The Water White Paper - Environment, Food and Rural Affairs Committee Contents


5  Market Reforms

61.  One of the most widely anticipated elements of the White Paper is its proposals for reform of the water and sewerage industry. At present, the industry in England and Wales is made up of 21 regional monopoly, vertically integrated, water companies, which provide a 'source to tap' service: obtaining water from source through abstraction, treating it to an appropriate standard, and providing it to customers' taps via company-owned infrastructure. Customers are directly billed by their water company for the provision of this service, with prices controlled by the regulator, Ofwat.

62.  The vast majority of both domestic and business customers have no choice about who supplies their water. The resulting lack of competition can result in time-consuming and expensive administration for businesses with several sites across the country who have to process multiple bills from different suppliers. The White Paper's market reform proposals seek to increase levels of competition in the sector in order to encourage efficiency, with the ultimate aim of reducing customers' bills. The introduction of greater competition at the retail end of the market would see new entrants buying water wholesale from incumbent companies at prices regulated by Ofwat and seeking to win business from incumbents by offering preferable prices and/or services to their customers. Retail competition in Scotland, introduced in 2005, has saved the Scottish public sector an estimated £20 million and over 50% of non-household customers have renegotiated the terms of their supplies.[96]

63.  The Water Act 2003 introduced competition to the water market but limited it to those customers using more than 50 million litres of water a year. This 'water supply licensing' (WSL) regime has had minimal impact, with the White Paper noting that only one customer switched supplier under this regime in the last six years.[97] Defra has already reduced the threshold to 5 million litres and proposals in the White Paper would lower the threshold to zero, greatly increasing the number of customers who would be eligible to switch supplier. As well as increasing the size of the potential market, the White Paper sets out further reforms intended to remove the current barriers to new entrants to the market. These include the introduction of a transparent wholesale access pricing regime to replace the current 'costs principle', which has been criticised for being over-complicated and deterring new entrants; the extension of the current WSL regime to sewerage services, meaning that companies can tender for water and sewerage services at the same time; and establishing statutory market codes to increase transparency and make it more straightforward for customers to switch supplier.[98]

64.  Reforms will not be limited to the retail market: the White Paper also includes proposals to increase 'upstream' competition which will enable new entrants to sell water to incumbent companies and take sewage and wastewater out of the network for treatment, removing the current requirement that providers of upstream services must also provide a retail function. A new network licence will be introduced which will allow new entrants to operate their own infrastructure which they can connect to an existing network and use to supply their own customers and other new entrants.[99]

Timescales

65.  Reform of the water market will require legislative change and preparatory work to be undertaken by water companies and regulators. We took evidence on the likely timescales of the changes. It was clear that, although the White Paper was a welcome signal of intent, water companies and regulators were keen to see more detailed proposals for the reforms as soon as possible. These are expected to be contained in a draft Water Bill which it is anticipated will be published before the Summer recess.

66.  Given the uncertainties about when legislation would be in place, witnesses were reluctant to put forward a market opening date, preferring to provide indicative timescales of how long would be needed once legislation was on the statute book. Ofwat felt that a timescale of three years from the date of legislation "could be achievable";[100] the Water Industry Commission for Scotland (WICS) felt that April 2017 was realistic (based in part on the concept that three years from legislation would be possible) but that any earlier "would be really pushing it".[101] Water UK were less willing to suggest a particular timescale, emphasising that the retail market should open "when it is ready",[102] with Anglian Water warning that "it is much better to spend the time getting the set-up right to avoid potentially unintended consequences".[103]

67.  Water companies had particular concerns about the timescale for implementation of the upstream market reforms to the WSL regime, noting that unlike the retail reforms, there would be no Scottish experience to draw on. They were particularly concerned that a near-simultaneous introduction of reforms to the retail and upstream market might coincide with changes to the price review process,[104] and warned that investor confidence in the sector could be under threat,[105] calling for a stepped approach to the introduction of the reforms with the introduction of retail reforms taking place first.[106] Ofwat accepted that the financial sustainability of the sector was crucial,[107] but were not persuaded that the White Paper's proposals would put this at risk. They described investors' response to the White Paper as "positive" and noted that share prices on the day that the White Paper was announced had shown very little movement.[108] They pointed out that Defra's impact assessments, published alongside the White Paper, estimated the net benefits of upstream reform to be £1,952 million[109] and argued that "it would not be sensible to delay obtaining those benefits beyond what is necessary to allow successful implementation".[110

68.  Increased competition in the water sector will bring clear benefits to customers. The Government should not delay reforms because of an overcautious approach to investor confidence. We recommend that Defra open the retail market three years from Royal Assent to a Water Act. Reforms to the upstream market may necessarily follow a different timescale to the retail reforms, but they should not be unduly delayed.

