Water Bill

Written evidence submitted by the Water Industry Commission for Scotland (WB 13)

Summary

1. The Commission was responsible for the successful introduction of retail competition for non-household customers in Scotland in 2008. Since that time, substantial benefits have been delivered both for customers and the environment, through lower bills (two-thirds of customers are now better off through switching supplier or renegotiating), increased customer satisfaction, and more tailored customer services. A summary cost benefit analysis is included at paras 46-49.

2. Importantly, as a result of the licensed retailers offering greater water efficiency advice for their customers, overall water use has fallen by over 7%.

3. We welcome the Water Bill as a real opportunity to build on the sector’s achievements to date. We do, however, have concerns that the Bill’s competition provisions:

· rely on negotiation between parties;

· prevent market participants from exiting the retail market if they choose to do so;

· allow scope for de-averaging (so risking incidence effects for smaller and more rural customers); and

· deter retailers from offering water efficiency advice and other environmental services.

4. This submission provides an overview of these issues, why they are important, and suggested amendments.

Issue 1: Negotiation between parties

5. Defra has assured us that its intention is to create a market where access is regulated (that is, the rules of entry are clear and observed by all market participants). Given the failure of the reform in 2003, Defra has perhaps understandably sought to avoid being over-prescriptive on the face of the Bill. However, in our view this misinterprets the main reason why the reform failed to deliver a working market, which is that new entrants had to negotiate with the incumbents (so skewing the playing field).

6. To create a level playing field, wholesale businesses should be required both to publish their charges and to offer only those tariffs to all retailers (including any retailer with the same ultimate ownership). Similarly, it should be clear than there are standard operational and settlement rules (normally enshrined in ‘codes’) that apply equally to all.

7. In the absence of this clarity, current incumbents could discriminate against new retailers by offering them higher prices, less preferable terms or poorer service levels.

Why is this important?

8. To create a level playing field in the absence of any clear, statutory framework it would be essential to put in place, and police, draconian rules on the interactions between the wholesale and retail business of an incumbent supplier. Notwithstanding these measures, some companies could still seek to frustrate the operation of the market by getting round or breaking these rules in order to maximise profit. This would be to the substantial detriment of all customers and the environment.

9. A lack of clarity on the rules of the game could also increase the up-front costs for new entrants. This may deter them from entering the market or – if they do so – will increase their costs (which are met by customers).

How is this different from what happens in Scotland?

10. In Scotland, we designed the competitive framework so that there would be a level playing field. Scottish Water was required to separate its retail arm on a functional basis but chose to create an arm’s length subsidiary. As a result the Governance Code is less onerous than it would otherwise have been. The Market and Operational Codes are common to all market participants. The Central Market Agency handles switches and determines how much each retailer owes Scottish Water.

11. Scottish Water is required to seek our approval on its wholesale tariffs. All entrants have equal access to all tariffs, even those that are the result of legacy arrangements between Scottish Water and larger businesses.

How should the current Bill be changed?

12. The Bill should be strengthened to prevent new entrants facing barriers and higher costs when trying to access the retail market. This would strengthen Ofwat’s hand in implementing the precise rules of the game.

Require wholesalers to publish their charges scheme

13. At present water and sewerage companies set out various standard charges in a charges scheme made under S.143 of the Water Industry Act 1991. The Bill proposes a new S.143B which would enable Ofwat to require publication of S.143 charges schemes. We believe that the Bill should be amended to ensure that new wholesale charges, ie those a water or sewerage company charges a retailer, are published in a separate wholesale charges scheme. This would also allow Ofwat to correct any inconsistencies between the published charges and the charging rules it will issue under Ss.66E and 117I.

14. Ofwat would also be able to use the new section 143B to ensure that charges are fair, eg by requiring some declaration that companies’ own retail businesses would be able to pay its published wholesale charges and still profitably serve any class of customer.

Ensure that appointed businesses treat all retailers equally

15. Clause 23 of the Bill would impose a new general duty on Ofwat to exercise its powers and perform its duties in a way that helps secure that no ‘undue preference or undue discrimination’ is shown by water and sewerage companies, including against water and sewerage supply licensees.

16. There are real risks in leaving vital parts of a successful market to be developed, and possibly challenged, through secondary regulation. The burden on Ofwat could be lifted by imposing the non-preference/non-discrimination duty directly onto companies. While general competition law arguably already prohibits such discrimination, enforcing such competition law duties has been shown to be a costly and prolonged process.

