LPF

In April 2017 non-household customers of the water industry in England will be able to choose their supplier for the first time. It will be important that the opening of the non-household retail market enhances the customer experience. Customers will rightly expect that the levels of service that they experience will be at least as good as they were previously.

In considering the new market framework attention does have to be paid to how we can ensure customers see the benefits that they expect. The Open Water programme has made excellent progress, working collaboratively with new entrants to and incumbents in the water industry, in defining the codes, processes and procedures that will underpin the new market arrangements. One of the principal areas of focus in developing the codes, processes and procedures was the importance of establishing a level playing field for new entrants. The draft codes have gone a substantial way to ensuring that this happens.

The procurement of the central systems required to administer the registration of customers to suppliers and settlement of transactions between retailers and wholesalers is also now well advanced.

MAP 3 Included two important appendices: a draft assurance framework and a summary of the issues that market participants may want to consider. Experience from Scotland suggests companies should be supported as they prepare themselves for the new market framework. In Scotland, we supported both wholesale and retail arms of Scottish Water as they prepared for the new market arrangements. This support was both time consuming and resource intensive but was crucial in ensuring that the market worked well for customers.

New entrants will rightly expect that they are treated appropriately by the incumbent businesses. The codes, processes and procedures only take us so far. The devil is in the detail with issues such as the level playing field. For example, how does an incumbent retailer communicate with its wholesale arm? It would not be fair for the retailer to have access to internal telephone numbers or a common email. Similarly, should it be able to capitalize on its knowledge of who is good at solving a particular type of matter arising?

Then there are a series of information issues. Has all information been shared? Is the administrative burden reasonable? The new entrant may perceive that he is being treated unfairly or has less access to information. And this may be the case – how could it be suggested that an incumbent’s prior knowledge of customers' payment histories or complaints should be forgotten. While a substantial amount of this information could be documented and shared, it could never be exempt from challenge. Memories are, after all, fallible!

As for the management of existing staff, how are issues of spouses, family, relatives and friends working on different sides of the 'Chinese wall' to be managed. Training can be important but can training be 100% effective in redirecting a long-standing commitment from solving a customer's problem as quickly as possible to a new set of systems and processes? Is there advantage to sharing of HR, legal, accounting, VAT management between wholesale and retail? Is any such advantage proportionate?

 

And finally, what about the conclusion of a contract? How long does it take to sign an agreement? Is this time reasonable?

In short, there is a whole raft of soft organizational issues that market participants will have to address if a level playing field is to be ensured.

Such questions are some of the most challenging that the incumbent companies will have to address. It relates to the actual experience of a new entrant trying to participate in the market. It relates to the behavior and relationships between former colleagues – not to the day to day operational; and financial issues that arise from documenting how retail interacts with wholesale.

So what are the consequences if these issues were not to be addressed? The likelihood is that entry to the new retail market is discouraged and less benefits would accrue to customers. In some cases, these non-price discriminatory issues will be so serious that a new entrant will seek to refer them to the competition authority. In many, perhaps most, cases, the costs in time, resources and loss of focus will result in the new entrant's effectiveness simply being blunted.

There is an alternative approach. Whether an incumbent company chooses to use the 'exit' regulations or stays fully vertically integrated, it would be possible to require the wholesale and retail activities of each incumbent to set out all their commercial and other relationships and how they would seek to manage the informational and behavioral issues set out earlier. These ‘governance’ statements would be specific to the circumstances of individual water companies and could be more or less onerous depending on how the company chose to structure its operations. A breach of a clear and detailed 'governance' statement would be easy to identify and would be likely to be much easier to resolve than a potential issue of non-price discrimination and the ensuing competition law process.

Importantly, perhaps, the introduction of 'governance' statements could also be a real benefit to the wholesale businesses as, appropriately policed through the use of compliance officers, they could substantially reduce the risk that an incumbent falls foul of competition law and the draconian penalties that could result. Moreover, an incumbent need not wait for the regulator to take the initiative - a well-prepared business may want to set an example to its peers!

Customers must come first

This article first appeared in Utility Week, 7 February edition.

So Ofwat has made its announcement on the cost of capital, imposing a reduction of 125 basis points. I find it interesting quite how much focus is placed by companies and investors on this number, especially considering that customers will be, on average, just £25 better off as a result.

Water company returns should not depend on creative financial engineering and a game of chicken with the regulator. But there is a more fundamental point: how could it ever be right for company financial structures to get in the way of implementing initiatives that would benefit customers?

