Monday 17 March 2008
Hayley Purcell
Ofwat
Centre City Tower
7 Hill Street
Birmingham
B5 4UA
1 Queen Anne’s Gate
London SW1H 9BT
Telephone 020 7344 1844
Fax 020 7344 1866
e-mail contact@water.org.uk website
www.water.org.uk
Pamela Taylor
Chief Executive
Dear Hayley,
This is Water UK’s response to the second part of your consultation
launched on 20 December. It comments on the second part of your
competition review, which looks at water competition beyond the
framework created by the current WSL regime and, indeed, beyond that
outlined in the Government’s 2002 consultation. We intend these
comments to help you develop your Spring consultation and to contribute
to the Government’s review of competition which it recently announced.
We are grateful to Ofwat for extending the consultation deadline, which
has enabled us to discuss a draft of this response with industry members.
While Water UK’s response has their support, water companies have
differing perspectives on competition, as it should be, and will respond
individually, in line with their specific contexts and strategies.
Water UK position
Water UK supports competition that benefits the generality of customers
by creating a framework for the water industry that encourages and
rewards efficiency and innovation. We therefore support Government’s
objectives for water competition that Defra has reaffirmed in its recent
‘Future Water’ strategy document. We support the principle that the
development of a water competition regime must protect the interests of
household customers and vulnerable ones in particular.
We were pleased to attend the competition roundtable which Ofwat
organized on 19 February. We found it a helpful discussion of
fundamental questions regarding the drivers of competition and the
objectives that could be assigned to it. We think such a roundtable, like
other collaborative processes, is a useful way for Ofwat to ensure that
water companies and other parties gain ownership of its work.
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Introduction
We have responded in some detail to proposals for changing the WSL
regime in our September 2007 response to your July consultation, and in
our February response to the first part of your December consultation. In
this response, we will focus on Ofwat’s proposals for four significant
changes to the framework designed by Government for water
competition:
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Access pricing
Accounting separation
Vertical integration of water companies
Household competition
We comment on these four topics below. We begin with a comment on
the method of working which Ofwat should use in its work to develop
competition.
Ofwat’s approach in developing competition
We believe that Ofwat’s work would move forward better if Ofwat were
to involve the industry much more than it does now. Our members,
inevitably, hold much information of use to the development of
competition. While Ofwat has been consulting on its thinking, it has not
shared – except in the most general terms – the work it has commissioned
throughout 2008. For this reason, it has failed to obtain informed
feedbacks from water companies, which could otherwise help it assess
information better. The recent accounting separation was an instance
when water companies provided valuable information but it was,
unfortunately, an isolated example of collaboration. Generally, if Ofwat
involved water companies in its work more, it also would be in keeping
with its duty in Section 2 of the Water Industry Act 1991 to have regard
to the principles of best regulatory practice.
We think that Ofwat should share the findings of its consultants or its
own analyses (on cost allocation, accounting separation, access pricing
and market analysis, for instance) with the industry. Also, it should
develop its collaborative working with the industry. We were surprised
to read in Section 2.1 of its consultation that it is working with industry
groups to improve the cost identification underlying ARROW costs.
While we understand that consultants are working on the topic, nothing
has been shared with the two advisory groups supporting Ofwat’s work
on competition (Operations and Monitoring Advisory Groups). We think
that Ofwat is limiting its effectiveness unnecessarily.
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We think that Ofwat should publish a ‘road map’ of its anticipated work
on competition and discuss it with its stakeholders. Such a ‘road map’
would be particularly useful to identify and show interdependencies:
Some of Ofwat’s regulatory decisions depend on legislative changes, for
instance. The ‘road map’ need not necessarily contain dates, since some
are not in Ofwat’s gift, but it would show a timeline which could help all
parties contribute to Ofwat’s work and collaborate with it more
effectively.
Access pricing
Ofwat proposes that Parliament should not be responsible for determining
an access pricing regime – as it has done in the WSL regime – but that
Parliament should enact general principles only, leaving it to Ofwat to
determine pricing regimes consistent with these principles. We do not
support this approach for two main reasons:
 An access pricing regime must reflect and express the objectives
that govern the water industry. These are given by Parliament in
primary legislation and determine Ofwat’s objectives as well as the
industry’s. Parliament must be responsible for enacting access
pricing principles which are consistent with the objectives it sets.
We do not think that Parliament should delegate as much as Ofwat
is proposing.
