retail competition: the story so far, the journey to come

Retail competition: The story so far, the journey to come1

Retail competition: The story so far, the journey to comeNovember 2011

www.watercommission.co.uk


Companies, investors and customers stand to benefit from an Anglo-Scottish retail market if we build appropriately on Scotland’s experience.

• Weneedtothinkbigtoaddresstheclearchallengesthatlieahead;thereisaneedtoimprovebusinessflexibilityandefficiencyandallowspaceforinnovation.

• Achievingthiswillrequiremuchmorecollaborationbetweencompanies,moretargetedregulationandrealengagementbetweencompaniesandtheircustomers.

• Measured,smallstepswilldeliverprogressandavoidalienatingeithertheinvestororthecustomer.

• Whyshouldacustomerhavetodealwithupto20+suppliers?

• Whyshouldmoretailored,un-regulatedvalue-addingservicesnotbeavailable?

• InScotland,customerchoiceencouragedinnovation,ledtomoretailoredservicesforalltypesofbusinessandthe publicsector,and,eventhreeyearslater,continuestoreducecosts.

• Environmentalbenefits,includingwaterandeffluentmanagement.

• Costreductionsinretailactivitiestothebenefitofcustomersandinvestors.

• Implementationcostskeptlow.

• Investorsworrylessaboutregulatoryrisk.

• Implementinganymarketframeworktakestime.

• AbespokemarketforEnglandcouldincreasecomplexityinitsimplementationanditsoperation.

• Ourapproach,basedonpracticalexperienceandinvolvingmanyinterestedpartiesinScotland,wouldsimplifyandde-riskimplementation.Itwouldbesupportedbycustomers,somecompanies,manyinvestorsandtheScottishGovernment.

Collaboration not rivalry

Businesses want choice

An Anglo-Scottish market(building appropriately on Scottish experience)

Tried and tested implementation


• Collaboration not rivalry

• Businesses want choice

• An Anglo-Scottish market

• Tried and tested implementation

➜


Economic regulation of the water industry has been very successful. Our success in Scotland results directly from the framework put in place by Government at the privatisation of the industry in England and Wales.

• Ofwat’sregulatoryframework,whichweadoptedinScotland,hadanumberofusefulincentiveproperties. TheseincentivepropertiesencouragedScottishWaterto:

• Reducecosts;

• Investtoimproveservices;and

• Improveservicelevels.

* Review of Ofwat and consumer representation in the water sector,Defra,July2011,page63.

** Financial performance and expenditure of the water companies in England and Wales 2009-10,Ofwat,November2009,page5.

*** Future water and sewerage charges 2010-15: Final determinations,Ofwat,November2009,page96,Figure11.

Scotland

£105lowerthantheywouldotherwisehavebeen

£4.3billionsince2002-03,or£220perbilledhouseholdperyearonaverage

35%reductionfromlevelsin2002

Averagehouseholdbills

Capitalinvested

Operatingcosts

England and Wales

£110lowerthantheywouldotherwise havebeen*

£90billionsince1989**,or£190perbilledhouseholdperyearonaverage

Broadlyflatinrealtermssince1989***


But there are now new challenges facing the water industry.

• Industry financing:Thereisanongoingneedtofinanceinvestment,butcompanybalancesheetsarenowstretchedand, inScotland,availablepublicexpendituremaybemorelimited;

• Walker Review (2009):Affordabilityandlegitimacyofhouseholdwaterchargingisagrowingissue.Upwardpressuresonbillsbecauseofstretchedbalancesheetsarelikelytoreinforcethisissue;

• Climate change and carbon mitigation:UKcommitmenttoreducecarbonemissionsbyatleast34%by2020andatleast 80%by2050*(InScotland,42%by2020and80%by2050**);

• Pitt Review (2008):Floodingandresilienceofthewaternetworkneedsattention;and

• Cave Review (2009):Innovationandcompetitioninwatermarketsshouldbeapartofthesolutionbycontributingto efficiencyandmoresustainableoutcomes.

*DECCwebsite,availableathttp://www.decc.gov.uk/en/content/cms/emissions/carbon_budgets/carbon_budgets.aspx.

