Default options

When designing default tariffs for the water retail market, Ofwat must protect customers while allowing competition to flourish, says Sam Williams

Ofwat has stated that it does not intend to apply formal price controls in the contestable water and sewerage retail market. Barriers to entry and expansion will be low so, in principle, effective competition could develop.

However, while competitive market forces should ultimately act to protect customers, a potential need for regulatory safeguards arises because of the uncertainty regarding how long it might take for competition to emerge. Delays in the development of competition might mean incumbent suppliers have a temporary window of market power, which they might take commercial advantage of by increasing prices or reducing service quality.

The regulator therefore wishes to apply some form of safeguard (or default) tariff to protect customers from excessive prices prior to competition developing. Such tariffs are generally designed to ensure a minimum level of service is provided at a maximum price. They therefore provide two forms of protection to customers in that they prevent service being downgraded below an acceptable level and prevent suppliers from charging excessively for that service.

There are a range of regulatory tools that could be used to address the issues raised by transitional market power, such as providing pricing transparency to customers or minimising switching barriers. It is generally preferable, where possible, to use measures that address the underlying factors that might be delaying competition (such as a lack of customer engagement) rather than the symptoms (such as customers being charged excessively).

In the water and sewerage industry, it is important to consider the implications that arise from the presence of multiple wholesalers (the existing water and sewerage companies will continue to be the monopoly wholesale providers of water and sewerage services in their respective regions). There will be a range of wholesale input prices that will vary across the regions. These will need to flow through to any default tariff “end price” to avoid margins in certain regions being squeezed or being set too high (both of which could ultimately harm customers). This means that, when discussing default retail tariffs for water and sewerage services, we are specifically referring to the “allowed retail cost” and “retail net operating margin” components of the end price, as indicated in the diagram.

The key implication is that, regardless of how default retail tariffs are designed, the end price paid by customers will need to vary by region. In other words, existing variance in company tariffs that is wholesale driven should persist.

Because default tariffs are designed to guard against risks associated with the exercise of temporary market power, their core aims are different from those of price controls in naturally monopolistic markets, where competition cannot develop. In particular, the primary purpose of a default tariff is to act as a backstop or safety net to customers, rather than seeking to mimic competitive market outcomes. This distinction is reflected in how other regulators have implemented safeguards in markets where deregulation or liberalisation has occurred. For example, during the deregulation of electricity markets in the 1990s, then electricity regulator Offer was explicit in its view that transitional (or safeguard) controls “should not seek to do the job of competition”.

The above goes to the core issue that is at the heart of how default tariffs are used in contestable markets: the balance between protecting customers from the temporary exercise of market power, and allowing competition to develop. How best to strike this balance is the key challenge faced by regulators because ultimately, it is largely a function of how they themselves design the tariffs (the speed and scope of retail competition is not independent of the regulatory design).

While the appropriate balance between these factors needs to be considered on a case-by-case basis, the regulatory risk of not allowing competition is typically greater than that of providing less customer protection. This is because the consequences of setting a default tariff that is so tight it deters competition would be that customers do not receive the benefits of competition, yet the regulatory costs of both supervising the market and setting default tariffs would persist. On the other hand, any customer detriment associated with setting a loose default tariff would, by definition, exist only temporarily until effective competition develops. For example, if the net margin element of the default tariff was set too high, ultimately it will be competed down.

While economic principles provide some guidance as to how such tariffs might best be deployed, in practice there is considerable discretion as to how they might be designed and implemented. In addition to the core consideration of the balance between customer protection and allowing competition, Ofwat has a number of specific design and implementation issues to consider. With respect to design, the key questions are: first, how the minimum retail service level should be set; second, what measure and level of allowed retail cost should be included; and third, what retail net operating margin should be allowed? Regarding implementation, Ofwat will need to consider to whom the tariff applies and whether customers are migrated to it as a “start price” at market opening.

Economics suggests there should be a single level of minimum defined retail service applied to all companies – and potentially a corresponding single level of allowed retail cost and net retail margin. However, if Ofwat wished to prioritise limiting any short run customer bill impacts, an approach based on “rolling forward” the end prices that would have prevailed under the existing price control regime (and deducting wholesale input prices from these) could be considered. The potential drawback of this would be that allowed retail costs and net retail margins would implicitly vary across the companies in a manner that could be detrimental to competition in the long run (if viewed from a national market perspective).

Ultimately, Ofwat has considerable discretion as to how default tariffs are designed and implemented – and there are few right or wrong answers. What matters most is balancing the benefits to customers that arise from short-term protection against those associated with delivering a vibrant, competitive retail market in the longer term. The benefits of regulatory reform itself are inherently tied up in the latter.

Sam Williams is a director of economics consultancy Economic Insight

This article first appeared in Utility Week’s print edition of 7th September 2012.

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