 We do not believe that a set of principles, as proposed by Ofwat,
would be sufficient to guide Ofwat in its implementation of
Parliament’s will for the industry. The principles proposed by
Ofwat so far can be interpreted in many ways and do not provide a
sufficiently structured framework, either for new entrants or
undertakers. We have shown in our September 2007 and February
2008 responses (relevant extracts attached) that the principles
proposed by Ofwat may often not be consistent with the current
objectives that Parliament or Government have given the water
industry – some of which have been recently emphasized in
Defra’s ‘Future Water’ document – and are insufficient for
guidance purpose in any case.
We agree that the Costs Principle has not supported effective retail
competition. We have already said that we would support Ofwat’s efforts
to investigate whether a different framework for retail competition might
work cost-effectively. However, for common carriage competition, we
believe that indicative prices published by water companies show that the
Costs Principle is consistent with entry by new entrants who actually
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contribute water to networks which are short of it. The Principle allows
entry into the water industry where entry is desirable and contributes to
the water industry’s ability to serve its customers while ensuring that
ineligible customers do not suffer increased prices because of
competition. Government has reaffirmed the need to ensure that noneligible customers should not be disadvantaged by competition and we
think it important that the objectives for water competition be consistent
with the other objectives given the industry by Parliament.
Accounting Separation
We have always supported Ofwat’s objective of understanding costs
better and, as we said earlier, we are glad that Ofwat held a workshop on
the matter at the end of January, in which we and industry members took
an active part. We believe that the water industry and its consumers can
only gain from a better understanding of its costs, not least because it
enables it to explain to its stakeholders why bills increase as they do; it
also allows the industry to develop its relationship with its customers
because customers may understand better the services they receive in
exchange for what they pay.
On costing, we have specific concerns relevant to how cost separation is
introduced:
 Cost separation in a sector like water will, in most cases, entail
complex and somewhat arbitrary rules of allocation and
apportionment. It is important that all stakeholders recognize that
business unit costs are not true cost data but the result of the
application of somewhat arbitrary rules. Ofwat needs to undertake
a convincing and effective communication programme to explain
that the eventual cost allocations which the project will yield are
arbitrary to some extent. Stakeholders must be clear that the cost
data produced by cost separation are not the only way of describing
costs.
 There is a risk that companies are expected to re-organize their
activities so as to facilitate the measuring and allocating of costs.
This might produce more objective cost data but only at the
expense of increasing cost overall, which cannot be desirable.
 The proposal that costing separation, let alone accounting
separation, should be implemented in 2009-10 is not realistic. We
believe that a rushed job will almost certainly produce misleading
information. Moreover, Ofwat needs to take the burden of PR09
work on water companies into consideration.
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At its January workshop, Ofwat explained its intention to go much further
than cost separation and create separate accounting entities for various
parts of the supply chain: the project is to determine the prices at which
each entity buys or sells services upstream and downstream. We think
that such a project is a significantly different exercise from costing
separation. The determination of prices between business units, including
balance sheet and cash flow considerations, is crucial in maintaining and
enhancing the efficient operations of the industry. Moreover, the
principles that apply to prices between business units depend on the
extent to which end-user prices should remain averaged, as they are now,
or should be de-averaged. It is important that the principles that will
apply to the determination of prices are considered, debated and
consulted on at some length, including their consequences for end-user
pricing.
Prices need to be designed in such a way as to maintain – for a
disaggregated model of the industry - the incentives that exist in a well
managed integrated entity. At certain points of the supply chain –
depending on the chosen model of competition – prices need to reflect the
marginal cost of decisions taken by agents elsewhere in the supply chain.
If prices are based on marginal considerations – to support an efficient
supply chain – it is also necessary to consider whether and how each
business unit is able to recover the totality of its efficiently-incurred costs.
Links with access pricing also need to be considered. Prices that embody
these considerations cannot be improvised and we are concerned that
Ofwat does not seem to recognize the importance of the work in hand. If
it was undertaken too lightly, the potential for Ofwat presiding over the
provision of seriously misleading information is such that regulatory risk
would be significantly increased for incumbents and new entrants alike.
Moreover, that could be counter-productive in promoting competition.
Vertical integrations of water companies
Ofwat announced at its January accounting workshop that it thought it
right to consider the vertical separation of water companies even if
Government’s objective has been so far to maintain vertically-integrated
companies. Defra has now indicated, in ‘Future Water’, that the
“regulatory regime for water in England and Wales allows significant
scope for flexibility in business models and different ownership
structures.” The question is whether Ofwat’s work on accounting
separation, which attempts to mimic vertical separation, beyond cost
separation, is a good use of resources and customers’ bills.
