Environment, Food and Rural Affairs CommitteeFurther supplementary written evidence submitted by Ofwat

Notwithstanding Ofwat’s commitment in oral evidence to using the tools at its disposal to police discrimination against new entrants, does Ofwat remain of the view that legal separation of water companies’ retail and wholesale functions would be its preferred option for the structure of the market?

It is very important as greater choice is introduced for non-household customers that there is a level playing field, so that existing companies are not afforded an unfair advantage over new entrants. Without a level playing field choice is unlikely to be effective and we will not realise the expected gains for customers. We will be consulting later this year on options for achieving a level playing field.

Legal separation will not be included as the government has determined that this is a route it does not wish to pursue. Instead we will be concentrating on the licence conditions and other requirements to ensure that choice can operate effectively for all non-household customers.

What is your estimate of the costs to (a) the regulator and (b) water companies (including any additional financing costs) were there a requirement for legal separation to be completed within three years of a Water Bill receiving Royal Assent?

When the Water White Paper was published, Defra published accompanying impact assessments. These estimate the costs of legal separation over a time horizon of 30 years. The Defra retail impact assessment includes:

costs the regulator will incur to establish and administer the market arrangements;

costs the regulator will incur to design and manage the market settlement and switching infrastructure;

costs companies will incur to set up and maintain legally separate retail businesses; and

financing costs companies will incur if they breach covenants and other financing arrangements.

To understand how the costs of legal separation look over time, it may be useful to consider the present value (PV) of the costs of legal separation over 30, 10 and three year time horizons, as follows:

Table 1

		Legal
		30 year PV	10 year PV	3 year PV
Regulatory market arrangements	Setup and on-going costs	46	29	18
Market settlement	Setup and on-going costs	79	44	20
Company	Setup and on-going costs	721	459	279
	Finance costs	529	409	308
		1,249	868	587
TOTAL COSTS (£m)		1,374	942	625

It should be noted that the Defra impact assessment also considered the benefits associated with legal separation and estimated their present value to be as follows:

Table 2

	Legal
	30 year PV	10 year PV	3 year PV
TOTAL BENEFITS (£m)	1,669	619	202

Defra’s impact assessment assumed that, while a large proportion of the costs of legal separation would be incurred early on, the benefits would accrue later. This explains why the costs are higher than the benefits over a three- year horizon, but the benefits are greater than the costs over a 30 year horizon.

What is your estimate of the costs to (a) the regulator and (b) water companies (including any additional financing costs) were there a requirement for functional separation to be completed within three years of a Water Bill receiving Royal Assent?

Again to understand how the costs of functional separation look over time, the present value (PV) of the costs of functional separation over 30, 10 and three year time horizons are considered as follows in Defra’s impact assessment:

Table 3

			Functional
			30 year PV	10 year PV	3 year PV
Costs	Regulatory market arrangements	Setup and on-going costs	63	38	21
	Market settlement	Setup and on-going costs	79	44	20
	Company	Setup and on-going costs	721	460	280
	TOTAL COSTS (£m)		864	542	321

However, the impact assessments prepared by Defra also considered the benefits associated with functional separation and estimated their present value to be as follows:

Table 4

	Functional
	30 year PV	10 year PV	3 year PV
TOTAL BENEFITS (£m)	1,264	466	152

As with the previous question Defra’s impact assessment assumed that while a large proportion of the costs of functional separation would be incurred early on, the benefits would accrue later. This explains why the costs are higher than the benefits over a three year horizon, but the benefits are greater than the costs over a 30 year horizon.

What was the cost to the regulator and companies of implementing accounting separation?

Ofwat first commenced working on accounting separation in 2008. Water companies started work on providing accounting separation data in 2009, with the first data provided in mid-2010. Ofwat has not asked companies to provide details of the actual costs of reporting accounting separation information. The accounting separation information currently collected is only cost allocation, rather than detailed accounting separation, and for several companies the costs are negligible (as they already have systems in place to carry out such cost allocation).

Ofwat therefore does not have actual costs of implementing accounting separation, only estimates from an accounting separation impact assessment prepared in 2009. This impact assessment gives a cost of £22.9 million present value over five years from 2009. These estimates drew from information provided by some of the water companies.

There are also figures Water UK provided to the Gray review of Ofwat. These show that the incremental costs of compliance with the June return process (a broader set of activities than those relating just to accounting separation) were £6.5 million in 2009–10. Initially, companies reported to Ofwat that providing commentaries alongside the June return data, was a significant burden. Anecdotal evidence from a stakeholder workshop held by Ofwat in June 2011 suggests that the burden for the June Return 2011 (JR11)—without commentaries—was reduced compared to that of the previous year’s JR10—with commentaries—but not significantly. However there was also a recognition that this was the first step, and it may take time for changes to embed in the companies.

What is your estimate of the savings to water customers over the first decade of a reformed regime (assuming that the White Paper proposals are implemented)? Are you able to provide comparative figures for projected savings over the first decade of a reformed regime in which water companies were required to (a) legally and (b) functionally separate their retail arms?

Defra’s impact assessment estimated the costs and benefits over a time horizon of 30 years. The Defra retail impact assessment shows that the net benefits over time horizons of 30, 10 and three years and can be seen in table 5.

Please note that table 5 only refers to retail savings. Defra’s impact assessments also estimated that upstream reforms would generate net benefits of £492 million over 10 years, which should be added to the retail savings to give an estimate of the total savings to customers.

Therefore the estimate of the savings to water customers over the first decade of a reformed regime (assuming that the White Paper proposals are implemented) is £521 million. Comparative figures for projected savings over the first decade of a reformed regime in which water companies were required to legally separate their retail arms is £198 million. In contrast the projected savings over the first decade of a reformed regime in which water companies were required to functionally separate their retail arms is £416 million.

Whilst the above assessment attempts to capture some of the fundamental costs and benefits that derive from offering choice to retail, non-household customers, it is worth noting that not all the benefits can be readily quantified.

In particular, customers benefit from a choice of supplier and service package they prefer. These benefits are hard to quantify. Experiences in the Scottish water and sewerage sector, shows that choice has facilitated better information to customers from their retailer and has help customers manage their own consumption better.

The Cave Review that informed the Defra Water White Paper considered the potential efficiencies to be gained from innovation in the water and sewerage section. They used a range of sources including the experience in Scotland and a number of academic studies.

The review highlighted the potential improvements that introducing retail choice could drive. In particular, companies are more likely to innovate to reduce their cost where they will provide wholesale inputs to multiple retailers in terms of more efficient resource and network management. Given the challenges we face in terms of dealing with the effects of climate change and demographic change, such innovation should be encouraged as much as possible.

May 2012

Table 5

			Legal			Functional			WSL
			30 year PV	10 year PV	3 year PV	30 year PV	10 year PV	3 year PV	30 year PV	10 year PV	3 year PV
Costs	Regulatory market arrangements	Setup and ongoing costs	46	29	18	63	38	21	75	42	19
	Market settlement	Setup and ongoing costs	79	44	20	79	44	20	79	44	20
	Company	Setup and ongoing costs	721	459	279	721	460	280	86	41	14
		Finance costs	529	409	308
			1,249	868	587	721	460	280	86	41	14
	TOTAL COSTS		1,374	942	625	864	542	321	240	127	53
	TOTAL BENEFITS		1,669	619	202	1,264	466	152	430	157	51
	NET benefits		295	–323	–423	401	–76	–169	190	29	–2