** Low Carbon Scotland: Meeting the Emissions Reduction Targets 2010-2022: The Report on Proposals and Policies,ScottishGovernment,March2011.


And there is a continuing need to improve outcomes delivered to customers and our environment. It is not the once and for all challenge that was originally expected.

• “Investment will remain high in the second half of the 1990s, it could revert to more normal levels in the early years of the next century”*

• Investmentinpublichealthandenvironmentalimprovementshascontinuedat highlevels**

Expectation

Reality

• Challengesaroundimprovingresilience,reducingcarbonandmeetingtheWaterFrameworkDirectivewillfurtherstretchbalancesheetsandputanupwardpressureoncustomercharges.Sustainableoutcomesrequirenewapproaches.

Future challenges

0%

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1990-9

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1992-9

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Industrygearing

(TotaldebtasapercentageofRCV)

Annual investment

➜

* Future charges for water and sewerage services: the outcome of the Periodic Review,Ofwat,July1994,page24.

** Future water and sewerage charges 2010-15: Final determinations,Ofwat,November2009,Figure9,page67,Figurein2007-08prices.


The financing constraints on the industry have the potential to alienate customers and/or investors.

• Equityfinancemaybeneededtohelppayforfutureimprovements.Overtimecompaniesmayconsideritprudenttoreducetheircurrentlyhighleverage.Thiscouldputanupwardpressureonbills.

• Agreaterportionofcapitalinvestmentwilllikelyneedtobefinanceddirectlyfromcustomerbills(particularlytopayforthegrowingcapitalmaintenanceburden).

• Politicaland/orcustomerpressuretokeepbillsdowncouldleadtheeconomicregulatortoviewthecostofcapitalasaneasyshorttermpalliative,oralternatively;

• Pressuretomaintainreturnscouldforcepriceincreasesthatwouldlikelyhaveanegativeimpactonwillingnesstopay forfutureimprovements.

• Allowing the company to earn a higher return within a lower cost envelope (e.g. from initiatives such as asset rationalisation that reduce the overall cost base).

• Engaging customers in price setting to improve legitimacy and willingness to pay for environmental improvements.

• Committing that all NPV positive projects will be allowed to meet their planned payback.

Potential undesirable responses that could occur

But the regulator can mitigate this risk


• Customers(andotherstakeholders)arenotsufficientlyengagedinpricesetting.

• Pricesettingisablackbox;

• Lackofcustomerinvolvementinpricesettingraisesconcernsaboutthelegitimacyofwatercharges;and

• Defacto,regulatorsdecidewhatcustomerswant.

• Thefixedfiveyearpricecontrolanddeliverycyclemaybebothtooshortandtoolong:

• Tooshort:Initiativeswithlong-termpay-backs(pay-back>lengthofthepricecontrol)areunlikelytobeimplementedbecausesavingswouldbelikelytobepassedtocustomersbeforetheinvestmentreachedpay-back;

• Tooshort:Largecapitalprojectsareunlikelytodivideneatlytofitthefiveyeardeliverycycle–whichcouldlead toinefficientprocurementandexacerbatethestop-startdeliverycycle;and

• Toolong:Flexibilitymayberequiredifprioritieschangewithinthefiveyears.

• Thereisaninherent,defacto,biastowardscapitalsolutionsandtheremaybeabiasagainstpotentiallymorecreative andinnovativesolutions.

• Potentiallylowercostorlowercarbonsolutionsmaybecrowdedoutbecausereturnsareearnedonlyoncapitalinvestment;and

• Regulationcanseekriskelimination;itshould,however,rewardeffectiveriskmanagement.

• Settinganaveragecostofcapitalmayleadtosub-optimaloutcomes.

• Weneedtorecognisethatifwewantcompaniestobemoreinnovativeorpursuelonger-termbenefitsonbehalf ofcustomersandshareholderstheywillrequiredifferentreturnsoncapital;

• Timehorizonsofinvestorsareunlikelytomatchthelengthofthepricecontrol.Re-estimatingthecostofcapital everyfiveyearsincreasesregulatoryriskandthecostofcapital;and

• Themarginalcostofcapitalmaybehigherthantheaverage–particularlyforlargeorinnovativeprojectsoropportunitiesforassetrationalisation.

