DEFRA and the Welsh Assembly Government have jointly published a consultation seeking views on recommendations made by the Cave Review and proposals for taking them forward in England (but not, for the most part, in Wales). This e-bulletin highlights key elements of this consultation.

The consultation can be found here. The deadline for responding to the consultation is 18 December 2009.

It's go for England; on hold for Wales

The consultation recalls that the UK Government accepted the recommendations of the Cave Review in relation to England in the 2009 Budget. The Welsh Assembly Government, by contrast, has said that it remains to be convinced that increased retail competition will deliver any measurable benefits in Wales. Welsh Ministers have still to decide how they wish to proceed with the recommendations contained in the Cave Review report.

Except where otherwise stated, the proposed legislative reforms and timescales referred to in this e-bulletin relate only to England – meaning, for this purpose, the area served by water and/or sewerage undertakers wholly or mainly in England.

Retail market proposals

Customer-facing retail functions account for approximately 10% of the water and sewerage value chain. DEFRA's proposals for the retail market include regulated access, replacing the cost principle, increasing the size of the retail market and legal separation of retail functions.

Regulated access

The current water supply licensing (WSL) regime is based on negotiated access – i.e. each new entrant has to negotiate terms of access with the relevant undertaker. DEFRA proposes to replace this with a regime based on regulated access. This will require a change in primary legislation to give Ofwat the power to develop standard market and operational codes binding on all market participants. Following a period of open consultation, Ministers will have a 28-day window in which require modifications to the codes proposed by Ofwat.

Draft clauses for this and certain other proposals are provided in a separate document sometimes referred to in the consultation as Annex D but listed simply as "draft clauses" on the DEFRA website.

Ofwat to set maximum access charges

The current statutory "retail minus" costs principle that governs the price payable by water supply licensees for access to incumbent undertakers' water supplies and/or networks will be repealed, despite the absence of a firm alternative proposal.

DEFRA proposes a change to primary legislation to give Ofwat the power to develop access pricing rules that will be binding on incumbent undertakers. Such rules will be able to specify the maximum charges that may be levied by undertakers. In developing these rules, Ofwat will be required to have regard to guidance issued by Ministers for that purpose.

Increasing the size of the retail market

It is proposed that secondary legislation will be amended to reduce the WSL threshold in England from 50 Ml to 5 Ml with effect from April 2010. (The threshold in Wales will remain at 50 Ml.) This will increase the estimated number of eligible customers in England from about 2,200 to about 26,000. Further work will be conducted before any decision is taken to reduce this threshold still further, possibly to zero.

DEFRA also proposes extending the scope of the WSL regime to include sewerage. Only those customers eligible to switch water supplier will be eligible to switch sewerage supplier.

DEFRA has no intention at this time of extending competition to the household sector.

Legal separation of retail functions

Despite the likelihood of significant transitional costs (including potential costs arising from breach of financial covenants by highly geared undertakers), DEFRA appears determined to press ahead with legal separation of undertakers' retail functions. Only water undertakers with fewer than 50,000 customers seem likely to be exempt, although this proposal is subject to consultation.

DEFRA is also seeking views on alternative models for achieving legal separation, including the option of requiring legal separation only of that part of an undertaker's business that offers retail services to non-household customers.

Other proposals for the retail market

DEFRA is further consulting on:

  • whether Ofwat should be given additional powers to undertake proactive investigations;
  • removing the restriction on in-area trading by licensed water suppliers related to an existing undertaker; and
  • giving Ofwat a power to produce a code specifying standards that undertakers and licensees must meet when providing information on service levels and prices.

But interestingly, DEFRA appears to have kicked into the long grass Cave's proposal to increase the engagement of consumers through "negotiated settlements".

Proposals for inset appointments

DEFRA's proposals for inset appointments include a more regulated approach and the removal of the large user criterion.

More regulated approach to insets

Pending any future introduction of the upstream and infrastructure reforms recommended by Cave to replace the inset regime (but which are not being consulted on here), both DEFRA and the Welsh Assembly Government accept Cave's recommendations to introduce a more regulated approach to inset appointments. These recommendations include:

  • the introduction of Ofwat-developed market codes and guidance that will set out the processes, roles, terms and conditions for market participants (it being intended that the codes and guidance will be given statutory backing and include a definition of an "unserved area" for the purposes of the regime);
  • new Ofwat-developed rules on charging by incumbent undertakers for supplies to inset appointees; and
  • new roles for the DWI and Environment Agency to assess the capability and capacity of applicants.