Regulators are not opposed to companies earning higher returns if customers also benefit. Investors and customers could benefit if companies were to be more innovative and deliver outcomes in the most effective and efficient way. In a world where lower carbon emissions are a priority and flooding is rarely out of the news, it is unlikely we have come close to identifying the full range of innovative solutions. To do so will require the industry to work closely with other stakeholders and to explain the benefits of untested solutions to the environmental regulators.

Let’s suppose a sustainable drainage and water reuse solution could build resilience into the water supply and sewerage system for, say, a fifth of the capital and operating costs of a traditional civil engineering solution (on a net present value (NPV) basis). In such circumstances, a water company could reasonably expect to earn a higher return on an ongoing basis to reflect the higher outcome delivery risks (it may still have to find an alternative solution if its initial approach does not keep delivering the required outcomes). It should also receive a higher return, for an agreed period, as a reward for its innovation. Even if, as a result, the actual costs of the same scheme were to double (in NPV terms, including these potentially much higher investor returns), the customer is paying only half as much for the required environmental outcomes to be delivered.

There is similarly great potential within the retail market for a genuinely innovative company to earn higher returns. The evidence from Scotland is clear: customers value being helped to reduce their impact on the environment. Reducing water consumption lowers operating and capital costs, and means future customers can be connected more cheaply. In the long run, this increases wholesale returns and offers the possibility for a retailer quickly to begin to earn a revenue stream from services. Sceptical? Take a look at the annual report of Business Stream, Scottish Water’s retail subsidiary!
Not all retailers will be successful in the competitive market. Those who consider themselves the best at customer service today may have to redouble their efforts to be among the most successful retailers. The rewards are high, but failure could put pressure on shareholders’ dividends.
I estimate that some 40 per cent of customers (the public sector and companies that operate large estates such as national chains, banks and hotels) could seek to consolidate their suppliers. Oxera estimates that such consolidation could reduce industry profits by about £50 million a year.

So I can’t understand why water companies have not argued more forcefully for the right to exit the retail market. No matter how good a company is at serving its customers, an option to exit the market is valuable. Why rely on arguing that my retail business (which is losing customers and has an increasing unit cost) is actually efficient and should be funded? It is not surprising that leading investment houses, such as JP Morgan and Macquarie, have voiced their support for exit.
Another risk that has attracted little attention is common carriage and de-averaged charges. The Water Bill allows for a direct link between the retailer and an upstream provider of resources; this may result in non-household customers paying different prices for the same service within the same appointed area. Some customers will benefit from such de-averaging, but benefits to some come at a cost to everyone else. It is hard to see how household customers would not feel the effects and smaller businesses in rural areas would certainly be adversely affected.

The government has said it does not want to see de-averaging of tariffs and plans to issue statutory charging guidance. But this appears to overlook the Competition Appeal Tribunal’s Albion Water decision in 2006. This identified that European law could apply in a case where the customer or supplier could be deemed to have an impact on European trade. As such, UK government statutory guidance may not protect us from this postcode lottery.
Common carriage also creates incentives that direct the retailer’s focus away from helping customers to reduce their water use and, more generally, from building industry resilience. If a new entrant retailer can access a new source of water more cheaply than the incumbent, its focus will be on the price it is able to offer the customer. There is no incentive to innovate or improve service.
It would be a missed opportunity not to amend the Bill to break the link between an upstream provider of resources and the retailer. There is clear scope for services businesses to develop in both the retail, customer-facing activities and in delivering desirable environmental outcomes in wholesale activities.

Creating a focused retail services market, one that forces retailers to differentiate themselves by the quality of their service to customers rather than price, could contribute to reducing abstraction and harmful discharges and to building a more resilient and environmentally secure water industry. Encouraging a similar services culture in the delivery of upstream outcomes could, in my view, be expected to improve customer value for money, enhance investor returns and increase resilience. Perhaps in future we should focus on eco-services, rather than financial engineering?

Alan Sutherland, chief executive, Wics

A checklist for water reform

This article first appeared in Utility Week, 29 November edition.

By the time you read this, we may finally have had the second reading of the UK government’s Water Bill. Politicians of all parties are now looking critically at the water sector. There may be attempts to make social tariffs compulsory, extend metering, bring forward abstraction reform and amend the government’s proposals for competition. There may even be suggestions that the industry is hit by a windfall tax or is made to pay more tax.