We believe regulation needs to evolve to meet these future challenges.

Customers

Investment

Finance


To meet these future challenges, we are introducing a number of evolutionary changes to the regulatory framework in Scotland.

• CustomerForumestablishedtonegotiatedirectlywithScottishWater,andmaketrade-offsanddecisions withinthepricesettingprocess;

• Simplifypricesettingtoopenuptheprocesstocustomersandotherstakeholders;and

• Liberalisedmarketfornon-householdshasdeliveredlowerbills,tailoredservicesandmoresustainableoutcomes.

• Focusontotalcosts;removingdefactobiasesarisingfromthedifferentialtreatmentofoperatingandcapitalexpenditure;

• Focusonagreedoutcomes,notonthewaysinwhichtheseoutcomesmightbeexpectedtobedelivered;

• Initiativesshouldearnareturnforthefullperioduntiltheprojecthaspaidback–withinandacrossregulatorycontrolperiods;and

• Rollinginvestmentreviews(separatefrompricereviews)tospecifyinvestmentoutcomesmorefrequently.Thisshouldprovidegreaterflexibilitytorespondtourgentand/orchangingprioritiesandprovidegreaterforwardvisibilitytoplanforlong-termimprovements.

• Introduceanincentiveandmonitoringframework,basedonfinancialreturns,tobuildconfidencethatareasonablereturnwillbeavailableforareasonablelevelofperformanceoverthelong-term.Thiswouldincludeamechanismtoshareexcessreturnswithcustomers;and

• Acceptthatahigherreturnmaybeearnedoninnovativeapproaches,providedtheoverallcosttothecustomerislower.

Customers

Investment

Finance






➜


Experience from Scotland is that choice has improved legitimacy and service. Business customers in England are now demanding the same. They want to exercise choice to have a stronger voice and receive more tailored services.

• AstudybyCCWaterfoundthat84%ofbusinesscustomerssupportedcompetitioninthewaterandsewerageindustry.*

• Thesamestudyalsofoundthatnearlytwo-thirdsofbusinesscustomersthoughttheywerelikelytoswitchifgivenachoice.

• Similarly,Accentfoundthat69%ofSMEbusinessesthoughttheprincipleofcompetitioninthewaterindustrywaseither agoodorverygoodthing.**

• AtarecentsessionofOfwat’sBusinessCustomerForum,therewas“unanimoussupport”forthecreationofasinglecompetitiveretailmarket.***

• Customergroups,suchastheMajorEnergyUsers’Council,havespokenoutontheirdesireforacompetitivemarket tobeestablishedandthebenefitstheyseefrombeingabletochooseoneortwoUK-widesuppliers.****

*Setting Strategic Direction: Competition Research with Business Customers,ConsumerCouncilforWater,June2007,pageiii.

** Small and Medium Business Customer Views on Competition in the Water and Sewerage Industry,Accent,June2010,pagei.

*** Business Customer Forum meeting note,Ofwat,14April2011.

**** Water Competition Action Group,MEUC,4August2011.


Retailers in the Scottish market are providing new and improved services.

• Retailersarenowtailoringtheirservicestomeetthespecificneedsoftheircustomers.Retailersdesigntheirservices aroundtheinterestsoftheircustomersandnotthewholesaler.

• Forexample,retailersworkaroundtheircustomer’sscheduletoavoiddisruptingtheircustomer’sbusiness.

• Satecarrangesforleakstoberepairedandmeterstobereplacedatnightinordertominimizetheimpactontheir restaurantcustomers.

• Retailersareincentivisedtoworkwiththeircustomerstoreduceconsumptionanddischargesinawaythatvertically integratedcompaniesarenot.Retailersmustrespondtotheircustomers’needsorrisklosingthemtoacompetitor.

• Aimeraprovidesregularmanagementinformationthatidentifiesusagetrendsandanyanomalies.Byproactivelyprovidingthisinformation,itscustomersareabletocatchandquicklycorrectanyunexpectedincreasesinconsumption,suchasleaks,andavoidrunninguplargebills.