17. We therefore suggest that the Bill be amended to make companies’ non-discrimination duties directly enforceable by Ofwat using its existing powers under section 18 of the Water Industry Act 1991. In our experience, this will help reduce the costs of implementing the market reform and the future policing of the framework.

Mandate the use of common codes

18. Market and operational codes are a key part of ensuring that the terms on which retailers and water and sewerage companies engage with each other are fair, clear and consistent and that there are standard levels of service which all retailers can expect.

19. The codes that Ofwat may issue under the proposed Clauses 66DA and 117F could be used to cover all such necessary terms, but under the current drafting:

a. The scope of the codes is ambiguous. Market and operational arrangements are left either to individual negotiation or to more indirect and costly regulation, eg through the introduction of new licence conditions.

b. The regulated market and operational codes would not be subject to the right of appeal to the new CMA set out in clause 35/section 207A. This could cause a disjointed market framework and make it harder to agree changes to the framework.

c. Appropriate protections are not in place to allow the safe and effective exchange of customer data through any central market systems.

We suggest that the Bill is amended to avoid those risks, while not fixing an undue level of detail within the statute.

Issue 2: Exit

20. We agreed with the Government that it was not desirable to mandate separation of the retail businesses of the vertically-integrated incumbents and that debt investors may have reacted negatively to this.

21. However, the current Bill goes much further by preventing a current incumbent from exiting the non-household retail market – even if it proves not to be as good at retail activities as some others. This decision not only risks unsettling equity investors (at a time when many see the sector as over-leveraged), it also raises the following problems for the competitive market.

a) New entrants will only be able to acquire customers by winning them one contract at a time.

b) The unit costs of vertically integrated incumbents will rise, putting upward pressure on the industry’s cost of capital.

Analysis by Oxera indicates that incumbents that lose c40% of their non-household customer retail revenues could see profits fall by up to 5% [1] . In other words, the cost of preventing the voluntary exit of underperforming retailers could be some £400 million in net present value (NPV) terms.

Ofwat has a duty to finance the functions of an efficient appointed business. Even if it could avoid funding what it considered to be an inefficient retail business, the effective cost of capital for the vertically integrated company would increase, possibly substantially, to the detriment of household and non-household customers.

c) The focus is likely to be on retaining rather than winning customers, reducing the levels of innovation and levels of service that would otherwise have been possible.

The decision appears to be in marked contrast to the OFT’s view [2] that trying to avoid or prevent exit from a market only increases the likelihood of future disorderly exit.

d) Contracting out is not the answer.

The only way to police poor behaviour from specialist retail service providers (for example not reading meters for small or remote businesses) would be enforcement action through the incumbent’s licence. Such action is usually reserved for serious licence breaches. It is not clear whether it could or should be used to deal with petty behaviour in the retail arena.

And why would a service provider have any interest in providing water efficiency advice or other tailored services to its customers? The absence of such services clearly reduces the potential of retail competition to benefit the environment and reduce abstractions.

e) Households would still benefit if exit is allowed.

The service experience of most household customers is principally a function of how well the wholesale business is operated. All customers would suffer if an incumbent were to cut corners in its wholesale business (because of pressures in its retail business).

How is this different from what has happened in Scotland?

22. Business Stream is legally separate from the wholesaler (and its ultimate owner) Scottish Water, and operates independently of it. The Scottish Government/Scottish Water could decide to sell Business Stream.

23. Household customers have benefitted from Scottish Water’s clear focus on improving its efficiency and levels of performance. Its accountability to retailers (eg notifying them of incidents or planned supply interruptions) has led to initiatives that have improved service to household customers. Moreover, the focus on improving the overall efficiency of the business benefits all customers.

How should the current Bill be changed?

24. We suggest that the Bill is amended to give each incumbent company the power to make a transfer scheme which would (subject to the Secretary of State’s approval) have the effect of placing all of the assets and liabilities associated with its non-household retail business into a separate company without having to obtain the consent of third parties (such as landlords or contractual counterparties). Crucially, our suggested approach would require the Secretary of State to consider the safeguards that are put in place to ensure that customers do not suffer higher prices or lower quality services as a result of the transfer.

25. Under a transfer scheme all of the contractual rights and obligations of the company as regards its customers would be assumed by the new company, which would hold the necessary water and sewerage supply licences to allow it to continue to serve those customers.