It is important that we look beyond these immediate political debates and take decisions that will benefit customers and the environment in the long term.

If we take, for example, the call for a windfall tax; customers would, in the end, pay more because the cost of finance would increase. A similar fate would befall customers if companies have to pay more tax because rules are introduced to limit interest tax  relief or limit the capital allowances on investment in improving services. And what about the poor taxpayer if we put off potential
investors in the UK’s infrastructure?

We must rebuild trust in our industry. Jonson Cox has started the ball rolling, demanding greater clarity in company corporate structures and governance. Equally important is Jonson’s expectation that any excess profits should be shared with customers.

A second example is the debate about social tariffs. We should recognise that metering households substantially unwinds significant social cross-subsidies. It can only become progressively more difficult to reintroduce them in the form of social tariffs.

This is not to downplay the role metering can play in managing demand. Meters should be introduced when the benefits (including environmental and resilience gains) exceed the costs (including any social impact). Perhaps we should consider whether metering could be combined with maintaining social cross-subsidies?

Government seems intent on delegating responsibility for social tariffs to individual companies. As a result the assistance available may depend less on how affordable the bill is and more on where the customer lives.

How will this work where different companies supply water and sewerage services? As a minimum, government should set out clear criteria, to apply nationally, about who should be eligible for social tariffs.

Another example where the longer term interest must trump short-term expediency is the decision not to allow exit from the retail non-household market. This appears a marked contrast to the Office of Fair Trading’s report Orderly Exit published in December
last year, which says trying to avoid or prevent exit from a market only increases the likelihood of future disorderly exit. Is this a path we knowingly wish to tread?

Disallowing exit may have reassured investors in the short run, but I wonder how many understand that most companies will see profits fall by up to 5 per cent. Pursuing this option can only increase the cost of capital for some companies in the longer run – to the detriment of all.

There is a way forward here. A relatively straightforward amendment to the Bill could allow controlled exit, where companies can only sell their customer base to organisations that hold retail licences (and subject to the secretary of state’s approval). This approach would allow economies of scale to be realised, help ensure a genuinely level playing field for new entrants, and increase the chance that retailers from other sectors might enter the market. Any other course will risk raising expectations only to disappoint
– 2003 all over again.

The Bill also lacks clarity in its apparent reliance on negotiation between new entrants and incumbents. We have been reassured that the intention is to create regulated access, yet there is no requirement for published wholesale charges (which would go a long way to reassure entrants) and it isn’t clear to me how non-price discrimination will be ruled out.

Perhaps most worryingly, there remains a potential link between new retailers and potential new suppliers of water resources. It is unclear how this link could be effective in delivering greater resilience overall. New entrants would naturally focus on areas where they can reduce customers’ bills, which will be areas where it is possible to supply water for less than the incumbent monopoly’s regionally averaged price.

This direct link creates a risk that tariffs end up being de-averaged by default. We should be very careful! In Scotland we specifically ruled out any direct link between retailers and upstream activities (unless there was an overall cost saving that could benefit all customers). De-averaging may deliver lower charges for some, but will result in eye-watering increases for others. Our joint analysis, with Oxera and Scottish Water, confirms that in Scotland 50 per cent increases are required from two-thirds of non-household customers to allow the other third to enjoy the benefits of a de-averaged charge. I will leave you to ponder what could happen to smaller businesses in rural areas.

Finally, we must ensure we do not create perverse incentives for wholesale businesses to treat less favourably retailers that offer tailored services, including water efficiency. In Scotland we have prevented this by including a specific “no detriment” provision to protect the wholesaler, Scottish Water – again this could be relatively easily addressed by introducing a similar clause in the Bill.

The Water Bill is a real opportunity to build on the sector’s achievements. Pursuing palliative, short-term responses may be superficially attractive but it will not serve us well. Instead we should think more expansively and build on strengths. Government
has an important role to play in setting a clearly defined policy agenda but the whole industry needs to think carefully about the Bill’s implications and ensure that a long-term, balanced approach is taken.

About Alan

Alan Sutherland

I’ve been Chief Executive of the Water Industry Commission for Scotland since its establishment in July 2005. Prior to that I was the Water Industry Commissioner for Scotland having been appointed to that role by Scottish Ministers in November 1999. In 1998 and 1999 I was a managing director of Wolverine CIS Ltd, a division of Wolverine World Wide. Prior to that I worked in strategic consultancy with Bain and Company and in the investment banking industry with Robert Fleming and Company.