• Aimerameetswiththeircustomerstoidentifyadditionalwaystoreducebillsandlowerconsumptionthroughservices suchasmeteringunmeteredproperties,fixingleaksanddrippingtaps,andinstallingrainwaterharvesting.

• WithAimera’sassistanceandtheinstallationofrainwaterharvesting,alargecaravanparkwasabletoreduce itsconsumptionby20%.

• Albion,apotentialspecialistlicenceholderinScotland,isworkingwithdevelopersonawater-efficientcommercialandresidentialdevelopment.Thebuildingswillbefittedwitharangeofwatersavingdevicesincludingintegratedgreywaterrecyclingsystems.


Business Stream – the Scottish Water subsidiary – has had not just to sharpen its pencil but to become much more customer focused.

• BusinessStreamisnowproactivelyofferingcustomerswaterefficiencyandconsumptionreductionservicestailoredtothecustomer’sneeds.Theyestimatethattheseserviceshavesavedtheircustomersover£13million,saved7.4billionlitresand reducedCO₂emissionsby8,025tonnes.

• BAESystemswillsaveinexcessof£300,000overthecourseoftheconstructionofthenewaircraftcarriersfromBusinessStream’sleakageandefficiencyservices.

• BusinessStreamoffersallofitscustomersconsolidatede-billing.Thissavescustomersadministrativecostsandmakes itmucheasiertocompareandreduceconsumptionacrosstheirsites.

• ASDAestimatesitsavesover£80,000peryearasaresultofconsolidatede-billing.

• Sinceseparation,BusinessStreamhasintroducedawiderangeofnewservicesandproductsthatitdidnotofferinthepast–fromautomatedmeterreadingstotariffoptimisationandcarbonefficiencyadvice.Someoftheseserviceshavebeenintroducedatthecustomer’srequest.

• Aspartofitswinningbid,BusinessStreamisprovidingfreeautomatedmeterreadingservicestotheScottishpublicsector.

• BusinessStreamhasintroducedagainshareschemewhereitfundswaterefficiencyimprovementsandsharesthesavings withthecustomer.

• GlasgowCityCouncilestimatesitwillsave£1millionayearasaresult,withouttheneedforup-frontcapitalexpenditure.


In England there is potentially even greater scope for an improved customer experience because many non-household organisations have to interact with more than 20 water and sewerage providers.

• Thisisnotuncommon.Forexample:retailers,restaurantgroups,hotels,thePostOffice,otherutilities,banksand governmentorganisations.

• Evenorganisationslocatedinjustonegeographicareacouldhavetodealwithmanywaterandseweragesuppliers.

• InKentaloneitispossibletobeservedbyfivedifferentcompanies(Southern,SouthEast,VeoliaWaterSoutheast, ThamesandSutton&EastSurrey).

• EssexCountyCouncilwouldhavetodealwithfivesuppliers(Anglian,Thames,EssexandSuffolk,VeoliaWaterEast, VeoliaWaterCentral).

• Ifacustomerwantstotrysomethinginnovativetosavemoneyorbecomegreener,suchasinstallingsmartmetersat allofitslocations,notonlywilltheyneedtoworkwithmorethan20companiestomakeitpossible,buttheyareunlikely toseeanyconsistencyinapproach.

• Eachwatercompanyhasitsownprocessesandproceduresforcustomerfacingactivities.

• Thiscreatesadditionaladministrativecostsforcustomersastheymustuse20+processestointeractwiththeirsuppliers.






➜


Our experience in Scotland is that retail competition has created value.

• TheCommissionspent£5.7m(fundedbygrant).

• TheScottishWaterGroupspent£13.6m.Thiswascapitalised.

• CMAsetupcostswere£3.2m.

Set up costs

• Regulator’slevyof£1.2m.

• CMAcostsof£2.5m.

• Extracostofcapitalof£0.7m.

Ongoing costs

• AssumingBusinessStreamwouldhaveimprovedatthesamerateasScottishWatersince2006-07,ithasfurtherreducedcostsby£8.1mperyear.

