The Water Act: fizz or flop?

Critics of the Water Act are disappointed that it isn’t breaking open the market immediately, but Matt Firla-Cuchra says its far-reaching reforms will be felt in the long term.

The Water Act became law on the 14 April but few people seems to have noticed. It got little fanfare, hardly any press comment and not much analytical response. The City reaction was also muted. The government’s own announcement was low key and the summary high level and rather bland.

This is in a stark contrast to all the controversy provoked by the Cave Review of 2009, which recommended the introduction of competition, followed by years of wrangling over the extent of market opening, retail-wholesale separation, potential departures from the regulated asset base, and the battle for licence modifications. It is as if a ceasefire was signed after a protracted battle.

So, is the final product a watered-down, grand compromise with little real bite, which will trigger only limited change because it will be so difficult to implement? Or have all the critical issues been discussed and stakeholders are now focusing on implementation?

Whichever is closer to the truth (and that might depend on the aspirations of those who judge), a lot has been put on the table with complex implications. Retail competition might now seem more familiar, but the consequences of upstream reforms or the resilience duty on Ofwat are not yet well understood.

Let us start with the sceptic’s view. The main focus has been on retail competition, but it is not clear that much competition will emerge in practice and there is a vast amount of work still to do just to make it possible even in principle.

The retail market is small: after allowing for wholesale charges, the retail revenue in the non-household segment that will be open to competition may only be £250 million. The allowed margin is also low: the 2.5 per cent net allowed by Ofwat (to start with) is small compared with other markets.

The start-up costs for potential market players are likely to be high. The need to create the market and the system interfaces needed to manage customer information implies significant costs before any benefits can accrue to customers, not to mention returns to investors.

Even retail exits, which arrived last minute and attracted a more lively response, may be years away. Detailed rules need to be developed, permissions granted, and the universal service obligation still applies.

Beyond retail, the upstream reform, where arguably the largest value lies, has been put on hold until after at least 2019. Given the government’s view that it will take a “measured” approach to introducing upstream competition, it may take longer still.

The key point that sceptics miss is that much of the Act is about the longer term and about enabling change rather than mandating it. This does not make it less powerful but does make the impact more uncertain.

Even the introduction of non-household competition in 2017 will require a change of culture. And the longer-term changes are not just about retail, but also the upstream segment with plenty of space for innovation.

Ofwat has already started preparing reforms in the wholesale segment, by introducing the “network plus” and network management incentives, which are the precursors to more separation. This implies a shake-up of industry structures even if it unfolds in slow motion. The risk is that if retail reform is perceived as complex and expensive, upstream reform will be more so.

On all these fronts the Act can be seen as enabling a real revolution. The question is whether any revolutionaries equipped with the appropriate tools and determination will turn up to start it.

Retail competition is clearly leading the charge as the most visible element. But the Act is only the first step; Ofwat and Open­Water will have to develop market codes, the market operator, settlement systems, customer data management and much more.

The wholesale changes that are needed to create the market are less obvious and will require at least as much work. There is a need for wholesalers to develop cost-oriented access prices. Experience from telecoms and energy shows that this is a process where the regulator will use its powers to develop consistent non-discriminatory prices and it will be difficult to get it right from the start.

While many operators have acquired Scottish and English retail licences now, in the future under the Act one licence will enable an operator to sell services in both territories. This should put a pressure on margins for the market offering and pricing to converge in England and Scotland beyond 2017.

One of the key measures that might have a significant long-term effect, if it actually takes off, is third party access. The Act enables new players to provide new sources of water and sewerage treatment services via regulated access to the networks. Ofwat will want more network separation to make this possible and there could be implications for the regulatory capital value (RCV). There might be a cliff edge risk here – competition for the market might be fine, but any real risk of asset stranding would have significant implications for the cost and availability of financing.

There will also be new market codes and charging rules from Ofwat that are meant to increase transparency and streamline negotiations between incumbents to trade water. Water companies will be under increasing pressure to show they are using the most economical and sustainable source of water rather than self-supplying and adding to their own RCV. This might encourage better planning and implementation of the most efficient solutions.

The overall impact of this Act will depend on the appetite of those who can leverage it across different parts of the value chain. England’s water sector is in private hands and market-oriented reforms ultimately require private participation.

Both the government and Ofwat will play a crucial role in determining what the Act translates into in practice. All changes will require a lot more planning and preparation work before they become reality. It might seem like the water revolution has gone quiet, but that is because there is so
much more to build upon and to implement over time.