Utility Week expert view: Karma Ockenden

“Times have changed since the government first signalled it favoured retaining vertically integrated water companies.”

Perhaps it is with one eye on affordability that the government has hitherto been wedded to the vertically integrated water company model, despite being poised to introduce business retail competition
in the Water Bill, which entered the committee stage
this week.
One of the raft of impact assessments published ahead of the second reading of the Water Bill was on the costs and benefits of adopting different structural models in light of retail market opening in 2017. Against a base case of doing nothing, the assessment considers retail competition plus: legal separation of water company wholesale/retail businesses; functional separation of water company wholesale/retail businesses; allowing companies to choose whether to separate along wholesale/retail lines; and no separation.
The government’s preferred option – no separation – is far and away the cheapest. Costs relate primarily to the regulator designing and adminstering new settlement and switching arrangements. However, the option also has the lowest level of benefit and the lowest net present value (though some take issue with this, insisting Defra’s numbers are a considerable underestimate).
The government justifies its decision mainly on the grounds of not scaring away investors (who have stumped up £90 billion since privatisation) and because it feels the higher benefits of other options do not outweigh the higher risks they carry.
On the surface of it, this seems a reasonable, cautious approach. But it carries with it a number of problems. Chief among which is, even by the government’s own admission, there is a real danger that retail competition could be completely scuppered if incumbents are in any way able to favour their own retail arms over those of new entrants.
The impact assessment notes: “Due to the higher potential for anti-competitive discrimination, there is a risk effective competition might not develop.” Surely if retail competition is being introduced at all, the underpinning framework must be fair and equitable. New Policy Institute director Peter Kenway, before the Water Bill committee on Tuesday, said the legislation looked like it had “an insider interest” rather then containing a properly competitive model new entrants would feel comfortable entering.
Legal separation, admittedly the highest cost but also the highest benefit option, would be the cleanest way to ensure new entrants get a fair stab. It has worked in Scotland, where wholesaler Scottish Water operates separately from retailer Business Stream and where 13 licensed providers offer choice and savings to business customers.
Shying away from following the Scottish model will be cumbersome and complicated because discriminatory behaviour will have to be prevented by other means. There are already both ex post (remedies) and ex ante (preventative) tools available for this and the Water Bill considers new ones, including enhanced licence arrangements, new codes and new charging rules.
Consumer Council for Water chief executive Tony Smith told the committee on Tuesday that Ofwat would have to be tough but could handle new entrant issues. But it would be a big job for Ofwat to oversee an active business retail market with regulatory tools; it would add multiple layers of complexity to what will anyway be a market demanding regulatory intervention and oversight. Even in the legally separated Scottish market, Business Stream is subject to licence conditions tempering its dominance and access to the market is regulated.
And with complexity comes cost. The cheap no-separation option may not stay cheap for long. Business Stream chief executive Mark Powles, interviewed on page 8, observes: “You spend your money on separation or you spend it on defending competition cases. Because if you compromise on the compliance regime, people [retailers] are going to poke at it and wave the flag and say this isn’t right.”
Finally, times have changed since the government first signalled it favoured retaining vertically integrated water companies. This followed effective lobbying from the water industry and its investor community after the Cave Review in 2009 against mandating structural change. Now many firms are reorganising behind closed doors into retail and wholesale divisions anyway. And when final determinations emerge from the business plans submitted by water companies to Ofwat on Monday, the regulator will for the first time treat wholesale and retail controls separately.
As the Bill is scrutinised by committee and makes its way through the House, ministers would be wise to give the retail market a real chance of working by reconsidering being wedded to vertical integration.
Legal separation would be the best – and a proven – path. But realistically, this is likely to be a bridge too far, particularly at this late stage in proceedings. Functional separation, supported by robust regulation, would be the next best thing. And actually has the highest net value of all the options priced.