• NosavingsachievedbyScottishWaterhavebeenincluded.

Current savings

achieved

• Incrementalretailefficiencies(1%peryear).

• Incrementalwholesaleefficiencies(0.05%peryear).

Savings from dynamic efficiency

PV of cash spent & savings already

realised

PV of all costs & savings if no

further efficiencies

PV of all costs & savings with

dynamic efficiency

-£22m -£22m -£22m

-£9m -£119m -£119m

+£18m +£279m +£279m

+£110m

+£85m

-£13m +£138m +£333mNPV


The introduction of retail competition in Scotland pays back in 7 years.

Pays back in 7 years

NPV = £333m➜

➜

Today


Adjusted by non-household revenue, Scottish Water’s retail costs were already lower than those of most companies, but after separation, Business Stream achieved further savings.

* Source:InformationforEnglandandWalesisfromJune Return 2009-10,Ofwat,2010,table21b(operatingcostsanddepreciation)andtable23(revenue).CostinformationforBusinessStreamisfromRetail competition in Scotland: An audit trail of the costs incurred and savings achieved,WaterIndustryCommissionforScotland,April2011,tables13 and17.RevenueforBusinessStreamisfromAnnual Report and Accounts 2009-10,BusinessStream,2010.

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

YorkshireWater

SouthWestWater

/nite1/2li2es

AnglianWater

SouthernWater

ThamesWater

DŵrCymru

AverageWASC

S=o>shWaterbaseline

WessexWater

SevernTrent

BusinessStream

NorthumbrianWater

!on$householdre-./lo0er.1n23os-s/n3lud/n2de0re3/.1on.s.0er3en-.2eo4non$

householdrevenue*• PriortoseparationScottishWater’scostsalreadycomparedwellwithmanywatercompanies;

• Nevertheless,BusinessStreamfoundsignificantcostsavings;

• Northumbrian’sleadingpositionmaybeexplainedbyitsparticularmixofindustrialcustomersanditsownershipofEssex&SuffolkWater;

• SevernTrent’slowcostsappeartoresultfromitallocatingonly12.5%ofretailcoststonon-households(industrynormis17-23%);and

• WessexWaterhasajointventurewithBristolWater(setupin2001)forretailactivities,withafocusonreducingbaddebt.


Similar benefits could flow to customers in England from opening up the retail market to competition.

Present value of all costs and savings without dynamic

efficiency

Present value of all costs and savings

with dynamic efficiency

-£182m -£182m

-£529m -£529m

+£1479m +£1479m

+£988m

+£734m

+£768m +£2.5bnNPV

• Assumenomergers.

• Assumeonaveragecompaniesachieve2/3rdsofthesavingsachievedbyBusinessStream.

Ongoing cost reductions

• Incrementalretailefficiencies(1%peryear).

• Incrementalwholesaleefficiencies(0.05%peryear).Dynamic efficiency

Set up costs

• Assumeconservativelythatcompaniessouthoftheborderincursamecostsper non-householdcustomer:• Noallowanceforcodesalreadyworking.• Noallowanceforexperiencealreadyearned.

• AssumeCMAtobefitforpurposeforpan-GBmarket:£10mnewexpenditure.• AssumeOfwatcoststoimplementframework:£8mnewexpenditure.

Ongoing costs

• AssumeCMAoperatingcostsincreaseto£10mperyear–a£7.5mincrement.

• AssumeextracostsforOfwatof£2mayear.

• Assumeextracostsofcapitalallowanceof£6mayear.


Based on costs incurred in Scotland, introducing retail competition in England could have a positive NPV of £2.5 billion and pay back in 7 years.

Pays back in 7 years

➜

NPV = £2.5bn➜


Following the Cave review, a number of consultants, hired by the water industry, have published reports on the costs and benefits of introducing retail competition in the industry.

• Deloitte (February 2011)*

• Deloitte’sanalysisofthecostsandbenefitsofretailcompetitionreliedonestimatesofcostsratherthantheobserved evidencefromScotland.

