What competition already exists in the English and Welsh (E&W) water industries?

There are two basic types of regulated competition in the E&W system, both of which are at the customer-facing end of the supply chain and concern only water (not wastewater):

1. Inset Appointments

These allow a company to take control of and develop a defined geographic area of the water network provided certain conditions are met (for example, that each of the customers served by that area of network use more than 50Megalitres (ML) of water a year, 250ML if they are based in Wales). The appointee will then physically provide those customers with water and act as their retailer, managing complaints / billing etc. The appointee is likely to purchase the water it needs to serve its customers from other water companies, using their infrastructure to transport the water as necessary.

There have been 17 inset appointments granted so far (and an 18th is being considered) the majority of which are extensions of existing appointments of incumbent water companies.

2. Water Supply Licences

There are two types of water supply licence, both of which mandate the provision of retail services to customers that use more than 50ML a year. However, unlike inset appointments, neither type authorises control of water infrastructure, or necessarily relate to specific geographic area. The two types of water supply licence are: (i) a retail licence which authorises retail functions only, in which case the licensee takes no part in the physical provision of water to its customer and has no choice but to take the water supply from the water company to whose network its customer is connected; and ii) a combined licence which, in addition to the performance of retail functions, authorises a licensee to purchase water from any water company and have it transported to its customer through the network that directly serves its customer. Seven water supply licences have been granted but no customer has chosen to switch to be served by a water supply licensee.

It is generally accepted that competition has not developed as it could have done. There are a number of factors behind this, of which the application of the 'costs principle' is arguably the most important. That principle is shorthand for the rules by which the prices to be paid by appointees or licensees for the wholesale provision of water by the incumbent water companies is to be calculated. Recent applications of that principle show that it can stifle competition by leaving no retail margin.

What does Cave recommend and what impact would that have?

The Cave review's interim report is clear that competition does have a role to play in the English and Welsh water industries but recommends that it is developed gradually. The interim report is more confident about the introduction of competition to retail services than competition in other parts of the supply chain and suggests that such competition could be developed in the following way:

  • Thresholds. That the threshold limits for contestable customers are reduced to 5ML as soon as possible. This would create a market of about 28,000 customers across England and Wales. Once systems have developed (perhaps around 2012) it also recommends that the threshold be reduced further to 1ML, which would create a market of about 162, 000 customers and that the extension of competition to wastewater services be considered.
  • Business Separation. That all water companies are required to legally separate their retail functions. This would not necessarily mean that water companies would be forced to sell their retail subsidiaries but it would increase the prospect for takeovers / mergers of those retail businesses. Once the retail or any other part of the supply chain has become properly contestable, the review also notes that the special merger regime that currently applies should be reformed or abolished.
  • Costs Principle Reform. That new legislation reforms the costs principle to allow wholesale charges to be set in a way which both complies with competition law and allows efficient retailers enter the market and compete with incumbent companies. This would be very likely to increase the retail margin that is available.
  • Access Codes. That a system of national codes regulating access to and operation of the water systems be developed (with legislative backing). This would harmonise the terms that appointees and licensees have to sign up to and would both reduce the cost and complexity of setting up as a competitor to the incumbent companies and would make it easier for those competitors to serve different sites / customers across E&W.

Finally, the interim report notes that competition in other parts of the water supply chain (for example, in water treatment services) may be possible but that the risk that changing the current monopoly system would increase the cost of debt to those water companies is greater in relation to those other elements. In part, this is because the current cost of debt is influenced by a nominal regulatory capital value that, ever since privatisation, has been less than the water companies' true capital value. The report therefore recommends that the work currently being undertaken by Ofwat and the industry to assess such financing implications is built on and that the potential for upstream competition is explored further.

What is likely to happen next?

The final Cave report is expected in the Spring. The Chancellor's statements in his recent pre-budget report suggest that the Government supports these interim proposals and, should the final report recommend similar steps, new legislation would be introduced to implement them. At present, the planned Floods and Water Bill, which is also expected to be introduced in the Spring, seems like the most likely vehicle for that change.