26. While the transferring, incumbent, company would retain its statutory duties as regards the supply of water and, as appropriate, disposal of sewage, these would effectively become duties of last resort. The new company would become primarily responsible under its licence for dealing with the needs of non-household customers and, in the event of the failure of the new company, those customers would be reallocated among other water and/or sewerage supply licensees under the new retail market framework. Similarly, the new company (or one of its competitors) would be responsible for providing a retail service to any new non-household premises connecting to the incumbent’s system.

27. Our suggested approach would also require the Secretary of State to consider the guarantees of service that those companies acting as provider of last resort will commit to before giving consent. It would also be possible to ensure that a competition authority could not impose separation on the sector by including a provision preventing the use of the transfer scheme mechanism in a ‘divestment’ context.

28. While the initial transfer of assets and liabilities is envisaged to take place between the incumbent company and a company within the same corporate group, it would of course be open to the owner of the shares in the transferee to dispose of those shares as it saw fit.

Issues 3 & 4: Disincentives for water efficiency and risks of de-averaging

29. The current version of the Bill risks tariffs being de-averaged (to the disadvantage of smaller and more rural customers) and appears to create disincentives to provide the water efficiency advice referred to in ‘Water for Life’ [3] .

1. The proposed direct link between the retailer and the provider of resources

30. If a new entrant retailer can access a new source of water more cheaply than the incumbent, the new entrant’s focus will, understandably, be on the price he is able to offer customers. There is no incentive to do much better than the incumbent on levels of service or to innovate more generally. Indeed its comparative advantage is now in the sourcing of water and not in the service of customers or in contributing to a better environment.

31. It could also mean that non-household customers may pay different prices for the same service within the same appointed area. Smaller businesses and non-household customers in more rural areas are most likely to be adversely affected.

2. The conflict in incentives between the retail and wholesale activities of water companies

32. The supply of water and sewerage services depends on assets that generally have long lives (many last for over 100 years). These assets are built to satisfy expected demand. If the volume of water that is supplied or treated falls, the water company’s unit costs will increase. In such cases the wholesale business may try to maintain its level of profits by favouring retailers that do not actively offer services such as water efficiency or better management of surface water drainage to their customers. It could do this in many ways, for example simply by being slow to respond to requests for services. Such non-price discrimination would severely limit the potential for the market to operate as it should, to the detriment of customers and the environment.

33. We should ensure that the Bill creates appropriate incentives to focus retailers on helping customers play their part in reducing levels of abstraction and, more generally, in building resilience. Equally we need to ensure that an incumbent water company can suffer no detriment from such activities – so that it does not feel the need to be obstructive.

Why is this important?

34. While some customers may benefit if retailers can supply from a new water source that is cheaper than the company’s regionally averaged cost, it may not add resilience or be efficient and may, at least partially, strand incumbent company assets. This would increase the costs to all other customers, including households.

35. Our recent analysis, with Oxera and Scottish Water, into the impact on customers were de-averaging to take place in Scotland found that even on very conservative assumptions, many businesses could see their charges rising by at least 25%. In a fully de-averaged scenario, some customers could end up paying up to ten times their current bill.

36. Similar impacts could be expected in some areas of England (where very rural areas co-exist with much larger towns and cities within a company area) were de-averaging to take place.

How is this different from what happens in Scotland?

37. Experience from Scotland suggests that there is significant scope to reduce water consumption and to reduce the harmfulness and quantity of wastewater returned to the sewerage system. Non-household water consumption is 7% lower as a direct result of targeted water efficiency advice. The retail market is specifically designed so that retailers can, normally, only differentiate themselves on the basis of their level of service to customers. As a result retailers offer more tailored services, including water efficiency advice and drainage/effluent management services.

38. The wholesaler is protected from suffering any loss of income from these services through a specific ‘no detriment’ provision in the Scottish legislation. This ensures that Scottish Water has a clear incentive to work collaboratively with all of the retailers rather than adopting an adversarial relationship, and retailers do not have to concern themselves with whether or not the wholesaler is losing out from their activities.

How should the current Bill be changed?

39. We suggest that a new secondary duty is imposed on the Secretary of State and Ofwat to exercise their functions relating to the competitive market in a way that not only helps secure participation in that market but is also not detrimental to the ability of water and sewerage companies to exercise their functions.

40. This duty would be different from the existing requirement to help secure that water and sewerage companies are able to finance their functions. Our legal advice is that that obligation relates to water and sewerage company finances in the round. Therefore circumstances or events that have a negative financial impact could be offset against those that have positive ones. Unlike the financing functions duty, our proposed new duty would be a secondary duty and would relate only to the competitive markets.