• Oxera report for UKWIR (June 2011)**

• OxeraquestionedtheassumptionsusedintheCaveReview’scostbenefit.

• OxeraformallyretractedcommentsmadeinthereportandissuedanapologytoProfessorCave.

• Deloitte (September 2011)***

• Deloitterecentlyissuedanupdatetotheirpreviouspaperwhichclaimedtherewouldbenobenefitfromintroducing retailcompetitioninEngland.

* Lessons for the water and sewerage industry from retail competition in the utility sector,Deloitte,February2011.

** The cost-benefit analysis knowledge base,Oxera,June2011.

*** Competition vs regulation?,Deloitte,September2011.


In its most recent article, Deloitte compares non-household retail costs by customer between companies to suggest that retail competition on its own will not bring benefits.

1.Deloitte’scomparisonincludesBusinessStream’sfinancingcosts,whicharenotincludedinthecompanies’numbers–overstatingBusinessStream’scostsby£28.2.DeloitteappearstouseanoutofdateestimateofthenumberofcustomersservedbyBusinessStream–overstatingBusinessStream’scostsbyafurther£8.3.TheDeloitteanalysisincludesthecostsofprovidingnewadditionalbilledservicesnotprovidedinEnglandandWales.4.BusinessStreamincurscostsinacquiringandretainingcustomersandindevelopingitsbrand.5.BusinessStreamalsoincurscostsofcompetitioninScotlandandcostsinseekingnewcustomersinEnglandandWales.

However, this article includes a number of errors.

➜


Given that it incurs the extra costs of operating in a competitive market, Business Stream is a clear market leader. It is the benchmark which other companies will have to match.

• BusinessStream’scostsarearound40%lowerthantheaveragelevel,whenexpressedasaproportionofrevenue, comparedto25%,whenexpressedpercustomer.

*Thecostsofwateronlycompaniesareincludedwiththeirrespectivewaterandseweragecompanies,inlinewithDeloitte’smethodofcomparison.TheresultsforAnglianWaterandNorthumbrianWaterreflecttwodifferentpossiblewaysofmakingacorrectiontoDeloitte’sanalysis.


Based on these comparisons, the companies in England and Wales only have to achieve between and third and a half of the savings made by Business Stream to cover all the costs of introducing retail competition. Before account is taken of the potentially substantial benefits...


There are many such potential benefits which we have not included in this cost analysis.

• Moretailoredcustomerservice;

• Theavailabilityofnewservices,includingtargetedwaterefficiency;

• Improvedsatisfaction;

• Additionalcustomerlegitimacy;

• Theopportunityfornon-householdcustomerstoswitchsupplier;and

• Thepotentialforanimprovedandlessbureaucraticregulatoryregime(ashasresultedinScotland).


A competitive market in England will benefit both customers and companies.

• ASDAestimatesconsolidatede-billingsavesitover£80,000peryearonadministrativecostsinScotland.Ifthiswasavailable UK-wide,theycouldsavebetween£500,000and£600,000.

• ScalingthesavingsachievedbyASDAtothe5largestretailersintheUKleadstoestimatedsavingsofaround£10mperyear inprocessingandadministrationcosts.

• B&QwasabletoreduceitsannualwaterconsumptionatitsScottishstoresbyover£20,000withthehelpofBusinessStream. IfitmadethesamesavingsUK-wide,itcouldsaveover£200,000worthofwaterperyearandreduceitscarbonfootprint.

• BasedonsavingsachievedbyB&Q,theother4majorDIYretailerscouldstandtoachieveestimatedsavingsofaround£700,000.

• PolicyExchangealsocitesexamplesofhowcustomersbelievetheycouldbenefitfromacompetitivemarketinwater*:

• Havingoneortwosupplierswouldbring“electronicbilling,assignedpointsofcontact,awillingnesstoresolveissues withoutthethreatofdisconnection,lesstimespentdealingwithqueries.”

• Acustomernotesthatwithanationalsupplier“therewouldbeloweradministrationcostsandeasierco-ordination, thesupplier’sobjectiveswouldbebetteralignedwiththecustomer,and‘gainshare’dealsonimprovingleakageand waterefficiencywouldbeeasiertoarrange.”

