Chief executive’s view: REC consultation must address margins

“The costs of participating in the retail market are higher than those assumed when allowances were set in PR16.”

As we near the second anniversary of the opening of the retail water market in England, there is a great deal of consensus across the industry about the issues that need to be addressed to make the market more effective and accessible for all customers. It’s really encouraging that both Ofwat and MOSL have issued a series of proposals in recent months, which should help to improve a number of key pain points.

Ofwat recently published its consultation on the “Retail Exit Code: Proposals for Price Protections beyond 2020” (REC), which includes a review of the retail cost allowances determined at the last price review (PR16).

The cost allowances set at that time were largely based on the costs of operating integrated water companies and didn’t fully recognise the obligations and costs that would be required to participate in the new market. The complexity of managing multiple wholesalers, poor quality data, increased meter reading costs, market operator fees and working capital demands have all significantly increased the costs for market participants. And, as a result, retailers’ costs to serve are between 30-75 per cent higher than the current cost allowance, as acknowledged by Ofwat in its consultation document.

Given these costs and the limited margins available, retailers are often unable to offer the price discounts, service innovation and value-added services that many businesses are expecting. This is particularly prevalent in the small and medium-sized enterprise (SME) sector (which makes up around 80 per cent of the market) where there has been very limited switching to date. Allowing the retail margins to increase from 2020, to reflect the costs of market participation, will help to ensure customers can realise the benefits the market has to offer.

The proposals for medium and larger customers are welcomed and will help to promote further competition in these segments of the market. The inflationary adjustment to the fixed cost allowance for customers that use between 0-0.5ML of water is also a welcome step. However, we share the view of the Water Retail Council that the proposals will not go far enough to close the gap between the PR16 allowances set and the actual costs and risks of operating in today’s market.

Wholesale charges are expected to fall under PR19, which means retail margins could be allowed to increase to cost-reflective levels without any detrimental impact on customers, which is effectively how competition was stimulated in Scotland. Given the original intention was to create a competitive market for all business customers – and key stakeholders such as the Consumer Council for Water and the environment select committee are calling for more to be done to stimulate competition for SME customers, it would be a missed opportunity if the REC review process does not address this issue.

In parallel, we also need to ensure that we address the other market frictions that exist. At the last Water Retail Council meeting there was strong alignment among retailers around those key issues, namely diverse wholesaler policies and practices; inefficient bilateral arrangements between wholesalers and retailers; data quality issues; and the complexity of wholesale tariffs. Plans to help resolve these issues need to remain a key focus. The data improvement programme of work being undertaken by MOSL, in addition to the proposals set out in Ofwat’s Forward Plan 2019/20, will provide opportunities to look at some of these wider issues to ensure steps are taken to remedy the barriers and inefficiencies that exist.

The market is still maturing and it’s only natural that there are still issues to resolve. We do, however, have consensus from across the industry on what the key issues are, so we should be better placed than ever before to address them. Ofwat’s REC review process provides an opportunity to revise retail margins to reflect the true costs of market participation. Doing so will help stimulate competition and ensure that all customers are able to access the benefits of the new market.