The Scottish experience

69.  Business customers in Scotland are already able to choose their supplier. The Water Services etc. (Scotland) Act 2005 introduced competition for all non-household customers, with the retail market opening for business in 2008. There are significant differences between the Scottish and English water industry; most notably, there is only one wholesale water provider in Scotland, the state-owned Scottish Water, whilst 21 privately owned water companies operate south of the border. Nonetheless, it was widely recognised by our witnesses that the recent Scottish experience of introducing a competitive retail market for water would be highly valuable when designing and implementing retail competition in England.

70.  The Water Industry Commission for Scotland (WICS) drew our attention to various lessons that they had learned from implementing the Scottish retail market, commenting that the following aspects of the reforms had been particularly complex and time-consuming:

  • development of competitive retail tariffs, reflecting appropriate retail cost drivers and scope for savings;
  • design of wholesale charges, taking into account the definition of wholesale activities and the results of the next price review and the appropriate retail margin for each customer class;
  • ensuring that data accuracy issues were ironed out before market opening; and
  • agreement of registration and settlement processes and transparent governance rules to enable efficient market entry, exit and alteration of market codes.[111]

71.  The experience of introducing a competitive water market in Scotland and the lessons learned from it must be fully exploited as the White Paper's proposals for market reform are implemented.

A joint Anglo-Scottish market

72.  The White Paper envisages a joint Anglo-Scottish retail market, in which businesses would be able to choose one supplier for all of their premises in both England and Scotland.[112] Whilst welcoming the joint market in principle, we had some concerns about the regulatory consequences, including the possibility of duplication or conflict between the Scottish and English regulator. It was clear that at this stage, details of how the joint market will operate remain to be developed. Both regulators sought to assure us that the possibility of conflict or duplication would be dealt with in advance of market opening, with Ofwat suggesting that a joint protocol or memorandum of understanding would govern how the regulators would work together on matters including the revocation of licences.[113]

73.  We welcome the proposed joint Anglo-Scottish water market but would be concerned should this lead to any duplication or conflict between regulators, or any additional bureaucracy for water companies and their customers. We recommend that Defra work with the Scottish Government to ensure that the most effective regulatory model is adopted, including an assessment of whether a single regulator for the joint market may be appropriate. The Government should ensure that protocols setting out the relationship between, and respective duties of, the English and Scottish regulators are in place before the joint market opens.

Future structure of the water sector

74.  The White Paper's aim to increase competition in the water sector will only be realised if new entrants to the industry are able to compete effectively with the incumbent monopoly water companies. The failure of the Water Act 2003 to introduce any meaningful competition to the sector has been partly attributed to the legal barriers facing new entrants and the practical difficulties of seeking to win business from incumbents.[114]

75.  Professor Martin Cave's report on Competition and Innovation in Water Markets considered a range of options for introducing effective competition into the water sector. He concluded that given the difficulties that new entrants faced in competing with incumbent companies, Government should mandate the legal separation of incumbents' retail operations from the rest of their business, thus minimising the likelihood of unfair discrimination and encouraging new entrants to the market.

76.  In the White Paper, Defra explains why it has taken the decision not to implement Cave's recommendation on legal separation:

We do not want to take risks with a successful model given the challenges we face in building the resilience of the sector...we have heard persuasive arguments that mandating structural change would undermine [investor] confidence.... Ensuring the sector remains an attractive prospect for investors will enable water companies to deliver continued investment at costs that customers will find acceptable.[115]

They argue that retail separation is not essential for the growth of a healthy competitive market and they will instead rely on the regulator to police discrimination by introducing statutory market codes and establishing a wholesale access pricing regime to govern the price and service levels which new entrants are offered by incumbents.[116]

77.  A constant refrain throughout the evidence we received was the need for a 'level playing field' to ensure that new entrants could compete effectively with incumbents and would not be subject to discrimination by water companies keen to protect their own retail arms. Such discrimination could be direct (for example the provision of less preferable wholesale prices) or indirect (the provision of less preferable services, such as delays in fixing leaks for customers of a new entrant). Ofwat told us that they had a range of tools at their disposal to police discrimination, including accounting separation, the requirement for no undue discrimination, transfer pricing, and licence conditions; and that their track record of taking enforcement action was "a big deterrent."[117] The Water Industry Commission for Scotland, with experience of introducing competition in Scotland, agreed with Defra's decision not to mandate legal separation. However, it felt that in seeking to establish a 'level playing field' Government should send a clear signal that those companies which voluntarily chose to separate their retail arms could expect a lighter regulatory burden.[118]

78.  Ofwat's preference would have been for legal separation, which they felt would have been "cleaner".[119] In the absence of legal separation, they were clear that some form of 'functional' separation between the retail and wholesale arms of incumbent companies would be required, with internal memoranda, agreements and codes of conduct forming a 'Chinese wall' within the company. They felt that the detail of how this would be policed was best left to the regulator, but wanted to establish "as clear a degree of separation as we could get".[120] Defra should consider setting out a requirement for functional separation in the draft Water Bill. Defra should also consider setting out in legislation a lighter-touch regulatory regime for companies which have legally separated their retail and wholesale functions.

