Customers must come first

Water companies need to focus on developing innovative solutions and improving quality of service for the customer rather than relying on creative financial engineering to earn higher returns.

So Ofwat has made its announcement on the cost of capital, imposing a reduction of 125 basis points. I find it interesting quite how much focus is placed by companies and investors on this number, especially considering that customers will be, on average, just £25 better off as a result.
Water company returns should not depend on creative financial engineering and a game of chicken with the regulator. But there is a more fundamental point: how could it ever be right for company financial structures to get in the way of implementing initiatives that would benefit customers?
Regulators are not opposed to companies earning higher returns if customers also benefit. Investors and customers could benefit if companies were to be more innovative and deliver outcomes in the most effective and efficient way. In a world where lower carbon emissions are a priority and flooding is rarely out of the news, it is unlikely we have come close to identifying the full range of innovative solutions. To do so will require the industry to work closely with other stakeholders and to explain the benefits of untested solutions to the environmental regulators.
Let’s suppose a sustainable drainage and water reuse solution could build resilience into the water supply and sewerage system for, say, a fifth of the capital and operating costs of a traditional civil engineering solution (on a net present value (NPV) basis). In such circumstances, a water company could reasonably expect to earn a higher return on an ongoing basis to reflect the higher outcome delivery risks (it may still have to find an alternative solution if its initial approach does not keep delivering the required outcomes). It should also receive a higher return, for an agreed period, as a reward for its innovation. Even if, as a result, the actual costs of the same scheme were to double (in NPV terms, including these potentially much higher investor returns), the customer is paying only half as much for the required environmental outcomes to be delivered.
There is similarly great potential within the retail market for a genuinely innovative company to earn higher returns. The evidence from Scotland is clear: customers value being helped to reduce their impact on the environment. Reducing water consumption lowers operating and capital costs, and means future customers can be connected more cheaply. In the long run, this increases wholesale returns and offers the possibility for a retailer quickly to begin to earn a revenue stream from services. Sceptical? Take a look at the annual report of Business Stream, Scottish Water’s retail subsidiary!
Not all retailers will be successful in the competitive market. Those who consider themselves the best at customer service today may have to redouble their efforts to be among the most successful retailers. The rewards are high, but failure could put pressure on shareholders’ dividends.
I estimate that some 40 per cent of customers (the public sector and companies that operate large estates such as national chains, banks and hotels) could seek to consolidate their suppliers. Oxera estimates that such consolidation could reduce industry profits by about £50 million a year.
So I can’t understand why water companies have not argued more forcefully for the right to exit the retail market. No matter how good a company is at serving its customers, an option to exit the market is valuable. Why rely on arguing that my retail business (which is losing customers and has an increasing unit cost) is actually efficient and should be funded? It is not surprising that leading investment houses, such as JP Morgan and Macquarie, have voiced their support for exit.
Another risk that has attracted little attention is common carriage and de-averaged charges. The Water Bill allows for a direct link between the retailer and an upstream provider of resources; this may result in non-household customers paying different prices for the same service within the same appointed area. Some customers will benefit from such de-averaging, but benefits to some come at a cost to everyone else. It is hard to see how household customers would not feel the effects and smaller businesses in rural areas would certainly be adversely affected.
The government has said it does not want to see de-averaging of tariffs and plans to issue statutory charging guidance. But this appears to overlook the Competition Appeal Tribunal’s Albion Water decision in 2006. This identified that European law could apply in a case where the customer or supplier could be deemed to have an impact on European trade. As such, UK government statutory guidance may not protect us from this postcode lottery.
Common carriage also creates incentives that direct the retailer’s focus away from helping customers to reduce their water use and, more generally, from building industry resilience. If a new entrant retailer can access a new source of water more cheaply than the incumbent, its focus will be on the price it is able to offer the customer. There is no incentive to innovate or improve service.
It would be a missed opportunity not to amend the Bill to break the link between an upstream provider of resources and the retailer. There is clear scope for services businesses to develop in both the retail, customer-facing activities and in delivering desirable environmental outcomes in wholesale activities.
Creating a focused retail services market, one that forces retailers to differentiate themselves by the quality of their service to customers rather than price, could contribute to reducing abstraction and harmful discharges and to building a more resilient and environmentally secure water industry. Encouraging a similar services culture in the delivery of upstream outcomes could, in my view, be expected to improve customer value for money, enhance investor returns and increase resilience. Perhaps in future we should focus on eco-services, rather than financial engineering?