, an innovation could merit (and be rewarded with) a higher return and still end up being beneficial overall for customers.
In Scotland, we are seeking to make such opportunities attractive both to Scottish Water and to its partners.
3. Rule in a level playing field
In Scotland, the 2005 Act redefined Scottish Water's non-household retail activities as 'non-core' and, therefore, not subject to regulation. Scottish Water had to separate these activities although the choice of a legal subsidiary was one of many options it could have chosen. Legal separation certainly made it easier for the Commission to ensure that there was a level playing field, although neither incumbent nor new entrant were probably happy with the decisions taken.
Ensuring that there are clear and effective governance rules will be even more important as there is no sign that the Government will allow water businesses voluntarily to separate their retail businesses.
While these measures are essential if we are to facilitate entry by new market participants (on the assumption that Government does not decide to allow for voluntary legal separation), they are, in my view, likely to require quite invasive governance codes. The codes would need to cover, inter alia, the handling of money, communication between the wholesale and retail functions (IT, human resources, data sharing etc) and the provision and cost of central (ie group) services.
Ironically, such robust governance arrangements (and their policing) are likely to add costs and could make the market opportunities less attractive both to new entrants and to end customers. It will also make it more difficult to gain market share (acquisition of customers would be problematical) and limit losses in the event that a vertically integrated retailer proved to be less effective than its rivals.
Clearly, the best option would be to allow for voluntary separation. Although problematical, the next best solution would be to put robust governance rules in place. If neither is done, the new market arrangements are unlikely to bring the desired benefits.
4. Rule in favour of a 'for the market' approach to upstream reform as opposed to an 'in the market' approach
Issues such as the minimum levels of resilience that should be maintained by water companies are, quite clearly, political decisions. It is then for the regulator, working with the regulated company, to establish the most cost-effective way of delivering these policy objectives.
In our view, the most effective way of delivering such incremental capacity to the water and waste water system is to place an efficient procurement obligation on the local monopoly company.
It is also desirable to ensure that the regulatory regime has no inherent features that might mitigate against the selection of the most effective and efficient outcome (either in the way capital expenditure and operating costs are treated or in the handling of appropriate returns). Such an approach should ensure that new entry is possible and that the most efficient solution - irrespective of who provides it - is delivered. This approach would benefit both customers and our environment.
These suggestions effectively strengthen the policy direction from Government, move the industry away from a common carriage model, focus competition on retail services and ensure that new capacity is procured as efficiently as possible. They would also make it much easier for the small player to make water resources or other skills available to the industry without having to go head to head with the incumbent monopoly.
A Bill that delivers these opportunities would be a major step forward for the industry, for customers and for our environment. It would also be consistent with the policy direction set out in the Government's White Paper. Intriguingly, it requires only relatively modest changes from the draft Bill that was critiqued earlier this year by the EFRA Select Committee.
Anyone for reform?
This blog first appeared as a guest blog for Utility Week on 28 March 2013.
Some commentators have suggested that retail competition for water and sewerage services only works if there is competition upstream too. Ofwat's methodology consultation remains focused on preparing for upstream competition. Deloitte has also suggested that upstream reform may be crucial to justifying the introduction of competition. But we should be careful what we wish for.
We know that the net benefit from retail reform in Scotland was £138 million. According to Defra's retail impact assessment, the potential benefits from retail reform in England would be just £190 million. This seems remarkably low given the relative size of both industries, the scope for cost savings that are available in England, and the fact that whereas our assessment does not include 'dynamic' efficiency (or what I like to call 'yet to be understood' efficiency), Defra's assessment does.
While we should realise the savings that could be brought about by retail competition, it is at least as important that we understand how, given the right incentives, retailers could be very effective in encouraging more efficient use of water. In Scotland, we have not sought to value this potential contribution to a much more sustainable environment.
It all depends on the type of retailer we want and the market arrangements we put in place.
Under proposals in the draft Water Bill, retailers would be able to source water as well as to sell it. Sounds good in principle. But in practice, even if the retailer has a source that is immediately available their costs would almost certainly be higher than those of the wholesaler - not least because of a higher cost of capital and the likely need for some upfront investment to get their water to a convenient treatment works.
It is not clear to me how these additional costs could be justified, when a wholesale business already has incentives to identify the cheapest overall solutions available. Instead, why not have the wholesaler build the pipe and add it to its RCV and purchase the 'new' water? Why pursue ever more complex incentive and governance structures for this industry?
Rather, we should be aiming for a clear division of responsibilities between the wholesaler and the retailer such that it is in the interests of both to collaborate to improve services to customers.
In Scotland retailers are required to buy water and sewerage services from the wholesaler, Scottish Water, at published wholesale charges. As a result, they focus their efforts on serving customers as well as possible by:
- offering more convenient and accurate billing and payment alternatives;
- providing advice on how to minimise costs and reduce the business's environmental footprint; and
- helping to manage the use and discharge of waste water from the customer's site.
Retailers are, in effect, the agents of their customers. As might be expected, they maintain a steady pressure on Scottish Water to improve its efficiency. This pressure has been increased further by the creation of an independent body, the Customer Forum, which negotiates outcomes with Scottish Water on behalf of customers as part of the price setting process.
The market arrangements ensure that the wholesaler focuses on what it is good at: sourcing water, managing and operating the assets, and devising low cost solutions to deliver environmental and water quality improvements.
We are taking things a stage further in Scotland now by working with Scottish Water to make sure it can demonstrate that it is procuring any additional resources it needs in the most cost-effective way. This requires Scottish Water to work constructively with third party suppliers who might meet either part or the whole of Scottish Water's need for incremental capacity. And, of course, given the clear focus of the retailers, there is likely to be less need for additional capacity for each customer than was previously the case!
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!