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We think that the separation of retail functions from other activities is
different from other forms of vertical separation. As Scotland is
developing a model of competition, it is understandable that Ofwat would
want to test it in England and Wales. However, it must be recognized
that Scotland is different in that Scottish Water does not have a retail
function for domestic customers; vertical separation of the business retail
function was therefore relatively simple. Nevertheless, separation has
been achieved at a high cost. Since the process would be more complex
in England and Wales, where water companies have retail functions for
all customers, it is important that retail separation – it is to be carried out
at all – should be implemented with the maximum care to minimize its
cost to customers.
The real question is the work involved in forms of vertical separation
other than retail. Such work may be expensive and raise important
question of incentive and investment (see comments above on pricing).
We think that an important difference between water and other sectors is
the fact that inputs of treated water can be made at many more points of a
network than they happen in energy. Separation between network and
resources may therefore be much more arbitrary and result in distortions
of competition and incentives that will cause inefficiencies unless:
 Boundaries between business units are delineated in a way that
reflects the reality of efficient operations
 Pricing rules protect incentives and do not convey misleading
signals
 Access by new entrants – whatever the competition model – is
efficient
Our purpose in making these comments is to highlight the difficulties of
the project and suggest that Ofwat needs to address them, and not dismiss
them. The project may well prove intellectually stimulating but it is
important that it is carried out in an efficient way to minimize its cost.
Household competition
In discussing household competition, we think it is useful to distinguish
retail competition from other forms of competition. Retail separation of
domestic customers preserves the essential of their supply chain intact
and is already demonstrated to work in Scotland. Household competition,
provided separation is working well, is therefore likely to be workable.
However, we doubt whether households will believe that they are offered
genuine alternatives with retail competition only. Such form of
competition may be desirable only if it allowed retail companies to offer a
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combined package of services – in water and other sectors – which could
prove attractive.
Our main concern with retail household competition would be how to
preserve a system that protects vulnerable customers and avoids cherrypicking. There is a risk that retail competition would target cheap-toserve customers only, at the expense of those likely to have difficulty
paying or those with special needs.
Concerning other forms of competition, our comments above indicate that
we believe that a number of the changes proposed by Ofwat have the
potential for increasing regulatory risk and this, not just for water
undertakers, but also for new entrants. For instance, changes in the way
access prices are determined will increase risk. The Costs Principle,
while slow because it is case-specific, at least gives an entrant some
certainty about the economics of its case. Whether access prices, in
future, are determined according to a set of principles which Ofwat may
interpret in different ways, or according to cost allocation rules which
may change since they are somewhat arbitrary, they may introduce
incentives for competition that prove short-lived. Short-lived incentives
lead to stranded assets (for new entrants as well as undertakers), reversals
in investment decisions and other costs.
A large business user or a new entrant may find the risk of incurring such
costs are outweighed by competition potential benefits. Business
customers can manage risk and deal with it if rewards are sufficient.
However, we do not think that household customers should be exposed to
the risks associated with the initial stages of competition. Until
competition is somewhat settled in the business market, and costs, prices
and incentives are better understood, opening the household market to
competition may prove counter-productive.
Apart from questions of risk and cherry-picking, even when it works
well, household competition raises the question of price averaging
particularly acutely, even if it arises in a business context too.
Competition can be used as a mechanism to unwind cross-subsidies
deemed undesirable and it does so in a way that can leave losers fully
exposed, often at very short notice, to price increases with which they
cannot cope. As we said in an earlier response, if it is Government’s
decision to de-average prices, we think it should be done as part of a
conscious, deliberate and planned strategy. Until this is the case, we
think it is a distraction to consider access pricing rules that make sense in
the context of de-averaged prices only, and this particularly in view of the
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affordability issues that water bills already create for a significant
minority of customers.
We shall be pleased to discuss our responses further with Ofwat and its
advisers. We are copying this letter to Defra, the Welsh Assembly and
CCWater.
Yours sincerely
Jeanne Golay
Economic Regulation Adviser
Tel: 0207 344 1808
Fax: 0207 344 1853
jgolay@water.org.uk
www.water.org.uk
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Access Pricing Criteria – Water UK Response to Ofwat’s July 2007
consultation
This question is not clear as the distinction between ‘principle’ and
‘detail’ is not clear-cut. Some people argue that Ofwat’s proposal reflects
the current situation, in which Ofwat provides detailed guidance for the
implementation of the principles expressed in the costs principle.
