A newly-published paper has provided further insight into water industry regulator Ofwat’s thinking on the proposed changes needed in the UK water sector – and whether the Draft Water Bill delivers. It also flags up Thames Water’s Tideway Tunnel as the perfect example of where competition for the market could be put to the test.

Ofwat’s Senior Director of Markets and Economics has described the Draft Water Bill – currently coming in for criticism from a number of high level players in the water sector – as a as a ‘watershed’ in the history of the sector, a very welcomed policy change segments and as offering an historic opportunity to implement a level playing field.

Sonia Brown was delivering one of the annual Beesley Lectures lectures about regulated industries held in memory of Professor Michael Beesley, who was a leading figure in UK regulation until his death in 1999.

Ms. Brown introduced her lecture - Overcoming barriers to competition in water’ on 11 October 2012, by saying that following the work of Martin Cave, David Gray and Anna Walker, the UK Government’s White Paper, ‘Water for Life’, had clearly established the strategic priorities for the industry. However, she warned that:

“Even now, in this historic moment when the vision and the strategy have been so clearly outlined, there are still voices saying: “Don’t risk rocking the boat – don’t scare the horses – hurry even more slowly.”

I personally believe that this point of view is naïve as it overlooks the stark challenges we are facing in the future.”

Ms. Brown said that a fundamental shift was now required in the water sector, which should focus on harnessing market forces.Whether this would be via competition ‘in’ the market or competition ‘for’ the market, a move away from the current comparative model throughout the whole value chain was needed.

Water industry's biggest achievement is "indisputably investments"

Describing the industry’s biggest achievement as "indisputably investments", she said that more than £108 billion had been invested since privatization and the ability to finance this through private capital had been a substantial achievement. Improvements in both environmental standards and efficiencies had come at a good value to customers with a litre of tap water costing the average customer 0.26 pence. - critically, 30% less than would have otherwise been the case without Ofwat’s price controls.

In Ms. Beesley’s view, while the Government had clearly set out the policy that choice will not be introduced for household customers, it would still be helpful for companies to approach household customers with the mind-set that "they could leave if they are dissatisfied with their offering."

Growing concerns about households’ ability to afford water bills and the distributional effect of affordability meant it was “fundamental to at least reassure customers that their money has been spent wisely” , while for non-household customers, the ability to exercise choice was key to the issue of legitimacy, given that this option had been available to customers of other utility sectors for some time.

Ms. Beesley said that a business customer had recently told her that the water companies think that “keeping Ofwat happy is more important than keeping their customer happy” – a perception which needed to change rapidly.

Customer choice could be based on green credentials

Ms. Brown suggested that choice would allow customers to decide their providers based on several criteria, including the “green credentials” of the supplier. An independent survey had shown that more than two thirds of the sampled customers were particularly concerned, or quite concerned, about climate change as an environmental issue.

Climate change presented two serious challenges to the water and sewerage sectors in England and Wales – one of mitigation and the other of adaptation. However, on the supply side, given the capital intensity of the sector, solutions were long term and costly while on the demand side, the sector relied on “quite intrusive measures of interrupting demand” without customers being able to signal the value of water.

Ms. Brown described this as an inefficient way of allocating resources which did not happen in other utility sectors where strong price signals guided companies’ management of supply and demand – especially in the short term and increasingly to underpin longer-term investment decisions.

The presence of water markets and prices would significantly help with the task of tackling the predicted strain on UK water resources, and the UK Government’s vision of reducing per capita consumption from 148 to 130 litres per person per day, and potentially to 120 litres a day depending on the available technology.

Retail competition benefits could “spill over” to household market

Ms. Brown suggested that competition could generate “welfare gains for society”in several ways, highlighting the benefits in the Scottish market, where according to the Water Industry Commission for Scotland, Business Stream was able to reduce its cost base by 35% following separation from Scottish Water and the introduction of competition. The reductions had come from better management of bad debts and overhead reductions.

Ms. Brown said the competitive pressures of retail competition would force businesses to share the gains, thus reducing prices and improving service quality for consumers, commenting:

“The benefits that might be achieved in the non-household sector could, according to Martin Cave and others, spill over to the household market segment as companies transfer best practices to their household retail arms and Ofwat receives better information about potential efficiencies in the retail sector.”

She cited examples in innovation from new appointees, including:

• a multi-utility approach, where a single company provides a package of services including gas, electricity, telecoms, water and sewerage services;
• grey water recycling;
• adopting and maintaining existing on-site sewage treatment works rather than connecting to remote sewage treatment works;
• using an existing on-site borehole to provide a site’s own supply of water rather than taking a bulk supply of water; and
• engaging customers about their water use in order to reduce consumption.

Competition will encourage efficient use of resources and investments

Ms. Brown said that competition would also encourage the efficient use of resources and that trading in the upstream part of the value chain would reduce the need to abstract water from rivers and boreholes located in areas of scarce water supply. In her view, this would translate into:

• a potential reduction in CO2 emissions driven by a reduction in the need for new carbon-intensive assets and infrastructure;
• environmental benefits in those areas subject to over-abstraction;
• other benefits including the reduction in inefficient capital expenditure (capex) needed to develop uneconomical water sources; and
• resource efficiency benefits that will accrue in the retail sector.