*Water retail services competition in England and Wales: Still Hobson’s choice?,PolicyExchange,July2011,pages7and13.





• Tried and tested implementation➜


There were three important lessons that we learned from establishing a retail framework in Scotland.

1. WorkingcloselywithScottishWater,itsnewretailsubsidiary,potentialnewentrantsand otherinterestedpartieswasessential.

2. Theremustbeaworkableplanthatminimisescostsandrisks.

3. Thereneedstobeacleardatesetformarketopening:thisisessentialsothatallparties maintainasingle-mindedfocusondelivery.


Based on our experience in Scotland, it would take time for the retail market to be fully opened in England.

Ourpricereviewidentifiedopportunitiesandthreatsofcompetitioninthewaterindustry

ConsultationbyScottishExecutiveandpolicy development

Resourceplandeveloped

WaterServices(Scotland)Act

FinalDeterminationfor2006-10

WholesaleServicesAgreementandOperationalCode

DevelopmentoftheCentralMarketAgencyandmarketcode

Wholesalechargesschemedefined

Marketopening

2001

2002-03

2004

2005

November2005

Summer2006

2006-07

2007

April2008

➜

England appears to be at this stage

➜


Some of the activities that need to be completed before market opening are complicated and time consuming. Since there are limited opportunities to complete them in parallel, a constructive dialogue needs to be maintained.

Companies(lead),regulator

Regulator(lead),companies

Regulator(lead),companies

Regulator

Companies,regulator

Regulator(lead),companiesandpotentialentrants

Allmarketparticipants

Developoperationalcodesandtemplatewholesaleservicesagreement

Developgovernanceandmarketcodes

EstablishCMAandpopulatemarketsystems

Setrevenuerequirementforretail

Preparewholesalechargesandsetdefaulttariffs

Developandfinaliselicensingprocesses

Systemstesting

Year 1 Year 2 Year 3 Year 4 Year 5 Market opening

Activity Organisations involved

➜1 year

➜1 year

➜1 year

➜2 years

➜½ to 1 year

➜3 years


However, building on our experience could simplify and de-risk implementation and minimise costs.

• TheScottishexperienceisbothscalableandadaptabletothechallengesthatmayariseduringthecreationandoperation ofanEnglishmarket.

• KeyteammembersinvolvedinestablishingthemarketinScotlandwouldbeabletoassistinthecreationofasimilarmarket inEngland(e.g.thelegalteam,CommissionstaffandtheCMA).

• TheexperienceofestablishingtheScottishmarketprovidesanexampleofhowtogettheregulator,theincumbentwholesaler,potentialretailersandotherstakeholdersboughtintotheprocess.Allofthepartiesworkedtogetherconstructivelytoopenthemarketonschedule.

• TheWholesaleChargesSchemewasdevelopedbyScottishWaterandtheCommissionworkingtogethertounderstand ScottishWater’swholesalecosts.

• TheMarketCodeandOperationalCodewerecreatedinconsultationwiththeLicensingFrameworkImplementationGroup,whichincludedpotentialmarketparticipantsandotherstakeholders,suchassomeoftheEnglishcompanies.

• TheCMAwascreatedonscheduleandatalowercostthanmanypotentialsuppliersbid.


The Scottish experience presents an opportunity to reduce the risk and cost of operating a retail market.

• TheproceduresoftheScottishmarketaretriedandtestedandhavebeenshowntoberobustenoughtoworkeven throughtwoveryseverewinters.

• TheScottishmarketframeworkensuredthatnocustomerlostmoneywhenoneearlyentrantfailed.

• TheScottishmarkethasalreadyidentifiedandresolvedmanyoftheday-to-dayissuesanEnglishmarketwouldface.

• TheCMA’sTechnicalPanel,whichScottishWaterandtheLicensedProvidersaremembersof,providesthemwith theopportunitytoproposeandapprovesolutionstomarketissuestheyhaveidentified.

• TheOperationalCodehasbeentestedbythreeyearsofactualwholesalerandretailerinteractions.

