Separation strategies for market opening

To allow for competition, water companies need to separate their non-household retail and wholesale businesses. Ofwat has offered three options to choose from to achieve this, explains Charles Vincent.

In April 2017, to allow for competition in non-household water retail in England, each water company needs to separate its non-household retail business from its wholesale business. This will ensure that the incumbent retailers do not have a competitive advantage over others trying to enter or expand within the market. Ofwat has now made clear the three choices each company has to achieve this:

1.    remain fully legally integrated;

2.    functional separation or outsourcing within the current appointment;

3.    transfer non-household customers to an associated licensed retailer through the exit mechanism.

With less than two years to go, those who have not already done so need to decide rapidly which option they are going to choose or risk not being ready.

Each option has distinct advantages and disadvantages and all require significant and divergent work to investigate and implement. With every English water company having to make the same decisions and implement them, access to the required specialist knowledge – particularly those individuals who have operational experience from Scotland – is limited and is proving increasingly difficult to access.

To choose which option, companies will need specialist advice to evaluate the:

•    value of the retail customer base if sold now or in the future;

•    capex vs opex impact of each option over the long term;

•    choice of being a national or local retailer;

•    impact on support service provision;

•    shareholder attitude to risk of exposure to a competitive retail operation;

•    risk of the regulator stretching margins through greater wholesaler efficiencies (as has happened in Scotland);

•    risk of a financial default by a large retailer;

•    complexity and cost of required governance;

•    provider of last resort obligations in area;

•    likely retailer behaviour and the “policing” that may be required.

The difference between options 1 and 2 is primarily one of organisational structure. However, adopting option 3 (retail exit) could prevent unnecessary expenditure on generating a retail capability that would be duplicated (and therefore redundant) if customers are transferred to another retailer that has those capabilities.

Possibly the hardest question to be answered by water companies is: “Do I have (or can I develop) the capability to compete in retail?” With the possibility of 40-50 retailers in the market, what is going to make customers pick a particular retailer? The answer might be that for a large number of customers there is insufficient incentive to switch and retail margins can be retained within the retail organisation for that reason. This customer “stickiness” might mean that it is cost-effective to manage a declining customer base. It is also a consideration as to what percentage of their business your largest key customers have in area and where they are headquartered as this may affect their likely switching behaviour.

This means there are two possible options:

Develop a retail proposition that will ensure customers making a choice will pick you – this will mean considering the price proposition, core customer service quality, additional retail services such as national consolidated billing and additional water services such as alternative water supplies or effluent pre-treatment. This is likely to require the largest capex and opex “war chest” to deliver and likely to carry the greatest financial risk if the proposition does not resonate with customers. The potential reward, however, is the ability to retain and increase retail margin within the organisation, particularly if margins grow.

Manage your existing customers effectively but provide no additional customer proposition – this is likely to be a lower cost option, but can only result over the long term in declining retail margins as customers switch. It is possible that this could result in higher levels of profitability at lower risk.

If neither of these options suit the overall corporate strategy, then realising the maximum value of your customer base and protecting wholesale income become the key focus. This also means that the business can focus its resources and key personnel on the wholesale business without such significant governance concerns as involved in option 2 and particularly option 1. This potential improvement in wholesaler performance areas such as data, operational code operation and retailer management may provide shareholders with a smoother transition into competition. This also does not preclude the option of creating a new retailer in the future that can cherry-pick customers and does not have a legacy low-value customer base.

Whichever option is chosen, each water company needs to decide fast. Option 1 and 2 mean generating either a separate or internal business unit, with option 1 requiring large amounts of regulatory preparation in addition to the need to develop an operational ability to interact with the new market operation. If the strategy is to win new customers, a retail proposition and sales capability will need to be in place long before April 2017, with the expectation of many of the larger deals being signed before the market is opened.

If retail exit is being considered, then knowing the value of the customer base is essential to making an informed decision and potentially allowing the set-up costs of a new retailer to be avoided. These negotiations may take an extended period of time and may leave the company in the situation where there is no time to set up a retail operation and it is forced into a distressed sale for less than the customer base may be worth.

Whichever option is taken, water companies need to ensure they have taken the decision not from the viewpoint of a monopoly water company but from the harsh commercial reality that the new market presents – where the wrong decision on retail could result in unexpected losses for shareholders in an industry that has traditionally been about long-term stable returns.

Charles Vincent, managing director, Ascendency Water