Select Committee on Environment, Transport and Regional Affairs Memoranda




  1.  The DETR consultation on water competition in England and Wales is a welcome step forward. Provided that a sound legislative and regulatory framework is in place, competition is a positive force which acts for the good of the industry and its customers.

  2.  Government has identified a number of objectives in Section 4 of its document and we support them fully. [These were health, environmental and social objectives.] Water UK strongly believes that, to achieve them, Government needs to adopt a strategic approach and develop a sound legislative framework for competition. The way competition is introduced and develops will have a far-reaching impact for customers, service quality and the environment.

  3.  In certain circumstances, some of these objectives may conflict with each other and we are concerned that Government has not yet developed proposals to put the mechanisms in place which enable the achievement of all its objectives in a competitive environment. In particular, the Competition Act 1998 has the potential to thwart the achievement of some of the Government's objectives if it is applied in an indiscriminate fashion to the water industry. We believe that legislative action is needed now to secure the Government's objectives and specify the role that the Competition Act must be allowed to play in water.

  4.  First of all, we believe that Government must decide what scope competition should have in water, for which an appropriate framework is needed. We discuss this and related strategic issues in Section 1 on the scope of competition.

  5.  We then discuss a number of broad principles governing regulation and charging in a competitive environment in Section 2, which are relevant whatever form competition takes. Then, in Section 3, we comment on the proposed changes to the abstraction licensing regime and water resource management generally. We shall make fuller comments in July in response to two further Government consultations on water resources.

  6.  We very much regret the order in which Government is consulting: the two specific consultations on water resources would have been more useful in anticipation and in support of the competition consultation instead of, apparently, following their own courses independently of competition. We attach a diagram to this submission showing how we believe the issues are linked.

  7.  Finally, in Section 4, we comment on the Government's proposals for incremental changes to the current competitive arrangements (inset, bulk-supply, mains connection etc). We are concerned that Government is proposing to remove some of the controls which existing water undertakers currently exercise to protect public health and the environment and appears not to have yet developed proposals for the mechanisms which it will need to put in place as a replacement. Without these replacement mechanisms, competition will be seen as increasing risks to the public when it need not be so.

[Section 1 omitted]



  8.  Competition will deliver most benefits if it is conducted according to certain rules which all competitors must follow. In water, the reasons for these rules are based on considerations of health and safety but also on the need to ensure that only those competitors succeed who are really best at serving their customers, and not merely those who gain a short-term advantage because they avoid some of the obligations currently placed on existing undertakers.

  9.  A fundamental principle for water competition is that all participants must be subject to licensing by the Director General of Water Services and monitoring by the DGWS, Drinking Water Inspectorate and Environmental Agency—and not by the existing undertakers. All participants should (as far as practicable) be subject to the same legislative regime as the existing undertakers. This principle is essential whatever form of competition is introduced for a number of reasons:

    —  Licensing provides for an independent check on the suitability of new entrants. Otherwise existing water undertakers would be policing entry to the water industry by potential competitors, which is inappropriate.

    —  Even if a new entrant were to engage in retail competition only, without common carriage, such a new entrant would need to be licensed to ensure that it fulfils appropriate environmental and social obligations like the other participants in the market.

    —  If common carriage is introduced as well as retail competition, licensing is essential to safeguard health, security of supply, and integrity of the network. The Drinking Water Inspectorate has jurisdiction over licensed undertakers only, and it would be unreasonable to expect the current undertakers, as pipe owners, to face a criminal liability for failing to supply wholesome water when the offending water has been provided by new entrants which are not subject to DWI controls. New entrants ought to be policed for water quality by an independent authority, namely the DWI, as well as by the organisation responsible for network management and the final delivery of water to customer taps.

    —  Moreover, licensing can require that appropriate provisions are made to ensure that a supplier of last resort exists for all domestic customers without stifling competition.