41. In relation to the proposed direct link between upstream and retail markets, we suggest that the scope of the wholesale authorisation – which presently envisages that an upstream entrant will make arrangements (for example, for the purchase and sale of bulk water) directly with a downstream retailer – should be altered so that an upstream entrant will instead make such arrangements with the incumbent company.

42. Having tested the point with leading counsel, we are confident that Parliament is entitled under EU law to break the link between upstream and downstream activities in this way (as is already the case in Scotland) given the substantial environmental, social and economic justifications that exist. There would be consequential amendments to the various duties owed to upstream licensees.

43. Our proposed amendment envisages that Ofwat would be able, through its code making powers, to encourage incumbent companies to facilitate competition and innovation in relation to the making of these arrangements (whether among new entrants or between them and their own resource activities) with a view to reducing the costs to be passed on to retailers through the incumbents’ wholesale charges.

44. We also suggest that amendments are made to the new sections 66E and 117I. These would require Ofwat’s charging rules to prohibit wholesale charges from being varied as a consequence of the retail customer’s location. Embedding that principle within the statute gives Ofwat the fixed point it will need to resolve any tensions in the charging guidance and avoid the negative incidence effects of de-averaging for some customers.

45. Further, we suggest amendments are made to the provisions on discounting rules in sections 66EA and 117J. These amendments would only allow discounts to charges where overall costs are reduced. Together these final two amendments will help ensure that there is a single, company-wide, wholesale price except where a wholesaler and retailer are able to agree variations that are to the benefit of all customers.

The costs and benefits of a competition framework

46. In 2010, we analysed the costs of establishing the retail framework in Scotland and the cost benefits that had been achieved. We did not seek to place any value on the more tailored services that had been provided to businesses, or the environmental or carbon benefits from reduced water consumption.

47. The NPV of introducing retail competition in Scotland was £138 million. This increases to £333 million if we make a conservative estimate of the potential for dynamic efficiency. Summary detail of the analysis is in Appendix 1.

48. Appendix 2 contains an extrapolation of this analysis to England and Wales. It is based on conservative information on the benefits that could be realised by the companies in England and Wales. We concluded that the NPV of introducing retail competition would be around £750 million and could be as high as £2.5 billion if the potential for dynamic efficiency is also included.

49. This compares with the £190 million contained in Defra’s impact assessment for its favoured option. The Defra analysis includes dynamic efficiency. It also includes benefits accruing to households and water efficiency benefits, which are explicitly excluded from our extrapolation from real experience of having opened a market in Scotland.

December 2013

Appendix 1: Costs in Scotland

Cost item	Description	Present value of all costs and savings with no further incremental efficiencies beyond those already realised	Present value of all costs and savings with dynamic efficiency
Set up costs	· Commission set up costs were £5.7 million · Scottish Water Group costs were £13.6 million · Market operator costs were £3.2 million	-£22 million	-£22 million
On-going costs	· Regulator’s levy £1.2 million annually · Market operator annual costs £2.5 million · Additional cost of capital £0.7 million a year	-£119 million	-£119 million
Costs savings achieved	· On assumption that Scottish Water’s retail arm would have reduced costs at same rate as wholesale business, extra incremental savings are £8.1 million a year · No additional savings in wholesale business	+£279 million	+£279 million
Savings from dynamic efficiency	· Incremental retail efficiency (1% a year) · Incremental wholesale efficiency (0.05% a year)		+85 million +£110 million
Total	Net present value	+£138 million	+£333 million

Appendix 2: Extrapolation of costs to England  and Wales

Cost item	Description	Present value of all costs and savings with no further incremental efficiencies beyond those already realised	Present value of all costs and savings with dynamic efficiency
Set up costs	· Assumes companies each incur same size adjusted level of expenditure as Scottish Water · Ofwat’s costs are £13.6 million · Market operator’s costs are £10 million (can build on Scotland)	-£182 million	-£182 million
On-going costs	· Regulator’s levy £2 million annually · Market operator annual costs increase by £7.5 million a year · Additional cost of capital £6 million a year	-£529 million	-£529 million
Costs savings achieved	· Assume no mergers · Assume savings in England are 2/3 of those achieved in Scotland	+£1479 million	+£1479 million
Savings from dynamic efficiency	· Incremental retail efficiency (1% a year) · Incremental wholesale efficiency (0.05% a year)		+734 million +£988 million
Total	Net present value	+£768 million	+£2.5 billion