We think that access pricing methodologies must reflect the important
objectives set by Parliament to the water industry – as the current costs
principle now does. For consistency’s sake, both objectives and access
pricing rules need to be embodied in the same document determined by
Parliament.
The examples of access pricing principles which are proposed in Ofwat’s
consultation demonstrate clearly that it would be insufficient to include
them in legislation without giving Ofwat the precise guidance that the
costs principle now contains:
 Cost-reflectivity
One has to assume that the cost-reflectivity principle intended here
is different from the second proposed principle. The question is
whether it means that there should be a separate access price for
each customer, or group of customers. It is not clear whether it
refers to the principle that tariffs are expected to be cost-reflective
for individual customers or groups of customers.
Ofwat’s Outcomes paper contains a most useful explanation of the
principle – which we support – that there must be consistency
between tariffs and access pricing. Lack of consistency encourages
inefficient forms of competition such as cherry-picking.
If a cost-reflectivity principle were to be included in legislation, it
would be important that it be defined in some detail by law.
Without further specification, a cost-reflectivity principle provides
no information as to what Parliament may mean.
 Entrants to pay for the services they require only
Such a principle encourages cherry-picking and inefficient
competition. Generally, such a principle risks being interpreted as
saying that new entrants’ customers should be charged on a
marginal cost basis, which would leave the majority of the water
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industry’s costs to fall on customers outside the eligible market.
This cannot reflect Government’s intentions for water competition.
In particular, such a principle would increase costs for customers
which are not in the contestable area because they would be left to
pay for socially desirable services which are not specific services
rendered to a specific customer but which the water industry
provides. A simple example is that of the fire service. It could
also entail that customers served by competitors would not
contribute, or not sufficiently, to the common cost of network
operations; these costs would fall on customers outside the
contestable market. The current costs principle ensure this does
not happen.
 Non-discrimination towards notional downstream arm
This concept is not appropriate in England & Wales for now even
if it is useful in Scotland. The reason is that incumbent companies
in England & Wales retain most of their retail activities and do not
have a separate self-contained retail activity for customers in the
contestable market. It would be costly and entail cost duplication
if incumbents’ retail activities were set up as two separate
organizations, one for the competitive and one for the noncompetitive group of customers. And that would be all the more
costly if threshold changes meant that retail operations had to be
perpetually altered.
But without separation of retail from network activities, there could
not be a principle of non-discrimination between a notional
downstream-arm-for-the-competitive-market and actual competitor
retail business.
 Exposed to market risks and incentives for services outside
core monopoly
As we said earlier, the ‘core monopoly’ has to be identified. It is to
be noted, for instance, that water companies have a duty towards
water conservation, which must be considered part of the ‘core
monopoly’ if they alone are subject to it. The example is relevant
because, in line with this duty, water companies are spending
significant resources, whether to work with ministers in the
Government Water Saving Group, in funding WaterWise and in
advising customers on how to save water. Water companies, in
line with this duty, are also continually reviewing their operations
to reduce the amount of water they use for their own purposes.
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Thus, water conservation activities are found in customer-facing,
corporate and operational functions. In the first case, they may
also be part of the contestable market. A principle such as that
proposed by Ofwat would then require that incumbents
differentiate between the various kind of activity they carry out
under the heading of duty towards water conservation.
 Conclusion
The brief review above of some of Ofwat’s proposed principles
highlights that they are not fit, in their current guise, to set a
general framework in legislation that could translate Government’s
objectives for water competition into access pricing principles. We
would prefer that Parliament stayed responsible for ensuring that
regulatory consistency in such an important matter is maintained.
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Access Pricing Criteria – Water UK Response to Ofwat’s December
2007 consultation
The examples of access pricing principles which are proposed in Ofwat’s
consultation demonstrate clearly why an approach based on them would
have serious shortcomings in providing a pricing framework. Legislation
based on them would not give Ofwat sufficient guidance on Parliament’s
objectives for the water industry, of the kind now contained in the costs
principle – for example to ensure the protection of domestic customers.
We review each of the principles proposed by Ofwat below:
Pricing that promotes effective competition
If legislation contained such principle, it would not give Ofwat any
guidance as to the kind of competition it should promote. Such a pricing
rule encourages any form of competition, at any cost, as long as it exists.
