The introduction of competition into the water industry in England and Wales has been on the agendas of the economic regulator for the water and sewerage industry in England and Wales, OFWAT, and the UK Government for a number of years. However, to date, the development of competition in the water industry has been slow and unsuccessful. Under the current regulatory regime the possibility of competition is confined to a small number of business customers and the scope for any competition is restricted by current legislation.  

The Cave Review  

A year ago, the Government asked Professor Martin Cave to undertake an independent review of competition and innovation in the water industry in England and Wales with the aim of recommending changes to the current legislation and regulation of the industry, so that the industry is prepared to meet future challenges, such as climate change, rising demand, pollution and increased environmental standards, and to deliver benefits to consumers and the environment.  

On 22 April, the Department for Environment, Food and Rural Affairs (DEFRA) published Professor Cave’s final report: “Independent Review of Competition and Innovation in Water Markets”. The report sets out a number of recommendations to reform the current legislative and regulatory regimes for the water sector in order to encourage innovation and increase competition - both “head-to-head competition” where companies seek to replace each other to gain market share, and “collaborative competition” where groups of companies work together to attract new customers.  

The Review does not recommend a “one-size-fits-all” approach for the reform of the water industry in England and Wales, since it recognises that different circumstances prevail in different areas, and states that some recommendations would be more appropriate for certain areas than others. Moreover, the Review has adopted a step-by-step approach to the proposed reform. It would then be for the UK and Welsh Assembly Governments to consider the costs and benefits of further change based on advice from OFWAT and experience to date.  

In particular, the Cave Review sets out proposals for:  

  • Major changes to the regulatory regimes for abstraction and discharge

The Review states that the current abstraction framework “fails to ensure that water goes to those who value it most or that it is used efficiently”, whereas the current discharge regime “does not ensure that wastewater is treated or released efficiently”.  

Professor Cave recommends, amongst other things, that abstraction licences and discharge consents should be fully tradeable (subject only to modification for direct environmental impacts, and, in the case of abstraction licences, subject to the impact on other users from a change of use or location). Where licensed abstraction levels are unsustainable, there should be a process for returning licences and, possibly, a scarcity charge. In the longer term, limiting the duration of abstraction licences could help deliver environmental benefits.  

  • The step-by-step introduction of competition in upstream markets

Currently, the upstream markets - i.e. the provision of water and wastewater treatment; the treatment and disposal of sludge; and the water industry’s infrastructure - are, according to the Review, dominated by the “local, vertically integrated monopoly incumbents”. The scope for innovation in these markets is therefore primarily determined by OFWAT’s system of economic regulation.  

The Review considers that innovation in these markets would be stimulated by the introduction of greater upstream competition and, to this end, proposes a step-by-step approach to minimise adverse effects on investment and customer bills.  

As a first step, the Review recommends reforming the Water Supply Licensing regime to ensure that it works more effectively and is supported by a framework of economic purchasing. For example:  

  • incumbent water companies would be obliged to procure the best value of water, wastewater and infrastructure supplies;
  • the current supply licence would be “unbundled” and two new licences would be created: (i) an “upstream” licence for companies wishing to introduce raw or treated water into an incumbent’s network; to remove and treat wastewater; or to treat and dispose of sludge from it; and (ii) a “network” licence for companies seeking to provide infrastructure. Note that the Review does not propose that existing licences for incumbents would be affected; and  
  • water companies would be required to publish supply costs of water and wastewater and transport costs based on a common methodology.  

In the longer term, the Review suggests that an independent entity contracting for delivery of water and wastewater services at best value could deliver greater benefits for customers and the environment. However, since the cost benefit ratio for this proposal is currently uncertain, the Review notes that, in the short to medium term, regulation will continue to be important in promoting efficiency and innovation in water and wastewater treatment.  

Further decisions as to when and how to extend competition would be for the UK and Welsh Assembly Governments. However, the Review stresses that any legislative changes should be flexible enough to allow the industry to adopt different models across the country and over time.  

  • The introduction of retail for, potentially, all non-household customers.

At the moment, those non-household customers using more than 50 megalitres of water a year are able to choose their water retailer via the Water Supply Licensing regime. However, as these retailers are unable to offer attractive terms, the Review states that the vast majority of networked customers remain supplied by their local incumbent with prices and quality standards determined by OFWAT.  

Professor Cave is of the view that the current 50 megalitres threshold should initially be reduced to five megalitres a year and states that there may be benefits in abolishing the threshold for non-household customers altogether on the introduction of “accompanying changes” to the retail framework. Such “accompanying changes” would include: the replacement of the costs principle, which determines the discount suppliers obtain from the incumbent for using their own resources, with an ex-ante access pricing framework; the introduction of national operational codes and systems biding on all market participants; and the legal separation of the retail business and a water company’s monopoly activities.  

