In a drive for efficiencies across the board in the next price review, Ofwat has turned its sights on bad debt, says Katey Pigden.

The £2.2 billion mountain of bad debt carried by UK water companies is a well-known problem, costing every customer in the UK an estimated £21, according to Ofwat. But not for much longer. As the regulator seeks to drive efficiencies across the board in preparation for the next price review, PR19, it has turned its sights on bad debt.

Ofwat commissioned a report from consultant PwC, comparing UK water companies’ handling of bad debt to that of other sectors. It finds that water companies lag behind their peers – evidence that Ofwat will use when setting the financial parameters that will drive penalties and rewards for bad debt in PR19.

The Retail Services Efficiency Benchmarking report published on 28 September says “the efficiency of debt management is now critical”.

“Bad debt impacts on all customers because companies recover the cost of bad debt from all customers,” David Black, senior director of Water 2020 at Ofwat, explains.

The regulator says it is becoming “increasingly important to measure how efficient water companies are relative to other sectors, and whether there is scope to push the efficiency challenge even further”.

And with the study showing the water sector is being outperformed in all areas relating to bad debt management by retail energy and telecommunication sectors, as well as local authorities, there is certainly room for improvement.

Ofwat estimates achieving an average performance level across the sector at the current frontier level of 0.6 per cent could save customers up to £9.40 each on their water bill.

So why are water companies performing poorly? Reasons in the report include: poor management of property voids and debt management in general; infrequent billing and contact with customers; and not providing real consequences to address payment avoidance.

The water industry may be “lagging” behind other sectors, but the gap in performance “cannot be explained entirely by the different legal frameworks” such as those that prevent the sector cutting off the supply to households due to non-payment, Ofwat suggests – insisting there’s no scope to reintroduce cutting off supply as a last resort for dealing with bad debt.

The regulator says companies could do more themselves to improve bad debt levels by focusing on areas such as debt management practices and customer service. However, it acknowledges there has been some improvement in recent years, although it highlights that net debtors are on the rise in the water sector.

Black hints Ofwat is interested in seeing more frequent billing and billing in advance to improve the management of customers that do get into a position of bad debt and measures “ensuring there are real consequences for customers who can pay but won’t pay”.

The report suggests water companies suffer significantly higher bad debt charges (the real cost to the business of uncollected debts) compared with energy, telco and local authorities, and more should be done to investigate void properties.

In its assessment of bad debt management, the report explores six areas in which companies can improve: the number of days sales are outstanding; doubtful debt ­provision; bad debt charges; unbilled debt; customer prepayments; and voids.

Ofwat explains that in setting targets for water companies to drive improvements, it is important to be aware of “unintended consequences”.

It acknowledges companies may have previously avoided good debt management practices because of the perceived impact on SIM or that the investment required to investigate void properties would be too expensive.

But the regulator says it will consider “a broad range of measures when determining water company performance on bad debt”.

It depicts a stark difference in performance levels across the water companies, but even frontier companies are not performing on a par with the other sectors.

Water and sewerage companies with the highest percentage of bad debt costs include Southern Water (5.7 per cent); United Utilities (4.3 per cent) and Welsh Water (4.1 per cent). Better performers include Severn Trent (1.8 per cent); Yorkshire (2.4 per cent) and Northumbrian (2.4 per cent).

Water-only companies perform better generally, with South East Water, Bournemouth Water and Sutton and East Surrey Water all achieving bad debt costs below 1 per cent. Worse performers include Bristol Water (3.4 per cent), South Staffordshire Water (3.5 per cent) and Affinity (3.6 per cent).

Then there are inconsistences with how companies perform despite having to contend with similar situations. For example, there is a strong correlation between deprivation and bad debt charge, but some companies are outperforming their peers with similar levels of deprivation.

Water-only companies are performing better than water and sewerage companies, due to, among other things, lower deprivation levels and lower bill values.

With bad debt forming a large proportion of the cost to serve equation – a key area of focus for PR19 – water companies will need to take stock of their current handling of bad debt and look within the business, across the sector and beyond for ways to improve.

Black says: “We have put more emphasis on not just comparing companies with each other and trying to see how this impacts on the sector, but also expanding the comparison to take into account leading practices in other sectors.”

He adds: “The good news for the ­sector is there is actually significant scope for improvement and the study has identified a number of areas where the sector could do better – drawing on other sectors particularly around better use of customer data and understanding who the customers are.”

Nonetheless, Black says PR19 will not include “glidepaths” to allow companies time to work towards the new, efficient cost of bad debt.

A spokesperson for Water UK says the industry provides support measures of more than £40 million each year to vulnerable customers.

“The water sector is proud of its unique statutory commitment to maintain supply to those who are struggling to pay their bills. However, some consumers do refuse to pay and we are working hard to tackle such situations and minimise the impact of any bad debt,” they add.

Q&A David Black

Senior director of Water 2020, Ofwat.

Some customers really can’t afford to pay, but that doesn’t explain the level of bad debt in the sector.

Are there going to be financial ­penalties and rewards associated with bad debt?

The level of bad debt is a key element of the cost allowance for retail price controls. In PR14, the conversation around bad debt was [whether it was] in proportion [to] the retail cost.

What we’ll be doing in PR19 is seeking an efficient level of cost drawing on this report, evidence from other sectors, and evidence of the best practice in the sector. Companies that have inefficient levels of bad debt costs will have to bear those costs themselves.

Companies with better and efficient levels will enjoy the benefit of being better performers of efficient bad debt.  

So, companies will make more money if they manage down their bad debt and less if they don’t?

If companies have inefficient levels of bad debt, and there is evidence to suggest that quite a lot of them have, then they will have to bear that cost themselves rather than be able to recover them.

What about exceptions for companies in areas of high deprivation?

One of the points that this study found, and we identified in PR14, was that the level of deprivation impacts the level of bad debt for the company.

There are some customers who really can’t afford to pay and that does drive some of the level of bad debt, but as the study notes that doesn’t explain the full difference between companies, nor does it explain the level of bad debt in the sector, so it may well be in PR19 there is a case for making some adjustments for the level of bad debt in allowance for the level of deprivation but it wouldn’t be the case that it would explain all the differences between companies.

Why aren’t water firms handling this as efficiently as other sectors?

It’s been a difficult issue for the sector for some time. I think retail costs themselves and bad debts are a key part of that.

Prior to the introduction of price controls in PR19, it has been an area the sector hasn’t had to focus on. There has been more focus in the last two to three years, but we think there is some way to go.

It squares with our findings on the retail review that when we compare the sector’s practice of retailing it hasn’t kept pace with other sectors.

The level of bad debt is growing despite the fact water companies have all introduced social tariffs – are these not doing what they are supposed to do?

The evidence suggests there has been some reduction in the level of bad debt charged in the last couple of years, but not strong enough to conclude what has been an improvement in the level of bad debt.

I think the level of social tariffs will help; it’s moved from 44,000 people on social tariffs in 2014 to 130,000 last year. That will help but it’s only part of the picture.

How far to do you want water ­companies to go? Would working with third parties to collect debt be a move you would look favourably on?

Water companies already engage with third parties to collect debt but we think there is more they can do in terms of data sharing. Some of the more exciting things are around the ways companies bill customers – and particularly the frequency of billing.

Some companies are billing on a six-monthly basis. That’s not common, other retailers are often billing much more frequently. For people struggling with tight cash flows, large bills every six months can be difficult to manage.

There also needs to be better identification of customers; if you don’t know who you are supplying it can be difficult to collect from them. There’s lots more companies can do to get on top of it early.