Competition would also increase efficiency in investments - the more that investment was delivered to respond to market signals, the lower the risk of inefficient investments or white elephants. Ms. Brown commented:

“The benefits of competition in my mind are clear in terms of greater productivity, increased efficiency in the use of resources and investment growth.”

Three major barriers to competition

Ms. Brown said there were three main barriers to competition - the cost of moving water due to its weight, the regulatory framework and the inertia towards cultural change. Given that water is relatively heavy and relatively cheap, with average household water use of 50,000 litres a year and an annual average bill of only £376, the figures suggested that the vision of having a single national grid for water may not be feasible for the foreseeable future.

However, this did not mean that there were no welfare gains from transporting and trading water between adjacent areas served by different incumbents. Ms. Brown commented:

“We have to remove the blinkers on companies so that they can see these opportunities.”

Lack of interconnection - a symptom of current regulatory framework

Referring to an Ofwat-commissioned study which found that building additional interconnection between England and Wales could lead to £1 billion in welfare gains, Ms. Brown described the existing lack of interconnection and the relatively low activity in water trading as a symptom in part of the current regulatory framework. There were no interconnections between water companies proposed at the 2009 price review – in contrast to their efforts to link up their internal networks.

Interestingly , Ms. Brown went on to suggest that in the future there was no reason to presume that investment in interconnection had to be undertaken by a local monopoly and that useful lessons could be learnt from the experience of ‘merchant’ interconnections in electricity. Under merchant arrangements a third party constructs and operates electricity transmission lines through the franchise area of an unrelated utility, subject to regulatory approval.

Scope for more competition and integration between England and Scotland

Commenting on the news that Thames Water and others will compete across the country to win new business in the intensive water users segment, Ms. Brown said she hoped more and more companies would consider providing water services outside their historical geographical areas which would “shine lights” on areas such as bulk supply pricing. In her view there is also potential scope for cross-border competition between Scotland and England, providing further scope for potential entry and also potential for further integrating the two markets.

With regard to the perceived capex bias, Ms. Brown said that Ofwat’s current price control mechanism rewards capital and operating efficiency differently - creating the perception that the water companies are better off by favouring capital over operating expenditure (opex). As a result, a water company might therefore prefer relatively expensive capex options (for example, building bigger sewers instead of encouraging sustainable drainage systems) over cheaper opex solutions. Ofwat is currently proposing to change the way it approaches the treatment of opex and capex by providing equal incentives for capex and opex via a totex approach.

The application of a single price cap for all activities undertaken by a water company under the mechanism also swamped customer-focused incentives as the companies were instead focussed on the ones driven by financing and asset-intensive activities.

Ofwat “historically forced to behave like corporate headquarters of local monopolies”

On cultural change, Ms. Brown commented:

“..I have often felt that Ofwat historically has been forced to behave at times more like the corporate headquarters of local monopolies than is desirable, when ownership of business plans and improvement measures should really be in the hands of water companies. “

She described the Draft Water Bill as a ‘watershed’ in the history of the sector since privatisation and a very welcomed policy change which would affect competition both in the upstream and in the retail segments. Describing the opportunity offered by the Water Bill as historic, Ms. Brown said Ofwat would implement a regulatory framework that was capable of creating a level playing field for all market participants. The regulator would also promote markets further by, inter alia, boosting efficient water trading and reducing abstraction from stressed water resources.

Outputs – “there will be temptations at various points in the price control setting process for Ofwat to take over”

Ms. Brown said that moving from an outputs to an outcomes-based regulatory approach meant that companies would be allowed greater freedom to innovate and find more sustainable solutions, together with greater scope for outperformance and rewards. Interestingly, later in the lecture she said that Ofwat had to further support the focus on customer engagement to drive outcomes and was currently monitoring compliance with 11,000 schemes covering 2,000 outputs, commenting:

“Clearly, there will be temptations at various points in the price control setting process for Ofwat to take over. However, our involvement needs to support rather than undermine the new approach.”

Thames Tidway "perfect example' where competition could be put to test

Ms. Brown said that the current regulatory framework should be open to exploit the benefits of competition ‘for’ the market – citing the Thames Tideway project as “the perfect example where competition ‘for’ the market could be put to test.” Describing it as very large and complex. she said that the project has a risk profile very different from other capital investments delivered since privatisation.

Ms. Brown went on to flag up the Flood and Water Management Act 2010 provision that certain large and complex projects may be delivered by a third party infrastructure provider, which may be regulated by Ofwat.

This approach would required Thames Water to put the project out to tender and allow Ofwat to issue a licence to the successful bidder - both the cost of finance and the construction elements of the project would be competitively bid for and the project delivered in a way that is structurally separate from Thames Water. Ms. Brown went on to suggest that the Thames Tideway could become a potential test case in competition.

"Team Ofwat" now working to embed risk-based approach

The lecture summed up by saying that “team Ofwat” was working to embed the risk-based approach instigated by the Gray report in the development of new price controls and in market reform. Ms. Brown said that as the regulator gets closer to publishing a draft methodology and take important decisions about key components of the price controls, the transparency offered by the new risk-based framework would allow stakeholders to challenge Ofwat wherever they think it has not followed its principles.

Success between now and 2015 would be measured on Ofwat’s ability to deliver the smooth implementation of a Bill that reflects the White Paper’s aspirations, the timely implementation of the price review and the emergence of a market design that has a level playing field for all participants.