It would run counter to many of the objectives that Parliament has given
the industry, in particular that of efficiency or the protection of various
classes of customers. At the very least, ‘effective’ ought to be defined.
Protection of service to ineligible customers
We note that the proposed principle refers to services only, but not to
prices. Consequently, such a principle would allow Ofwat to introduce
competition by increasing prices to ineligible customers. This would be
inefficient competition and we are surprised that such a solution should
be entertained.
Non-discrimination between an incumbent’s downstream arm and its
competitors
This principle implies that Ofwat should treat a vertically-integrated
industry as if it was vertically-separated. As we noted above, we are not
aware that Government has changed its objective of retaining a verticallyintegrated water industry. Costing and pricing rules that are appropriate
for a vertically-separated sector do not necessarily create the right
incentives and produce efficient results when applied to a verticallyintegrated industry.
Entrants pay only for services received and required
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This is a principle which we have already strongly criticised in our
September response. It encourages cherry-picking and inefficient
competition. Generally, a narrow interpretation of ‘services received and
required’ in such a principle creates the risk that new entrants’ customers
are charged on a marginal cost basis, which would leave the majority of
the water industry’s costs to fall on customers outside the eligible market.
This cannot reflect Government’s intentions for water competition.
In particular, such a principle would increase costs for customers which
are not in the contestable area because they would be left to pay for
socially or environmentally desirable services which are not specific
services rendered to a specific customer but which the water industry
provides nevertheless.
A simple example is that of the fire service, to which everyone connected
to a water network now contributes, but which new entrants’ customers
might choose not to support. Another example is that of highway
drainage, which Government has decided every customer should support
even if it is a service that is not rendered to water industry customers.
Ofwat’s proposed principle could also entail that customers served by
competitors would not contribute, or not sufficiently, to the common cost
of network operations; these costs would fall on customers outside the
contestable market. The current costs principle ensures this does not
happen.
The costs of an efficient operator of non-contestable (natural
monopoly) services can be recovered
This principle does not do more than re-state the principle that Ofwat
must ensure that an efficient operator can finance its functions. We
welcome the recognition that it is one of Ofwat’s duties.
However, we raised the question in our earlier response of how noncontestable (natural monopoly) services should be defined. This principle
assumes the question away, which is not helpful.
Incumbents to be exposed to market risks and incentives for
contestable services
As the purpose of competition is indeed to expose market participants,
including incumbents, to market risks and incentives, we do not see what
this principle adds to the discussion of how access prices should be set.
What should be discussed is how the costs of risk - and its rewards – can
be ring-fenced so that customers who do not benefit from competition do
not pay for it. Increasing risk for water companies increases their costs of
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capital. Should this increased cost apply to all water company activities?
We do not think this is desirable. Similarly, there must be a mechanism
whereby a company that has taken risk can share the rewards with those
who bore the increased cost of risk. There is also the question (raised
above) of how to distinguish core monopoly activities from contestable
ones.
Compatibility with competition law
This is much too vague a principle to be of use. Moreover, competition
law is not suited for the introduction of competition, but only the
regulation of existing competition.
Competition law is also unlikely to suit competition on networks where a
large element of monopoly is retained, specific objectives are set for the
industry and the interface between monopoly and contestable areas needs
special rules to avoid undesirable distorted incentives. In our earlier
response, we also highlighted difficulties in defining ‘core monopoly’
with the example of water conservation activities.
Optional principles
We are concerned that Ofwat’s consultation relegates a number of
principles to an ‘optional’ category and this optional category includes
principles such as efficient entry and maintaining the cross-subsidies that
Government has said are desirable. We do not think that Government’s
objectives can be treated as optional. Also, we think that the principle
that competition should be efficient is a fundamental principle, currently
embodied in the costs principle approved by Parliament, and we are
concerned that Ofwat does not consider such a principle to be essential in
justifying the cost and risk of introducing competition.
Concerning cross-subsidies and the principle on the desirability of
geographic price signals, if it was Government’s intention to remove
geographic and other average pricing rules, we would expect such an
intention to be carried out as a conscious, deliberate, planned strategy.
We would also expect a related collaborative communication programme
in which Government and Ofwat would take a lead explaining to the
customers who will be negatively affected why the move is one which the
water industry regulators consider worth the transitional difficulties they
are experiencing.
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