Ofwat has said that the scale of potential cost savings available from greater interconnection is around £914 million (2012-13 prices) compared to the cost of the schemes proposed in water companies’ 2014 Water Resource Management Plans.

The figures are included in the background provided by the regulator setting out its preferred option for the proposed market design for increased water trading in its major Water 2020 consultation paper published last week.

Key evidence used by Ofwat to develop its proposals includes its own examination of the latest data available from the bulk supply registers (for 2013-14) on current levels of water trading between regulated companies. This shows that the  total volume of water exported in 2013-14 was 619 Ml/d, and the revenue earned from these exports was just under £34m.

According to Ofwat, the figure for  2013-14, which is similar to previous years, confirms that the volumes of water exported have not changed significantly over time.

The analysis reveals that distribution of water trading volumes is heavily skewed, with a small number of trades accounting for the vast majority of water traded. Out of a total of 140 reported trades in 2013-14, the 9 largest accounted for over 90% of traded volume while the largest trade accounted for almost 50% alone.

The majority of water traded is non-potable (raw) water, which accounted for 76% of exports by volume in 2013-14. Potable (treated) water accounted for 24%. Ofwat  said it is worth noting that the majority of individual trades were actually of potable water, but these trades were much smaller on average.

The regulator also examined the date on which bulk supply trades were first agreed; and specifically, whether the agreements were already in place prior to privatisation of the industry in 1989. Contracts agreed prior to privatisation were found to account for the majority of water volumes traded (94% of the total volume in 2013-14, versus 6% of volume under contracts agreed after privatisation).

Ofwat has also updated its quantitative analysis of the potential savings available from water trading in England and Wales first carried out in 2010, commenting:

“The analysis suggests that the potential gains in relation to water trading between incumbents still appear to be substantial.

“In our base case we estimate the scale of potential cost savings available from greater interconnection is around £914m (2012-13 prices) over the lifetime of the assets compared to the cost of the schemes proposed in water companies’ 2014 WRMPs. Across all the scenarios tested, the cost savings (in 2012-13 prices) from greater interconnection ranged from £754 million to £1,077 million.”

The regulator has also separately considered the potential impact of increased water trading on resilience and takes the view that increasing water trading will improve the resilience of the sector as a whole.

Ofwat also considers that promoting water trading will likely lead to increased interconnection – thereby  increasing the flexibility of the water supply system as a whole, which will enable it to better respond to shocks.

Increased interconnection should not reduce the resilience of the environment as water trades will only be agreed with the Environment Agency if they are environmentally sound, Ofwat said. By allowing more water to be moved from areas of lower water stress to higher water stress water trading was also likely to improve environmental resilience.

The regulator also separately commissioned Deloitte LLP to undertake a study on ‘Water trading – scope, benefits and options’. A key issue examined by Deloitte is whether the historically low levels of trading reflect economic fundamentals (such as the cost of transporting water) or other barriers and market failures.

Ofwat said this is critical because, if it is primarily the former, then this would indicate that there are no regulatory reform options that would materially increase trading in future. However, if it is the latter, then, in principle, the regulator should be able to identify specific issues and problems that could be targetted via a regulatory approach.

The Deloitte study identifies a number of barriers to trading, including:

• Security of supply obligations – regulatory obligations and incentives regarding security of supply may encourage companies to favour their own water supplies.
• Information asymmetry – namely, that information required to identify trading opportunities (such as supply and demand forecasts, water scarcity and cost information) may not be sufficiently transparent.
• Regulatory and policy barriers – including uncertainty over the future abstraction regime and insufficient guidance regarding pricing rules in relation to third parties.

Ofwat said engagement with stakeholders who are currently, or have the potential to, participate in water trading and/or in the provision of water resources had revealed a number of key themes,  including:

• there is appetite for greater participation in water trading;
• barriers to this include a lack of awareness and information; and
• fundamentals, including water transport costs and capital investment requirements, also limit the scope for increased trading.

Ofwat’s preferred approach to for water trading market design includes:

• a separate binding price control for water resources
• implementation of an offset mechanism to ensure that new entrants can recover the cost of new resources appropriately, while also ensuring that prices reflect average costs
• creation of a market information database and bid assessment framework to allow for the ‘bidding in’ of third party resource options on an ongoing basis – as outlined in the Deloitte report
• proposal for a third party organisation as best placed to manage the information database
• more measures to be introduced to increase transparency and certainty around security of supply for water trading

Deadline responses to the consultation is 10 February 2016 – click here to download the consultation paper Water 2020: Regulatory framework for wholesale markets and the 2019 price review