Water UK

Competition in the water sector must bring added value

12/09/08

Competition for customers is not happening in the water sector much, even if other forms of competition may be thriving. Various culprits are fingered: Parliament and Defra (for passing unworkable legislation); the water industry (for obstruction); Ofwat (for being ineffective); the unique circumstances of the water industry (for invalidating competition models in other utilities); and new entrants (for lack of truly creative proposals). The announcement of the independent Cave Review on competition and innovation, commissioned by the Treasury and Defra, is therefore a welcome step forward.

The Cave Review’s terms of reference require it to start from the objectives which government has for the water industry and water competition, namely to encourage sustainable innovation and to benefit customers and the environment. The recognition that competition is a means to these ends begs the question of which forms of competition are most likely to deliver them and, critically, by which rules water competition should develop so that they are achieved.

For water competition to be productive and sustainable, it needs to ensure that competitors succeed because they bring added value to the industry, not because they find a way round the current regulatory systems administered by Ofwat and the EA. There are good and bad forms of competition.

Sharing the financial burden

The current regime imposes heavy environmental, social and health-related obligations on the water industry. Critically, it also ensures that water customers share the financial burden of improving our society and its water environment. The rules of water competition need to ensure that this financial burden continues to be shared and no competitor wins customers merely because it exempts them from contributing financially to these goals. The terms on which competitors gain access to the parts of the water supply chain that remain a monopoly – most essentially, the networks of pipes – need to be designed accordingly. It is important that competition should not be accompanied by a re-balancing of charges between customers – a zero-sum game – because that would be arbitrage competition, which is inefficient and of no eventual benefit to customers.

Ofwat reports that more than half of the current water service price reflects the provision of monopoly services. Therefore, competition rules in line with the government’s objectives have already fixed more than half of the price that competitors can charge the customers they have persuaded to switch.

New entrants therefore need to differentiate themselves and provide additional value with less than half of the water supply chain to play with. Beside competition for retail services (10 per cent of supply chain), competitors may hope to win customers with the added value they provide at the other end of the chain, in the provision of raw or potable water. This depends on the way the Environment Agency provides abstraction licences and encourages trading in them. However, its own regulatory objectives may stand in the way of competitors because it is more likely to withdraw abstraction licences which become available for use by competitors than to leave these licences available for trading.

Step change

For competition to succeed, it is not just the way the EA regulates access to water resources that needs to change. There also needs to be a step change in the way Ofwat promotes competition. Instead of blaming the current access pricing regime, which has the merit of protecting customers from arbitrage competition, Ofwat should identify the access pricing regime that would be consistent with the Government’s objectives and the protection of customers. Its recent consultation document fails in this respect and Ofwat seems content with asking Parliament for wide-ranging enabling powers.

Ofwat also needs to recognize that one of the biggest impediments to competition is not the access pricing regime determined by Parliament but transaction costs. Ofwat should understand the realities of negotiating commercial contracts and accept that it ought to have a pro-active and enlightened role in reducing avoidable transaction costs, many of which will arise similarly with each of the 22 water companies in England and Wales. Water UK’s own experience in facilitating common carriage agreements is that the negotiation of such agreements requires detailed information-sharing often about matters not previously considered. Such exchanges are best carried out when they have been anticipated with the principles and rationale agreed well before the heat of negotiation. For water competition to be successful, stakeholders’ behaviours need to change, including that of regulators.

NOTE
Versions of this article appear in Utility Week 12 September and on the magazine's website. Changes made during editing caused inaccuracies in the print version which will be publicly corrected in the next edition of the magazine.

Jeanne Golay
Economic Regulation Adviser