  10.  Primary legislation will be needed for a well-functioning licensing system to be set up and to ensure that the criminal liability for supplying unfit water is assigned correctly. Water UK offers to work closely with DETR to settle the details of the required legislative changes.

  11.  Apart from provisions for universal licensing, the regulatory framework needs to be augmented by provisions which make it clear that the current statutory undertakers, as pipe owners, retain overall control of the network and inputs to the network.

  12.  We believe that there is already a substantial degree of reasonable consensus on access to networks. The water industry has agreed and published its Principles for Network Access. A combination of these Principles and a clear framework of legislation and regulation could form a sound basis for a national code.

  13.  The industry and Water UK would wish to take the lead in developing such a code in partnership with relevant stakeholders. The result would be fair and balanced and would reflect the needs of both parties to an agreement as existing members of the industry, so far, have been the most active competitors and new entrants in others' territories.

  14.  If Government felt it necessary, such a code could then be translated into a statutory code under of the Water Industry Act 1991. It may be necessary to legislate to ensure that such code is exempt from the Competition Act but further legislation would be counter-productive. Indeed, such a code can provide a broad framework only, as many local issues need to be resolved on a case-by-case basis. Also, and most important, any access code, even a national one, needs to be able to evolve over time.

Cost of Competition

  15.  It is important that the introduction of competition is accompanied by efficiencies in regulation, where possible. However, we are not over optimistic about the scope for reducing the costs of regulation as we see little opportunity for significant reduction of OFWAT's regulatory activities as a result of this consultation paper. OFWAT's budget has increased inexorably ever since it was set up and this year's increase has been justified by the need to take on extra work arising, in part, from the Competition Act. Also, the cost of regulatory activities for DWI and the EA could increase significantly.

  16.  Nevertheless, we think OFWAT should be challenged by central Government to put forward proposals for efficiency savings.

  17.  We would like to see a proper regulatory appraisal by Government of the costs and benefits of introducing competition, in whatever form. We presume that this will be issued at the time that Government responds to consultation and would welcome confirmation of this.

  18.  The prime aim of competition, as set out in section 3 of the consultation document, is to achieve greater efficiency than might otherwise have been achieved under the existing competitive pressures that already apply—OFWAT's approach to comparative efficiency, and capital market disciplines. In water, regulation via comparative efficiency has already led to substantial efficiency gains, and the scope for further improvement may be limited.

  19.  In framing an assessment the impacts on all customers should be considered. As paragraph 3.7 of the DETR document indicates it is important not to give some customers benefits at the expense of others. The impact on average bills for all customers over the medium term, relative to what might otherwise have happened, is therefore a good indicator.

  20.  Other important issues are whether there are impacts on public health, environmental quality, water quality and service standards, and on vulnerable groups.

  21.  We agree it is important that potential new entrants pay a fair share of regulatory costs. As an OFWAT letter to Managing Directors (MD154) indicates the direct costs of new entry should not be spread across the entire customer base. This is supported by observation of competitive markets, where cost of entry is borne by the new entrants and recovered from successful contracts.

  22.  One mechanism that achieves this is to ensure that the licence fees paid by existing undertakers and new entrants are all properly cost reflective. We are not aware of OFWAT's policy on this matter, which perhaps needs to be reviewed. Another mechanism is to allow incumbents to charge for work to assist new entrants.


  23.  The competition framework must be designed to ensure that all customers receive financial and other benefits from competition, not just a few at the expense of others. Water UK welcomes Government's clear statement that it wishes to maintain regional averaging. This objective, however, has a fundamental impact on the way access to the pipe network is priced.


  24.  The continuation of regional averaging requires both legal and regulatory support. Indeed, it is because of this support that the consultation document, in the last sentence of paragraph 7.20, can refer to the maintenance of averaging in gas and electricity, and it would be misleading to suggest that the maintenance of averaging in these sectors is not the direct result of statutory and regulatory action.

