Government should cease requiring water companies to be vertically integrated

December 2, 2013

The benefits from vertical integration of the big energy companies has recently come under political scrutiny.  This is an organisational structure that the market has delivered, and there are complex arguments about the costs and benefits of it.  But in the water sector, it is legislation that requires vertical integration.  And the Government’s Water Bill proposes to continue to require it, in the face of broad-based opposition.

The Water Bill proposes opening-up of the English market for water and sewerage retail services to non-domestic customers.  All businesses will be able to choose which supplier provides them with customer-facing services, and it will be easier for new entrants to challenge incumbents, as is already the case in Scotland. (The Bill does not propose that domestic customers should be able to choose their supplier).

In our 2011 report, Water retail services competition in England and WalesPolicy Exchange researched the significant potential benefits from water retail market opening, and advocated the changes that the Water Bill is now legislating.

Making a new water retail services market work well and maximising the benefits for customers will be challenging.  It will be made more challenging by the omission from the Water Bill of mandatory legal separation of incumbents’ retail and wholesale businesses, in line with Scotland and as advocated by Policy Exchange and others.  Such separation would do much to help create a level playing between entrants and incumbent retailers, and reduce the need for interventionist policing and regulation by Ofwat.

But the Water Bill, as currently drafted, falls even further short of what is needed. Incumbent water companies would not even be allowed to legally separate off their retail business, nor exit retail services.  The Bill maintains an integrated water company licence which requires incumbent water companies to offer all services.

For an effective market there needs to be an ability for new entrants to enter and for existing market players to exit. Customers benefit from more effective and efficient suppliers replacing poorer performing businesses.

Allowing incumbent water and sewerage companies to exit from retail services would help ensure successful development of the new retail services market and thus benefit customers:

  • Successful entrants could more quickly acquire critical mass – by buying the customers of the less successful or committed incumbent retailers.  There appears to be plenty of scope for customer benefit if high-performing companies were to take on the customers of other companies.  Ofwat data has suggested that one water and sewerage company can spend up to twice as much as another providing retail services to each domestic customer; and Ofwat reports significant variations between companies’ customer services standards.
  • Where they wished to, incumbent retailing businesses would be better able to compete if separated from their wholesaling business.  A customer-facing business is a very different beast from the engineering-focused businesses of water wholesaling (water sourcing, transport and treatment) that dominate current vertically integrated companies.  Allowing separation would free retailers’ management to focus exclusively on customers and to take the sorts of rapid decisions that competing, customer-facing companies need to.
  • Where a company separated its retail and wholesale businesses it would be easier for the regulator to ensure that the competing retailer was not unfairly benefitting from its relationship with the monopoly wholesale business.  This would reduce the need for burdensome regulation on that company to ensure a level playing field for competition.

Allowing separation and exit would generate more general benefits for the sector, which could also be passed through to customers:

  • Where a company considered its strength was in wholesale water activities, allowing it to sell its retail business would enable its management to focus on wholesale.
  • Water wholesaling and retailing have quite different sets of risks.  Exiting retail services would reduce a wholesaling company’s risks from, for example, bad debt.  The sector would overall be able to access investors with a wider range of risk appetites.
  • Allowing exit from retail services would enable mergers between retail businesses, with benefits from increasing scale and scope.  There are currently twenty incumbent retailers each with large fixed costs such as billing systems and call centres.  In its impact assessment of alternative policy options, Defra recognised the significant potential benefits from increased economic of scale, suggesting that about seven water companies are below ‘minimum efficient scale’.  About 12 million customers are currently supplied by water-only companies and separately by sewerage companies.  Ofwat assumes that it costs 50% more to provide retail services to a domestic customer that is served separately by a water and by a sewerage company, than if the customer is served by a merged water and sewerage retailer.

These latter benefits – on scale and scope economies, on more specialised management focus, and on risk allocation – arise from allowing separation from the wholesale business of both the competitive non-domestic and the monopoly domestic retailing businesses.  Indeed failing to allow separated domestic retail services could lead to increased total numbers of retail businesses, losing existing scale economies, as well as reducing the potential for ‘spill-over’ benefits to the domestic sector from non-domestic competition.  (The regulator would need to police the boundary between monopoly domestic and competitive non-domestic retail businesses, as it would under current proposals.)

In its impact assessment, Defra found that not allowing voluntary separation would forego benefits worth around £200m – and this didn’t include estimates for all of the lost benefits such as from scope and scale economies.

The Government should bring forward an amendment to the Water Bill to create separate wholesale and retail licences that incumbent water companies could then choose to adopt.  The environment select committee, Ofwat and (according to a Utility Week poll) 78% of water companies support allowing exit from the retail services part of the water and sewerage market.

The government has so far resisted this (rare) coalition – on the grounds that separate licences could lead to mandatory separation reducing the industry’s attractiveness to investors; and that domestic customers would lose out on spill-over benefits from competition.  But the amendment proposed here would make use of separate licences voluntary – and allow both domestic and non-domestic retailing to be separated as a whole.

It is hard to see the grounds for Secretary of State Owen Paterson to require water companies – that lack the ability or desire to efficiently provide excellent customer service – to remain in the retail services market.  To do so would severely limit the benefits to customers from the Water Bill.

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