Memorandum submitted by South East Water
Ltd (Ofwat 21)
INTRODUCTION
South East Water welcomes the opportunity to
contribute to the inquiry carried out by the Environment, Food
and Rural Affairs Committee into the current Periodic Review 2009
of water price limits being conducted by the Office of Water Services
(Ofwat). We thought that the brief summary below and the documents
attached focusing on competition issues may provide useful information
to the committee.
The current regulatory regime has delivered significant
operating efficiencies and water quality improvements. At the
same time, the scale of any price increases has been limited.
Any changes to industry structure as part of the promotion of
competition in the sector must be considered in this context and
should not jeopardise the ongoing delivery of these achievements.
South East Water supports the progressive approach
proposed in the interim report of the Cave Review starting with
activities where the risk-return ratio is favourable. We agree
with the Cave Review that extensive consultation and dialogue
with stakeholders will be required at each step. Any reform should
favour pragmatic solutions that offer clear benefits and are based
on a lucid assessment of risks. Ofwat should follow a process
that truly involves all stakeholders at all the stages and is
based on clearly identified benefits.
We set out below an Executive Summary addressing
our main observations in relation to issues that we believe should
be the focus of any process developed by Ofwat.
We also enclose the company's submission to
the Cave Review, which provides more detail on the views of the
company on the development of competition in the water sector.
EXECUTIVE SUMMARY
Financial arrangements:
1. The UK water sector has very significant
funding needs that it has, to date, been able to meet by raising
medium- and long-term debt on very advantageous terms primarily
through the issuance of public securities. This is because the
sector is perceived as having one of the lowest levels of risk
amongst corporate borrowers.
2. If competition is introduced, investors will
change their views as to the stability of the industry as company's
business risk profile in a competitive environment is likely to
be substantially different.
3. Existing funding arrangements typically include
provisions intended to protect lenders against the risk of material
changes at the issuer or guarantor level. The introduction of
competition, especially upstream competition, would trigger these
provisions and potentially the repayment of the debt. The outcome
will be an increase the cost of capital.
For more information, please refer to:
— Moody's Report "UK Water Sector:
Moody's Comments on competition review" (attached to this
document);
— NERA's report "Financial Implications
of Competition Models" Water UK DEC 08 for further details
on these important issues;
— Standard & Poor's report "Enhanced
competition could alter Standard & Poor assessment of the
UK water sector" (attached to this document).
RCV Allocation:
4. To introduce effective retail and upstream
competition, prices must reflect the economic value of the assets.
5. Because of the decisions made at privatisation,
the Regulatory Capital Value of water industry assets is significantly
below the MEAV (a proxy measure of economic value). At industry
level, as noted in Ofwat's consultation, the RCV is £44 billion.
This is equal to just over 18% of the industry MEAV (£239
billion).
6. If retail prices, and potentially upstream
prices, are determined by a competitive market they would need
to reflect a market value (commensurate with the MEAV). The RCV
will therefore need to be allocated between the separated retail
entities and production & treatment entities and the network
as a natural monopoly.
7. Due to the discount of the RCV, once
the RCV has been allocated to retail and the upstream part of
the business, the remaining RCV to be allocated to the regulated
network business would then be very small or potentially negative.
This would not be sustainable.
Upstream competition potential:
8. We would encourage Ofwat to consider
further the specific characteristics of the water industry in
England and Wales when reviewing the case for upstream competition.
The costs and risks involved with an upstream water market are
potentially significant and the benefits are likely to be limited.
9. Potential regional upstream market will be
small and hence entry will be limited due to natural constraints
specific to the water industry. Water is heavy, uncompressible
and costly to transport; much more so than the product of any
of the other liberalised utility networks. There are also physical
constraints, from the natural environment and the distribution
network, which is required to get water from producers to customers.
10. We are also concerned that the proposed
model of independent procurement entity would split the industry
between a legacy sector and a dispersed new sector, which would
add complexity to the management of resources and increase the
risk of stranded assets. A single entity will assess demand requirements
with less diversity of views than the coordinated approach currently
in place in the south east between companies and regulators.
Water efficiency:
11. We question the assertion that retail
competition would in itself help promote water efficiency. Extending
retail competition to a greater number of large non-household
customers cannot help promote water efficiency to household customers.
Instead, an effective water efficiency policy coordinated across
different sectors must be put in place. Changes of behaviour and
investment in the water efficiency of buildings are required,
water efficient devices must be promoted and customer information
developed. This requires the involvement of manufacturers, retailers,
the construction industry (to promote water harvesting and grey
water reuse), government agencies as well as the water industry
and its regulators.
12. It is likely that incentives or subsidies
will be required to promote water efficiency measures, as is required
in the energy sector even though the price signals are much stronger
and competition has already been introduced.
Innovation:
13. The interim report of the Cave review
has identified the main issues relating to innovation in the water
industry. We would support the changes it suggests to the regulatory
regimes designed to provide incentives for companies to innovate.
South East Water Ltd
March 2009
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