Ofwat is seeking to drive forward the debate about competition in water and sewerage services. Its recent consultation paper, which followed a disappointing response to its April "Outcomes" paper, was reinforced by a stakeholder discussion forum attended by Herbert Smith. In this e-bulletin, we focus on those options for change that seem most likely to be pursued by Ofwat.

On the 13 July, Ofwat published its Consultation on market competition in the water and sewerage industries in England and Wales. This consultation is the latest in a series of steps by Ofwat directed at addressing the absence of competition in the water sector despite the introduction in 2005 of the water supply licensing (WSL) regime.

This latest consultation is split into two main sections. The first sets out options for change to the current WSL regime. The second contains "options for longer term change".

In truth, the distinction Ofwat has drawn between changes to the WSL regime and longer term changes is artificial. The majority of options put forward under both heads would require legislative change to implement – and hence the support of HM Government. It remains to be seen whether the department concerned, DEFRA, will come out in support of all or any of Ofwat's ultimate conclusions. Historically, DEFRA has afforded a low priority to promoting competition. There have been some signs recently of a more positive approach: in June this year, Minister Ian Pearson made positive noises about ensuring greater competition. But Ian Pearson is no longer a DEFRA Minister and it is not clear whether his pro-competitive approach will be carried forward under the Brown government.

Repealing the Costs Principle

While Ofwat claims to be open minded about many of the options put forward in the consultation, it appears to have very clear views about one option in particular: doing away with the Costs Principle.

Under the current WSL regime, prices charged by incumbent water undertakers for access to their water supply system must be set in accordance with the "Costs Principle" (as defined in section 66E of the Water Industry Act 1991).

The Costs Principle is interpreted by Ofwat as a "retail-minus" method of access pricing. In broad terms, the access price is the prevailing retail price charged by the incumbent undertaker, minus what the incumbent saves from not supplying the target customer. Ofwat has concluded that the Costs Principle is a significant constraint on the competitive market because:

  • he WSL regime, as constructed, creates a new link in the vertical chain of supply that does not exist outside the WSL regime (ie, the concept of a wholesale supplier of services to retailers rather than end customers). This, Ofwat concludes, is likely to introduce additional costs;
  • the Costs Principle requires the licensee to pay all of these new transaction costs without the possibility of reducing other costs and
  • inefficiencies that are currently embedded in the retail price; and
  • the licensee must also pay the incumbent's unavoidable retail costs as well as its own retail costs.

In an open attack on the legislative regime created by DEFRA in 2003, Ofwat complains that the existing WSL regime frustrates the potential for new entry by protecting incumbent water undertakers fully from the financial impacts of entry by licensees and by preserving the existing retail pricing structure (which includes regional averaging).

Ofwat's proposed solution is to replace the Cost Principle with legislation that sets out the policy framework for the development of competition while leaving Ofwat, as the economic regulator, to implement access pricing regimes that meet those principles. In Ofwat's view, appropriate legislative principles might include:

  • cost reflectivity;
  • unbundling;
  • non-discrimination between an incumbent's own notional downstream arm and its downstream competitors;
  • efficient operators to recover their reasonably incurred costs for the provision of the services; and
  • incumbents to be exposed to market risks and incentives for services that are not part of the core monopoly.

The suggestion that prices should be cost reflective is controversial. If adopted, it may sound the death knell for regional averaging. That is likely to lead to cherry picking by new entrants with the result that prices rise for those customers that remain with the incumbent water undertaker. It is difficult to see how such a result would benefit those customers that are not eligible for competitive supply and therefore have no option but to remain with the incumbent.

Indeed, while Ofwat might criticise the Costs Principle for protecting incumbent water undertakers from the financial impacts of competition, it may be compelled to recognise that it is certain classes of customer that may lose out most from the repeal of the Costs Principle.

Other changes to the existing regime

Of the other options for change to the existing WSL regime addressed in the Ofwat consultation, two have greater prominence:

Ofwat would like to see a reduction to the current eligibility threshold for competition. At present, only non-household customers that consume at least 50Ml of water per annum are eligible for competition. This equates to approximately 2,200 customers. Ofwat has concluded that the current eligibility threshold is likely to be a significant barrier to the development of competition in the water sector. It therefore recommends an eligibility threshold reduction, although it has yet to decide to what level the threshold should be reduced.

Ofwat has concluded that competition in retail sewerage is viable and should be included within the WSL regime. Each of the options for change summarised above would require amendments to primary and/or secondary legislation.

Cost transparency and accounting separation

The second part of Ofwat's consultation considers approaches for promoting competition in water and sewerage that do not build on the existing WSL regime.

At the stakeholder discussion forum held in Birmingham on 20th July, it was clear that Ofwat is going to push hard for greater cost transparency on the part of incumbent water undertakers. As well as facilitating competition, Ofwat considers that transparency in cost allocation will underpin many of Ofwat's key strategies. A better understanding of where costs lie will help demonstrate where markets are contestable and where they are not.

In line with this view, it seems likely that Ofwat will come out in favour of accounting separation. No doubt one of the attractions for Ofwat is that accounting separation can be achieved without the need for legislative change and hence without the need for support from DEFRA.

It is not clear whether the split, if it comes, would be along wholesale / retail lines or whether Ofwat would push for more detailed separation (for example, distinguishing between "production" and "transportation" costs). It would certainly be more straightforward to achieve the former than the latter, although not without difficulties and costs.

One question is whether pursuing accounting separation along retail / wholesale lines will ultimately encourage Ofwat to push for structural separation. Such a move would require substantial changes to primary legislation.

For the sake of completeness, other options addressed by the Ofwat consultation include:

  • Household competition
  • Competition in the "production" of water
  • Competition in abstraction
  • Next steps

Ofwat plans to publish in December a response to comments made on this consultation paper. This response will set out next steps, including changes to the current WSL regime that Ofwat proposes to develop. A consultation on wider changes to competition in the water and sewerage industries is planned for Spring 2008.