Certain aspects of the inset regime will therefore resemble the revised WSL regime, as described under the "Retail proposals" heading above.

Removing the large user criterion

Currently, one of three criteria must be satisfied before an inset appointment can be made, namely:

  • the appointment relates to a large user whose premises are each likely to use at least 50 Ml a year in England (250 Ml a year in Wales);
  • the appointment relates to an unserved site; or
  • the incumbent undertaker consents to the appointment.

DEFRA and the Welsh Assembly Government are minded to remove the first of these (i.e. the large user criterion) once all the WSL reforms, including appropriate new licences to enable entry to the range of upstream activities, are in place and shown to be effective. In the meantime, DEFRA invites views on reducing the large user threshold in England from 50 Ml to 5 Ml in line with the reformed WSL, although it does not itself think that this would be appropriate.

Ensuring customer benefits

At present Ofwat operates a "no worse off" approach to inset appointments, by which Ofwat expects customers of an inset appointee to be no worse off initially in terms of prices and level of service than if they had been supplied by the incumbent undertaker, with Ofwat retaining power to set specific price limits for the inset appointee at a later stage. DEFRA and the Welsh Assembly Government seek views on whether the current system provides sufficient benefit for customers over time or whether a more explicit test for entry is required.

Abstraction and discharge

The message from both DEFRA and the Welsh Assembly Government with respect to Cave's proposals for abstraction and discharge is very much "watch this space".

The consultation notes that further work needs to be done to explore the Cave Review's recommendations and how these might be given effect. In particular, further work will be undertaken to understand the costs and benefits of the proposals and the impact of charges on different business sectors and their end customers.

There are no firm proposals being consulted on. The consultation asks only whether there are measures that should be taken to help remove barriers to abstraction trading, ahead of any fundamental reform to the abstraction licensing regime.

Upstream proposals

DEFRA's upstream proposals include unbundling the combined water supply licence and extending the WSL regime to cover upstream sewerage services.

New water supply licences

DEFRA accepts Cave's recommendation to unbundle the combined water supply licence so that new entrants can specialise in different supply chain functions by offering different services to customers and other licensees within the WSL framework. The new upstream (or "wholesale") authorisation will authorise the licence holder to input into and distribute water through an undertaker's supply system for the purpose of supplying water to other licensees or to its own customers. Currently, the holders of a combined licence may only input water into a supply system for the purpose of supplying that licensee's own customers.

The Cave Review recommended that in addition to the unbundled combined supply licence there should also be "a network licence for those looking to provide infrastructure". The consultation invites views on how this network licence should operate in practice.

Draft clauses for the new water supply licences (other than the network licence) are provided in the separate "draft clauses" document on the DEFRA website.

New sewerage licences

The Cave Review recommended extending the WSL regime to sewerage services, including sludge treatment and disposal. This recommendation has been accepted by DEFRA. Licensees will be able to provide non-household customers with a full range of upstream and network services using sewerage undertakers' systems. Such licensable activities will include:

  • inputting sewage into an undertaker's system on behalf of its own customers or other licensees;
  • drawing off and treating sewage and/or sludge from an undertaker's system for its own customers and other licensees; and/or
  • disposing of and/or recycling treated sewage and/or sludge from an undertaker's system for its own customers or other licensees.

The sewerage element of the WSL regime will be broadly similar to that for the revised water supply regime.

Draft clauses for upstream and retail sewerage licences (but not Cave's proposed network licence) are provided in the separate "draft clauses" document on the DEFRA website.

Duties on sewerage undertakers

DEFRA and the Welsh Assembly Government believe that, as regards communication with public sewers, the rights of licensees and their customers should be no more or less than those granted to other dischargers of trade effluent. It is therefore proposed to introduce duties on sewerage undertakers that reflect their duties in relation to other dischargers. The consultation seeks views on whether it is necessary to make access rights for new entrants clearer.

Access prices for upstream and network markets

The Cave Review recommended:

  • with respect to the provision of water resource supplies to incumbents, replacing the costs principle with an ex ante access pricing framework based on the full economic cost;
  • that access prices would be determined by Ofwat at a water resource zone level based on a common methodology with reference to guidance from DEFRA and Welsh Ministers;
  • that Government should mandate the compulsory publication of water and sewerage supply costs at a water resource zone level and transport costs across undertakers' areas based on a common methodology.