• TheCMA’ssystemshaveprovencapableofmaintainingtheregistryofsome140,000waterandseweragecustomers andprocessingthesettlementforthem.Settlementhastoberegionalbecausewholesalechargesareregional, butthesettlementsystemsshouldbewithintheoneorganisation.

• TheScottishmarkethasshownitworksforallnon-householdcustomers,fromlargeurbancustomerstosmallremote ruralones.


Investors in the English water industry agree that reforms along the lines of the Scottish experience could benefit companies and their shareholders.

J.P.Morgannoted: “Our impression... is that a restructuring of the England and Wales water sector in line with Scotland could create opportunities for the companies to realise value from their retail businesses which under current regulation are just a cost centre.

• The key building blocks of the reform (the Scottish experience) were:

• The RCV was not subdivided, it all went with the wholesale business;

• The WACC was not changed;

• The retail providers pre-pay the wholesale charges (hence taking the bad debt risk)...”

Liberum Capital noted: “Many thanks for coming [to] our investor lunch yesterday. I have had some very positive feedback from the meeting. The clients included some large investors in the water industry including Fidelity, Barings, UBS amongst others and I think you might have helped in convincing them that the introduction of competition is not necessarily a bad thing…”


Based on our experience and dialogue with companies and their investors, eight principles seem to be important.

1. Government,theregulatorandthecompaniesneedtoworktogethertointroduceretailcompetitioninalowrisk,practicalway.Therealsoneedstobemovementtowardsmoreconstructiveengagementbetweencompaniesandtheircustomers.

2. Thetimelineformarketopening,includinganytrialorshadowoperation,needstobalancemovingquicklywithensuring thatthearrangementsarerobust–ittookusaroundfiveyearstocompletetheprojectfromfirststepstomarketopening inApril2008.

3. TheRCVandassociatedreturnsofthewatercompaniesshouldbeallocatedinfulltothewholesalesideofthebusinessandfuturewholesalepricesshouldbeadjustedtoensurethattheimpactofretailcompetitiononthatbusinesswillbeNPVneutral.

4. Thereshouldbeanadditionalreturnoncapitalavailabletotheseparatedretailbusinesstoreflectitsriskandallowittostandaloneinthemarket.

5. Theretailbusinessshouldbeartherisksassociatedwithbaddebtsandreceivablesbecauseitisbestplacedtomanagethem.

6. Theretailbusinessshouldpre-paythewholesalerwherethewholesalerconsidersthattobenecessary,makingiteasiertolicensenewentrantsandavoidingtheriskthataninferiorcreditreplacesatop-notchcreditintheexposureofthewholesalebusiness.

7. TheplayingfieldshouldbedemonstrablylevelwithregulatedaccesstothenetworkandaGovernanceCodecoveringeachincumbent’sretailandwholesalebusinesses;thecontentsofeachGovernanceCodebeingdependentontheextenttowhichtheregulator,otherentrantsandcustomerscanbesatisfiedthatalevelplayingfieldexists.

8. Theretailbusinessmustbeabletobenefitfromtheeconomiesofscaleinherenttosuchoperations;inEnglandthiswouldmeanallowingmergersbetweenretailcompanies.


Building on what has been created in Scotland, and adapting appropriately for a larger market, could minimise costs and risks and reduce lead times.

• ThewaterindustryinScotlandisdifferentfromtheindustrysouthoftheborderonlyinitsownership:inotherrespectsitsactivitiesaresimilartoothercompaniesinotherareasofGB.

• Retailcompetitionispartofapackageofregulatoryreformstoempowercustomers,enhanceincentivesandencourageinnovationtothebenefitofbothcustomersandinvestors.

• Retailcompetitioncan,ifpursuedjudicially,bothreduceriskinthewholesalebusinessand createvalue.

• Offeringnon-householdcustomerschoicewillincreasethelegitimacyofwaterchargesand reducepoliticalandregulatoryrisk.

Water Industry Commission for ScotlandFirstFloor,MorayHouse,ForthsideWay,StirlingFK81QZE:[email protected]:+44(0)1786430200

www.watercommission.co.uk

retail competition: the story so far, the journey to come

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