In relation to the possible legal separation between a company’s retail business and its monopoly activities, the Review suggests that it may be appropriate to introduce a threshold below which the Government would not order companies to separate their retail operations from their monopoly activities. The case for extending retail competition to household customers is “weak”, according to the Review.  

The Review recommends that OFWAT, having consulted stakeholders, provides the UK and Welsh Assembly Governments with further advice on the costs and benefits of any of these proposed changes.  

  • Significant amendments to the existing special water merger regime

The current special regime applicable to mergers in the water industry requires an automatic reference to the UK Competition Commission for every merger involving a water company with a turnover in excess of £10 million. The Review considers that, while this supports OFWAT’s regulatory approach based on comparative competition, it also “reduces management incentives, limits the scope for the transfer of best practice between companies and increases financing costs”.  

According to the Review, the need for comparator companies will diminish in the future as a result of the introduction of other methods for assessing company performance, the introduction of accounting separation and the development of retail competition.  

Therefore, the Review recommends that the reference threshold should be raised to £70 million and applied to the smaller of the merging companies. The Office of Fair Trading, as opposed to the Competition Commission, should be undertaking the initial assessment of a proposed merger based on advice from OFWAT. Taking into account both an assessment of the loss of a comparator and any other competition effects arising from the merger, the Office of Fair Trading would then decide whether the merger needed to be referred to the Competition Commission for further investigation or not. In other words, the mandatory in-depth review regime would be abolished.

  • Amendments to the arrangements for the grant of inset appointments

The Review identifies significant barriers to entry as the main reason why the current system for inset appointments - the ability of certain users to replace the local incumbent water supplier with an alternative supplier - has not been able to “guarantee” the potential benefits of introducing consumer choice, lower prices, better service and a reduced environmental impact.  

In the long term, the Review suggests that inset appointments should be incorporated in the reformed upstream framework to enable inset appointees to provide upstream, infrastructure and retail services to a much wider market on an equal footing with incumbents and other providers.  

For the interim, the Review recommends a number of measures that would remove the existing barriers to entry which it identifies, including:

  • introducing a framework of access, binding on all market participants, to support the appointment process as well as streamlining the appointment process;
  • allowing inset appointees to specialise in the provision of upstream, infrastructure or retail services, subject to a last resort obligation;  
  • introducing binding common codes and systems for supply; and  
  • reforming the system of supply prices so that an efficient inset appointee would be able to make a fair return whilst contributing to the local incumbent’s supply costs. The supply price should also recognise any structural differences in the incumbent’s and appointee’s costs.  
  • The national promotion of research and development and innovation

The Review concludes that the current framework of economic regulation does not always encourage significant investment in research and development or innovation.  

Therefore, it recommends that a national water research and development body is created that would be supported by funding of about of £20 million a year. The UK and Welsh Assembly Governments, the industry, the regulators, suppliers and other stakeholders should agree a shared research and development vision for the industry and should coordinate their work.  

Finally, the Review recommends that OFWAT is given a statutory duty to promote innovation. OFWAT would be under a duty to report to the UK and Welsh Assembly Governments every five years on the measures it had taken to support innovation.  

Next steps  

The UK Government welcomed the findings of the Cave Review in its Budget for 2009 and announced its next steps in relation to the recommendations made. The Government intends to consult with stakeholders on the implementation of:  

  • the legal separation of large companies’ retail operations from their natural monopoly activities.

This would follow further advice from OFWAT whether it would be appropriate to introduce a threshold below which the Government would not order companies to separate their retail operations from their monopoly activities;  

  • a package of further reforms to the upstream Water Supply Licensing regime, including replacing the cost principle for supplies to incumbents, retailers, or large customers with criteria to be determined by OFWAT;
  • reforming the special mergers regime for water; and
  • reforming the inset appointments regime.  

The Government will also discuss with stakeholders the Review’s recommendations to improve innovation in the water sector.  

The Government stated that it agreed with the Review’s conclusions that, without further consultation, there is currently not a convincing case for extending competition to households and introducing retail competition in the water industry. Therefore, DEFRA intends to issue a consultation on the introduction of retail competition in the water industry in the next few months - before the summer recess - so that its outcome can be covered by the final Floods and Water Management Bill1. This consultation will also set out in detail how the Government intends to take forward the rest of the Cave Review’s recommendations.