  25.  The statement in paragraph 7.21 that Government believes it important that "costs continue to be averaged across all customers in a region" provides an initial statement of Government policy that needs to be developed further. We believe that the principle of average pricing should be retained for all domestic customers and the link between policy for business prices and that for domestic average prices needs to be carefully assessed and controlled.

  26.  The Competition Act may lead to pressure from customers, particularly in distinct sub-regions, for a de-averaged price, using a challenge under the prohibition contained in Chapter II of the Act. Government could help to avoid this by modifying the application of relevant aspects of the Competition Act with regard to the water industry.

  27.  Beside the maintenance of regional averaging, a regulatory and legal framework needs to be put in place to ensure that the burden of the social and environmental obligations currently borne by all customers continues to be shared among them in a fair way. Customers should contribute to these obligations independently of who supplies them with water services. One method to achieve this would be through the universal licensing process which we advocated earlier.

Charging for network access

  28.  The principle of price averaging at the retail end must be backed up by regionally averaged network access charges, rather than charges reflecting the local costs of distributing water for a specific new entrant. [Allowances for leakage, for instance, may also need to be averaged over the whole of a regional network.] Government needs to provide clear guidance to the economic regulator that such charges [and leakage allowances] should be supported but it is important not to over-constrain companies at this very early stage of the development of competition.

  29.  There will be pressures on—and, perhaps, incentives for—companies which own pipes to which new entrants seek access to set access prices on the basis of relevant costs. This is likely to lead to a degree of regional de-averaging, for example between divisions within companies. One way forward could be for existing companies (pipe owners) to put forward access charging proposals that are appropriate to their local circumstances and for these to be reviewed by the regulator against principles agreed with Government.

  30.  Without express statutory provision, we do not think that regional averaging will be sustainable in water. This results from the relatively high costs of transport between regions, and the variations in the costs of new resources between areas. There is significantly less connectivity in the water "grid" both between regions and within regions. Hence transporting water is not only expensive, but often physically impossible without further capital investment.

  31.  As Government notes, the costs of laying pipes vary with geographical conditions (paragraph 7.20). This is likely to remain a relevant fact and we do not fully understand the first sentence of paragraph 7.20 suggesting that the unit cost of pipe laying and maintaining could be driven towards an industry norm. There is nothing in the Government's proposals that would increase the incentives to drive that cost towards an industry norm over and above incentives that already exist under the existing regulatory regime.

  32.  Cost differentials within regions are probably large. Reliable information is unlikely to be available because the water industry has not needed to assess the differentials until now. Experience in other network industries is that estimating cost differentials is not a straightforward exercise; it relies heavily on the chosen methodology and benchmarks. If Government wants to assess the cost of regional cross-subsidies, we suggest that an industry-wide exercise is needed to develop an appropriate methodology.

Charging for supply of last resort

  33.  The cost of being a supplier of last resort must be recoverable by the organisation responsible for it, currently the existing water undertakers. For business customers the arrangement should be a commercial matter to be agreed between the pipe owner and the new supplier, subject only to normal competition law.

  34.  Operational costs might only be charged for when the particular failure arises that causes a call to the supplier of last resort. If spare capacity must be maintained then a capacity charge would be required, which should be charged to customers of the new supplier, not customers in general. The opportunity cost of water reserved for cases of need but not sold to others must also be recovered. And the incumbent would need to be reassured that payment would be made.

Charging for trade effluent

  35.  As the consultation document notes, the water industry charges business users on the basis of an agreed formula, the Mogden formula. There is a lot of misapprehension about the nature of the Mogden formula which is reflected in the questions posed in the consultation document. The Mogden formula does not raise any significant competition issues that are not already addressed by the economic regulator.

  36.  The Mogden formula is a flexible framework and companies are entirely free to adapt the formula to their own local circumstances by, for instance, adding cost drivers for new substances. The balance between components is investigated by OFWAT to ensure that charging schemes are properly cost reflective.

  37.  Most concerns that customers have about trade effluent charges are essentially about rising charges, especially at coastal sites, which are a direct result of government policy to raise standards of treatment. It is the underlying cost pressures, not the formula, that constitute the real problem.

