Chief executive’s view: Dr Jerry Bryan, Albion Water

The real benefits of upstream competition come not from targeting the lowest cost-to-serve customers but the highest. Incumbents should harness upstream competition to reduce these imbalances.

Established utilities often go to great lengths to protect the status quo when faced with market reform. One effective defence mechanism has been to raise fears of serious unintended consequences but, powerful though it undoubtedly is to remind a minister that a typhoid outbreak would not be good for his political career, the reality is that many of these fears are unwarranted and potentially self-defeating.
Incumbents have lobbied hard against the potential ill effects of upstream water competition, arguing in particular that this would lead to entrants “cherry picking” those customers who are cheapest to serve. This, the argument goes, will inevitably lead to the de-averaging of tariff structures, to the significant detriment of those who are most costly to serve, notably the rural poor. That cry has been taken up by a number of industry stakeholders, notably the Consumer Council for Water, which has spoken out against cherry picking.
I speak as someone who has been intimately involved in promoting water competition for almost two decades and who has often been challenged by the cherry picking accusation. Sharing a Utility Week conference platform with a Severn Trent director over a decade ago, I was accused of cherry picking and challenged instead to take on Severn Trent’s high-cost customers in Shropshire. I readily agreed to do so but the offer was withdrawn as rapidly as it had been made.
Looking at this from a commercial point of view, I can find no evidence to support the perceived risk of cherry picking and no commercial logic to drive such behaviour on the part of entrants. Let’s look at the facts.
There is no doubt that some customers are far more expensive to serve than the average and, logically, some will be significantly cheaper to serve. It would technically be possible for an entrant to target those cheapest to serve, but only if it could obtain some form of locally cost-reflective wholesale terms from the incumbent. There are no realistic prospects of that occurring and Ofwat has set its face against any such approach. For those aware of Albion Water’s decade-long battle for fairer prices for Shotton Paper, this was not a case of de-averaging but rather a challenge to a discrete non-potable tariff. In that case the courts found that the applicable costs, which were used to justify that tariff, had been significantly and abusively overstated.
I would argue that the natural target for any innovative entrant is not the lowest cost-to-serve but the highest. Information from Scotland suggests that 1 per cent of the population served make up some 16 per cent of the total opex and that some customers are 30 times more expensive to serve than the average. For these customers, innovation has the potential to drive down those costs to the benefit of the incumbent, the generality of customers who are currently cross-subsidising high-cost services and, of course, the entrant that is taking a commercial risk and seeks reward.
Instead of perpetuating an irrational fear of cherry picking, incumbents should be following the Scottish example and identifying their highest cost-to-serve customers. Prior to 2009, many incumbents appear to have had little knowledge of these detailed costs, but since Ofwat introduced the requirement for accounting separation there is no excuse for not knowing who to target.
Incumbents or their existing supply chains are capable of driving down these costs, and they should be doing so vigorously. Where this requires technological or service innovation, that may not be easy. Most incumbents appear highly conservative and find it very difficult to accept the risk that significant innovation entails. The water industry’s attitude towards technological innovation may best be illustrated by the plans to celebrate the centenary of the introduction of the activated sludge process for treating sewage. It was introduced in 1914 and is still responsible for treating the vast majority of sewage both in the UK and in urban areas worldwide. Yet it is a process that turns potentially valuable organic material into carbon dioxide by expending a lot of energy. The industry should have moved on long ago to treatment processes that recover value from sewage with minimal carbon footprint, but progress has been glacial.
If technological change is difficult, then fundamental service innovation must be more so. The concept of continuous supplies of wholesome drinking water and the discharge of all wastewater to sewerage systems has been with us since late Victorian times. These Victorian service definitions still drive the water industry despite growing concern that we are flushing toilets and watering gardens with drinking water, while rainwater and greywater often go to waste or contribute to the flooding of overloaded combined sewer systems. Water companies’ ability to reinvent water services is very often constrained by legacy systems and conservative attitudes.
It needn’t be so. If incumbents cannot satisfactorily drive down the cost of their most expensive customers then perhaps we need to see open competition as a potentially valuable tool to achieve that end. Incumbents could identify the characteristics of such customers and the key cost drivers and invite innovative solutions from entrants and others. Success would benefit incumbents, customers generally and the innovators. Those innovators would also be expected to shoulder some or all of the costs of failure, but even failure would assist our understanding of what was needed. We could start with the most costly 1 per cent – a modest and low-risk proposition and somewhat easier to agree than the whole of Shropshire. With apologies to the Romans, it was the UK that invented modern water and wastewater systems in the 19th century. Perhaps we could harness our innovative potential to make those systems lower cost and sustainable in the 21st.