DEFRA will produce guidance on access charges in line with Cave's recommendations. As regards the compulsory publication of costs, this is proposed to be implemented "through a provision in any market codes and included in undertaker's [sic] charging schemes which will be developed to regulate upstream markets". DEFRA will work with Ofwat and others in taking forward this recommendation and consider whether any guidance to Ofwat or a change of legislation is required.

Other upstream proposals

Among other things, DEFRA is also consulting on:

  • the need for the equivalent of a secondary supplies regime for spare sewerage capacity in secondary sewerage undertakers' areas; and
  • whether certain sewerage services provided by licensees should be designated as "strategic" where there is a substantial risk to the environment if the service was withdrawn;

DEFRA is also proposing new sewerage-related offences arising from extending the WSL regime to sewerage.

Reform of the water merger regime

The water sector has a special merger regime which requires an automatic reference to the Competition Commission in the event of two or more water companies, each with a turnover of over £10 million, "ceasing to be distinct". The purpose of the regime is to preserve Ofwat's ability to make comparisons between different undertakers as part of its price review process and when it carries out its other regulatory functions.

Mergers of legally separated retailers

The Cave Review recommended that, on the introduction of retail competition, retail only mergers should be removed from the special water merger regime altogether.

DEFRA recognises there may be some merit in allowing consolidation between retailers if it implements the legal separation recommendations. But in taking forward Cave's recommendation, DEFRA wants to be sure that the interests of customers who are not able to switch suppliers will continue to be protected once legal separation is complete. It is concerned that implementing the Cave Review proposal to remove the special water regime from retail only mergers entails a risk that such customers may no longer be adequately protected by regulation.

While DEFRA is minded to accept Cave's recommendation in this regard, it seeks views on how the jurisdictional "share of supply" test for the regular merger regime should be applied to the water market so that customers remain protected.

Merger jurisdictional threshold

The Cave Review recommended that the current £10 million jurisdictional threshold for the special water merger regime be raised to £70 million.

DEFRA seems uncertain about this proposal, noting the importance of Ofwat's ability to be able to make meaningful comparisons between undertakers. It states that the turnover threshold should be set at a level that incentivizes mergers where the benefits to customers of the merging companies from consolidation just outweigh the costs to all England and Wales customers from the detriment to Ofwat's ability to make meaningful comparisons between undertakers. This need not necessarily mirror the £70 million turnover threshold that applies in the regular merger regime. DEFRA invites views on the appropriate turnover threshold.

DEFRA agrees with Cave that the turnover threshold – and, indeed, the application of the special water merger regime – should be kept under regular review.

DEFRA also welcomes views on what alternatives models OFWAT could develop to replace comparative competition, and over what time period.

First stage test for water mergers

The Cave Review recommended the introduction of a first stage test for the water merger regime under which the OFT would consider the scale of any prejudice to the ability of Ofwat to carry out its functions arising out of a water merger prior to any reference to the Competition Commission.

The Cave Review noted that the OFT would need specific guidance on the implications of the merger and in particular the effect of the loss of comparators. The OFT would therefore be required to consult Ofwat as part of the first stage referral process. Currently there is limited transparency regarding the methodology used by Ofwat to evaluate the loss of a comparator.

DEFRA appears to have accepted the principle of a first stage test (although this is implicit rather than express). It recommends that Ofwat should be given a statutory duty to publish guidance on how it assesses the loss of a comparator. It also proposes that the OFT should be given similar remedy-making powers as it has under the regular merger regime to accept undertakings from acquiring undertakers in lieu of a second stage referral to the Competition Commission in circumstances where such undertakings would clearly address any concerns arising out of the potential loss of a comparator.

Innovation

In summary, with respect to innovation:

  • DEFRA is cautious about imposing a new statutory duty on Ofwat to support innovation in the water industry, as recommended by the Cave Review. It invites views on the recommendation and asks whether there could be an alternative approach which could incentivise innovation;
  • DEFRA appears less than enthusiastic about the Cave Review proposal to create a new national water R&D body;
  • There is more enthusiasm for Cave's proposal to require Ofwat to report to the UK and Assembly Governments every five years on the measures it has taken to support innovation in the sector, and how effective these have been. DEFRA suggests that a periodic evaluation obligation might extend to include competition as well as innovation, and be widened to cover the whole sector and not just Ofwat's actions.

Implementation of the Cave Review

DEFRA has said it will take a gradual, step-by-step approach to the implementation of the Cave Review's recommendations. The intention is to give the new regime a chance to prove itself and allow reform to take place at the right pace.