  38.  We do not believe that changes are needed and, therefore, do not have suggestions for making alterations. Enforcement under the Water Industry Acts would be an unnecessary addition to the burden of regulation and inconsistent with Government policy on better regulation. It would also add rigidities in a pricing mechanism which, subject to the provisions of the Competition Act and OFWAT's regulation, must remain responsive to the industry customers' requirements.

Cost of capital

  39.  The view attributed to OFWAT (at the foot of page 10 of the consultation document) that competition will have a minimal impact on the cost of capital is clearly incorrect. Markets are already aware that Government wishes to extend competition in water and that this is likely to lead to sizeable losses in incumbent company revenues.

  40.  This prospect is already included in water company share prices and is one factor, together with the 1999 price review outcome, which explains why the market value of many companies is currently below regulatory capital value.

  41.  The economic regulator has a continuing duty to finance companies' functions. This means that at the next price review the DG should allow a more realistic cost of capital than allowed in the 1999 review and make proper allowance for the risks associated with competition, including stranded assets.


  42.  In responding to this part of the DETR consultation we have taken other Government consultations into consideration as far as possible, namely that by the DETR on Economic Instruments and that by the EA on Catchment Abstraction Management Strategies (CAMS). A diagram[21] at the end of this response outlines how we believe the issues are linked. We shall comment more fully on issues relevant to water resources in responding to these two consultations.

  43.  If Government decides that competition should develop through common carriage and competition for water resources, the need is then to devise mechanisms for water abstraction and treatment which ensure that competition for water resources leads to greater water efficiency and cost savings. We do not believe that the current proposals will necessarily achieve this result. Specific proposals may, instead, increase the cost of abstraction licences, which will eventually be passed to customers.

  44.  We agree with the policy objective in paragraph 4.4 that there must be no detriment to the environment from changes in the abstraction licensing regime. Any changes must be underpinned by clear legislation.

  45.  We are very disappointed that various proposals in the three consultations apparently ignore the fact that the industry needs to retain licences because of its obligation to supply and its role as supplier of last resort. If the current water undertakers are to retain their obligations as suppliers of last resort, which would seem appropriate for the time being, then they must have a guarantee that the water resources will be available. Indeed, our understanding of the Water Resources Act 1991 (section 15) is that it provides that the Environment Agency must have particular regard to the effect on water undertakers of the exercise of its statutory powers.

  46.  Many of the proposals also do not seem to recognise that the water industry is far from having a monopoly over water resources.


  47.  The supplier of last resort issue is important and needs to be properly addressed. In the interests of our customers, we must start from the presumption that, for domestic customers, the obligation to supply of last resort rests on the current water undertaker, as now. There is no such presumption for industrial customers. To impose one will limit innovation and, hence, competition.

  48.  Companies hold licences which they do not use because of their need to plan for drought years in particular. It would be inappropriate to assume that these licences are therefore hoarded in contravention of the Competition Act. We are concerned that Government does not appear to recognise this essential point.

  49.  The new legal framework which we are asking for must make clear provisions identifying the supplier of last resort, recognising that this role could evolve as new entrants become large suppliers. The concept of "supplier of last resort" will need to be defined very carefully. It must relate to objectively measurable conditions such as "extreme drought" and not, simply, to the fact that a competitor has used cheaper, but unreliable or interruptible water sources. As we said earlier, the costs to the supplier of last resort must be realistically assessed.

  50.  For the time being, the network owner must remain responsible for drought contingency plans.

Transfer of licences and bulk supply

  51.  We do not support giving a special role to DG to order compulsory transfers of licences or bulk supply. Additional powers for the Director General merely add another layer of complexity. Management of the abstraction licence process and water resources generally needs to be clearly defined and left to the EA in furtherance of their own statutory water resource duties. The Director General, the OFT and the courts can already challenge companies for the abuse of a dominant position under the Competition Act.

January 2001

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