The water sector faces a far-reaching upheaval over the next 5-10 years after a brief and unexpected announcement from the government.
According to the Treasury and BIS, “Building on opening up the non-household retail market to competition, the government wants to extend choice to households. Ofwat will provide an assessment by summer 2016 of the costs and benefits of extending retail competition to household water customers. Following this, the government will work with water companies to begin the transition to retail competition before the end of this Parliament.”
As the market absorbs this, it will be vital to understand whether the benefits of competition will be expected to exceed the costs (both centrally and for market participants), alongside the associated industry structural changes and political risks.
Government will have to weigh up the extent to which these benefits could be captured through more refined forms of monopoly regulation. And some of these are already assumed in the cost-benefit assessment for non-household retail competition through the concept of spill-over benefits.
Nonetheless, what we are seeing is a clear shift in policy position from one that has been at best neutral on household retail competition to a more positive stance.
The statement’s wording on timing is carefully nuanced and much of the instant commentary on the opening of the market by 2020 is likely to be misplaced. In practice, there would probably have to be a fairly long timetable towards implementation.
The government would have to consider, for example, whether any further legislation would be needed to facilitate the market and associated consumer protections, and then find time for it in the parliamentary schedule. This could include extending the retail exit arrangements beyond non-household retail functions and company licensing. An industry-wide change programme to develop and then implement the rules, systems and processes would have to be established – effectively a successor to the current Open Water Programme. And Ofwat would have to include the necessary arrangements in the PR19 price control methodology in 2017.
So, a full opening of the household retail market in the early 2020s looks like a more realistic aspiration.
This would allow a structured implementation that would not only take into account but build on the lessons from introduction of non-household retail competition, including any work that will have to be carried out to deal with teething problems.
The complexity of implementing household competition should not be underestimated. The market is ten times larger than the non-household sector. It is unlikely that the systems and data transfer arrangements are fully scaleable. The arrangements would deal with a much higher proportion of non-metered premises and estimation in financial settlement. Consumer education and protection will be much higher up the agenda, as will sensitive transition issues around the unwinding of cross-subsidies and other potential incidence effects.
In ten years, it’s likely that we’ll see an industry landscape with significant competition at both the upstream and downstream ends of the value chain.
For investors, widening retail competition to cover all customers would change their risk exposure materially. Non-household retail competition has a very small impact on shareholder value, but household competition could put 10 per cent of shareholder company value at risk. On the other hand, the split between wholesale and retail activities would become much cleaner. We are more likely to see value chain specialisation emerging, with some companies choosing to exit retail completely to focus exclusively on wholesale activities, and others combining their retail businesses with other participants to form large national players.
In response, incumbent water companies would do well to consider all the decisions they make through the lens of competition and not just outperforming on PR14 cost and service commitments.
• How well you know your customers and their requirements?
• How good is your understanding of cost-to-serve and profitability of individual customer segments?
• How good is your data about individual customers?
• What would it take to retain customers?
• How might disruptors and new entrants view the sector?
Companies’ longer term positions on household and non-household business separation may also change. If full competition goes ahead it will be less beneficial to have separated household and non-household businesses, so companies should consider whether they are establishing arrangements that are flexible in multiple scenarios. The same applies to decisions about longer term service delivery models, such as the agility of customer management, billing systems and metering contracts
Any new entrants are more likely to come from outside of the sector than is the case in the non-household market. This will present its own licensing challenges for Ofwat and competitive challenges for incumbents.
The last time household retail competition was mooted, there was significant interest from some of the major energy retailers, and British Gas even considered the acquisition of a water company.
We should expect significant interest from the energy sector again, but this will be tempered with healthy scepticism about timing and the political will to go all the way.
But the era of converging utility retail may be a step closer.
Richard Laikin, UK water sector leader, PwC