2005
Starter’s orders
By
Stuart Cook and Mark Caines of PA Consulting Group
Utility Week,
21 October 2005
Water competition starts on stronger ground than the electricity and gas sectors did, say Stuart Cook and Mark Caines. But does it have the legs?
This autumn will see the implementation of new arrangements in the water industry that will allow the competitive supply of water to large, non-domestic customers.
Competition in water supply is not a new idea. Existing legislation allows companies to provide competitive supplies by obtaining inset appointments. These appointments permit a competitor to replace the incumbent in part of the incumbent’s appointed geographic area. However, to date, there have not been enough inset appointments to make a significant competitive impact on the industry (by 2004, Ofwat had made only 11 inset appointments).
The arrangements to be implemented on 1 December bring competition to all non-domestic customers in England and Wales consuming at least 50 megalitres (Ml), of water a year, reducing the existing threshold from 100Ml in England and 250Ml in Wales. This doubles the number of customers that can take advantage of competition, to around 2,200.
Some would argue that this still delivers only a limited expansion of competition. Indeed, when the proposals were first announced, many in the industry put their retail market programmes on hold. However, the arrangements will provide far greater flexibility for customers, who will now have the right to buy water either from an integrated water company or a specialist water retailer. Moreover, they represent a change that will bring water closer into line with energy markets, which have been progressively liberalised around the world over the last 15 years.
Given this background, it is appropriate to ask whether the new arrangements will provide a platform for extensive water competition in the future. In other words, will it be a success? The answer is a qualified “yes”.
Water has already avoided the mistakes made in retail energy markets. In some cases, the failure was in establishing appropriate industry governance arrangements. This was the problem that bedevilled the 1994 liberalisation of the electricity market in England and Wales. There was no forum to address changes that resulted from the introduction of retail competition, and there was no framework for the market that had been agreed by all parties. These failings are judged to be a major factor behind the delays and confusion that accompanied this phase of deregulation.
In Germany, although technically the electricity market was liberalised in April 1998, there was only modest customer switching at first. The industry was highly fragmented and lacked standardised arrangements to support competition – a model that increased administrative costs for retailers, there was no secure, simple consistent design.
In the fully opened Swedish electricity market, initial switching rates were low because all customers were required to pay for the installation of a new meter before they were able to switch. The costs of doing this were often prohibitive.
The implementation of competition has been troubled in most instances where it has relied on complex IT systems. The most recent example of this problem is very close to home – in Northern Ireland, where the introduction of competition to non-domestic customers is being hampered by IT system delays.
Another problem has been that in order to compete effectively, retailers need access to incumbents’ networks and to supplies at an appropriate price. Wherever this has not been possible, the evolution of competition has been slowed. This is the problem that hampered competition in Spain, where the structure of the electricity industry forced suppliers to buy on the spot market with few options to hedge the trading risks. In Germany, distance-related transmission charges created local monopolies.
The water industry appears to have sidestepped these pitfalls. The industry has worked hard to establish appropriate industry groups to debate and formulate an agreed framework for the new regime. There will be a common protocol to support customer transfers across the market. Barriers to entry are being reduced through the new arrangements, and specifically, customers will not be required to pay for the installation of metering where they do not already have it. At least in the early stage of the market, the industry has established arrangements that do not rely on the deployment of complex IT systems. Finally, the proposed access pricing regime has been designed to strike a balance between flexibility, simplicity and price certainty. Whether it has succeeded in this will become clear as the market develops.
Yet, the initial phase of liberalisation is unlikely to attract vigorous competition. A lesson from electricity and gas retail competition is that the market for the larger customers is driven almost entirely by price. Large customers have the most to gain by securing low cost supplies and also have the greatest resources to turn this desire into reality. However, in comparison with the electricity and gas markets, there are fewer opportunities for water retailers to differentiate themselves in price terms.
The proposed access regime means that the vast majority of costs are non-controllable from a retailer’s perspective. The access price paid to the incumbent will be based on a 'retail minus' approach. In essence, this charge is calculated by subtracting any costs that can be avoided, reduced, or recovered through other means from the retail charge that would have been levied by the incumbent. As a consequence, a competitive retailer can undercut the incumbent, only if it has access to cheaper water resources (which will only be true in isolated instances) or if it has lower customer service costs. The latter are only a small proportion of the overall bill, and therefore unlikely to give rise to material price differences.
In the energy markets, retailers’ competitive activities are frequently directed towards 'cherry picking' customers whose tariffs do not reflect their underlying costs of supply. However, two factors suggest this activity will be less intensive for water. First, according to The Department for Environment, Food and Rural Affairs, cross subsidies have largely been unwound for large users. Secondly, and perhaps more importantly, the 'retail minus' approach to access pricing should act to lock-in tariff anomalies. Where a user’s existing tariff is too high, the access charge paid by competitive retailers will also be artificially high.
There may be benefits in extending competition to domestic water customers. The electricity and gas experience suggests that competition is at its most vigorous among the largest customers - switching activity diminishes with customer size. However, there is evidence to suggest that the water market might look rather different. In fact, there are good reasons to think that if competition were introduced in the domestic water market, it might be more vigorous than for large, non-domestic customers.
A number of domestic energy retailers have sought to extend the range of services that they provide to their customers. This is typically for three reasons. First, there is evidence of a relationship between the number of products sold and reduced customer churn. Second, there is scope to secure cost savings where customers take more than one service from a retailer. Third, additional products provide a way for energy retailers to protect their core margins through discounts to those additional products.
However, energy retailers have often struggled to find products that fit naturally with their core offerings. Generally, the further they have strayed from this core offering, the less successful their endeavours have been. For example, forays into telecommunications and financial services products have been less successful than retailers hoped. This is also the case for many water companies who have sought to exploit their customer base.
Water however, could well be regarded by domestic customers as a more natural bedfellow of electricity and gas and it is a product that could be sold by energy retailers with only limited adjustments to their existing systems and processes. Furthermore, the relative lack of volatility of wholesale prices makes water a less risky proposition than either gas or electricity – removing the need for investment in upstream assets.
For these reasons, a number of domestic energy retailers have already expressed an interest in extending their offerings to include water. The pressure to extend the arrangements to domestic customers could well increase. However, the question of domestic water competition is one of economics and politics. If there is a compelling case that competition will provide greater benefits to residential customers than enduring regulation, if policy makers can be assured that competition will not undermine social, economic and environmental objectives, and if the costs of implementing such arrangements can be effectively managed, then it may happen yet.
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