79.  Under the current WSL regime, incumbent companies' licence obligations require them to provide a retail function. Ofwat argued that Government had missed an opportunity to enhance competition by introducing separate licences for wholesale and retail activities, thus providing a mechanism by which incumbent companies could choose to exit the retail market should they wish to focus on wholesale activities only:

This would leave retail services to those better able to deliver them and provide scope for new entrants to innovate in this area. It would also allow customers to gain from the clear economies of scale in retail activities through mergers.[121]

In oral evidence Ofwat expanded on this point further, arguing that the opportunity for less successful retailers to exit the market was an important factor in creating a "well-functioning" and "dynamic" market.[122]

WICS agreed that separate licences would benefit competition:

It would clearly be better for [less successful] retailers to realise some value from disposing of their remaining customers than to continue to incur losses in their retail activities... Not to allow this could lead to higher bills for all those customers (including householders) who continue to be served by the unsuccessful retailer.[123]

Defra told us that there were "risks" attached to allowing companies to voluntarily exit the market, with the Minister explaining that:

If you were to allow exits you could see competition authorities at some point being able to push, for example, towards a more legally separated route, and that is one we have firmly rejected for a variety of reasons, the principal one being that we want to secure continued investment.[124]

Ofwat's evidence, however, suggested that they did not believe that providing a mechanism for voluntary exits through the issuing of separate retail and wholesale licences would adversely affect investment, arguing that it would in fact do just the opposite, with investors and companies able to choose the most efficient structures for their businesses.[125]

80.  We are not persuaded by the Minister's arguments against allowing a mechanism for companies to voluntarily exit the retail market and we agree with the English and Scottish regulators that providing an exit route should enhance competition and efficiency in the sector. We note in particular Ofwat's view of the importance of an exit mechanism in achieving a well-functioning and dynamic market. We recommend that Defra include such a mechanism in the legislation implementing the market reforms.

Consumer representation

81.  The monopoly characteristics of the water industry, which will continue for domestic customers even after the competitive retail market opens for business customers, make it essential that a strong body represents the interests of customers. Currently that representation is provided by the Consumer Council for Water (CC Water), an independent statutory body established in 2005 which represents both business and domestic customers.

82.  In October 2010, the Cabinet Office announced that it would consult on the future of a number of consumer representative bodies, including CC Water, with a view to possible abolitions or mergers. David Gray's 2011 Review of Ofwat and consumer representation in the water sector subsequently recommended that the current arrangements regarding CC Water should be retained, noting in particular the need for a strong consumer view to be maintained throughout the forthcoming challenges to the sector.[126] The White Paper commits to retaining CC Water in its current form until the 2014 Price Review.[127] In evidence, CC Water explained why they should be retained beyond this date:

...the alternative proposals for CC Water do not really address business customer issues; it is all around domestic customers. Business customers who, today, have got issues with the water industry and probably will have during the implementation of the competition regime, would be unprotected in that sense.[128]

83.  Evidence from Whitbread Hotels and Restaurants gave some flavour of the issues that CC Water alluded to, describing the process of making complaints as a "time consuming and frustrating process" and accusing water companies of lacking customer focus.[129]

84.  It is essential that there is a strong voice to represent the interests of consumers through the far-reaching reforms to the water sector to be implemented over the coming years. We recommend that Defra commit to retain the Consumer Council for Water in its current form for a period of three years after the White Paper's market reforms are implemented. Any new arrangements for consumer representation which are introduced subsequently must take account of the unique needs of business customers.



96   Ev 65 Back

97   Water for Life, p68 Back

98   Ibid, pp70-72 Back

99   Water for Life, pp72-73 Back

100   Q 40 Back

101   Q 3 Back

102   Q 220 Back

103   Q 176 Back

104   Ev 94 Back

105   Ev 96 Back

106   Ev 94 Back

107   Ev 77 Back

108   Q 44 Back

109   Benefits accrue to incumbent water companies in the first instance but are expected to be passed on to end customers in the form of lower bills. Back

110   Ev 77 Back

111   Ev 66 Back

112   The Welsh Government has decided to retain the current 50 million litre threshold at which non-household customers become eligible to switch supplier. Customers whose water use exceeds this threshold will be eligible to participate in the new market arrangements (see Water for Life p70). Back

113   Ev 78, Q 26, Q 68  Back

114   Water for Life, p68, 71 Back

115   Water for Life, p 68 Back

116   Ibid, pp71-72 Back

117   Q 51 Back

118   Ev 70 Back

119   Q 51 Back

120   Q 55-56 Back

121   Ev 76 Back

122   Q 70 Back

123   Ev 74 Back

124   Q 299 Back

125   Ev 76 Back

126   Gray, p84-85 Back

127   Water for Life, p76 Back

128   Q172 Back

129   Ev w68 Back


 
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Prepared 5 July 2012