Thames Water prepares to compete

Photo courtesy Southern Water

Thames has won a license to start selling water across England and Wales. The move is in response to Defra allowing companies that use more than 5 MGl per year to buy their water from a third party. But will this really drive down costs for companies like Coke Cola or Tesco?

For a nationwide company to have just one supplier and a combined bill may help it understand where its using water and where savings are possible. But the cost of the water will not reduce significantly by competition. The water companies will still have to buy the water from an existing water company. It will be exactly the same water being supplied to a factory as is currently the case it is just the bill that will come from another supplier say Thames Water.

The problem is that the cost of water is dominated by the fixed costs of maintaining and investing in the infrastructure. Billing costs are relatively trivial. Look at what has happened in Scotland. When Business Stream the industrial retail arm was separated from Scottish Water, significant one off costs were incurred that Ofwat estimates will take over four years to pay back. Worse annual costs were also higher due to the complexity of the new systems and new IT costs. The net saving was only £4 million a year. This is less than 0.5% off water bills. Would you switch water suppliers for a saving of 0.5% off your bill?

In the view of this blog competition is an unnecessary distraction for the water companies. It would be better that they should focus on their core business and drive down their costs for 99% of the business not waste management time focussing on the roughly 1% represented by the cost of sales 

Flood or drought - who knows!

Photo source: BBC news

The wet summer raises the vital question. Is this a statistical anomaly and unlikely to be repeated for another 100 years or is it a sign of things to come?

The question is vital for the water industry. To date most of the thinking about the impact of climate change has assumed that the UK will have generally drier summers especially in the South East. Already massive investment is underway to improve resilience and increase water supplies. Bristol Water are planning a new reservoir yet the current one is currently literally overflowing.

IF the impact of climate change is to move the gulf stream north and this year’s wet summer becomes the norm that has massive implications. Already the signs are that this year will see the worst bathing water results for at least 10 years. Major tourist beaches likely to fail the standard include Bude, Exmouth, Weston –super-Mare and Blackpool.

With the tougher bathing water standards being introduced in 2015 and the new requirement to display visible signs warning the public not to enter the water the potential impact on some of Britain’s major tourist beaches is disastrous. People will vote with their feet and go elsewhere. Massive investment will be needed to cope with the storm water and reduce flooding incidents.

The answer is that no one knows what is likely to happen to the weather. This is probably the worst position for the water companies as it means their plans will have to allow for the two possible extremes. If both dryer summers and wetter summers are realistic possible outcomes this will require investment to both improve water supplies and manage floods. The result will be much higher water bills something none wants.

Urban Waste Water Directive now completed in the UK

Photo courtesy of Southern Water Services

March 2013 marks an important milestone, with the commissioning of the Brighton and Hove wastewater treatment works all UK cities with more than 15000 pe will have secondary treatment. In Northern Ireland there is only one site left to complete namely Ballycastle, where plans are progressing. 

To mark the milestone DEFRA has published a review of waste water treatment in the UK. 

The situation in Europe is not so positive especially with the southern European countries where significant investment is still required despite the passing of the 2005 deadline!

The water companies currently collected about 96% of all wastewater generated the remaining 4% is mainly from very small rural communities or individual properties which will typically have private wastewater treatment plant or cess pits.

There are two main areas left where significant further investment will be required, sensitive areas and combined sewer overflows or as they are now often called unsatisfactory intermittent discharges (UIDs).

In 2011 the UK designated a further 68 sensitive areas bringing the total to nearly 600. Typically this will require water companies to install tertiary treatment. In addition the demands of the Water Framework Directive often required enhanced secondary treatment or tertiary treatment.  To meet the requirements for the new sensitive areas alone a further £40m of capital investment is likely to be required in the next regulatory period starting 2014. The deadline for completion is 2018.

The second major area is UIDs, here the wet summer has exacerbated problems and major investment will undoubtedly be needed – this will be covered in a subsequent blog.

It is a major achievement to have met the main requirements of the Urban Waste Water Directive and the total bill is likely to have been about £8 billion.   

Future price limits for UK water utilities

There is much to be welcomed in Ofwat’s “Future Price Limits - statement of principles". Certainly focussing incentives carefully to deliver desired outcomes and reducing and removing regulation will be welcomed. But is there still too much emphasis on the Regulated Capital Value (RCV)?

RCV measures the money invested in the water business and the water company’s shareholders get a guaranteed return for the investment made. It’s a nice simple and easy method for the regulator. But is it in the best interest of customers? The big problem is that it encourages water companies to invest in capital solutions not revenue. So innovative ideas like managing the water catchment better to prevent pollutants entering the water course rather than paying to remove them get penalised as often they involve no significant capital expenditure.

Ofwat have looked at the issue of Capex bias and recognised there may be a problem. There is a natural tendency to want to engineer and build things – finding the right balance between Opex and Capex is not easy.   

Will social water tariffs make a difference?

The Government has announced today that water companies will be allowed to reduce water bills for those unable to pay – the so called “social tariff” This will be paid for by cross subsidy from other water customers.

On the face of it, it is an imaginative idea to solve the problem of escalating bad debts. This is already adding over 1% to customer’s bills. The Government is proposing that water companies must ensure that the increase in bills is kept to a level that customers find acceptable perhaps around 1.5%. If the introduction of social tariffs helps to significantly reduce bad debts then it is an excellent idea.

But will it actually work? There is a significant problem. At the moment local citizen’s advice offices are advising those in debt to pay their water bills last – after they have cleared all other bills. This is because there is nothing a water company can do (except plead) if a customer says they cant afford to pay. The result is that many ‘poor’ customers are choosing to pay their Sky bill but not their water bill – is that fair? Unlike other utilities cutting off the water supply is not allowed. So bad debts for the water companies have been escalating rapidly.

It would have been better for the government to suggest a much larger social tariff discount but then to back this up by restoring the right to cut off the water supply.  That is more likely to be perceived as fair to all customers.

Future Price Limits

Photo: Southern Water

A major change in the way the water industry is regulated is underway. Ofwat in its Future Price Limits – statement of principals maps out the intended changes. The biggest changes are the move to setting outcomes and not outputs with the outcomes set in conjunction with customers. The rational is to encourage water companies to innovate and outperform.

But has Ofwat gone far enough? Several key constraints of the current system will remain. Regulated Capital Value stays as a vital determinant and the regulatory period stays as five years. This means that two of the biggest concerns of the current system are likely to remain, the inherent bias towards capital solutions and the adverse impact on the industry of the drop in investment at the end of each regulatory period.

Ofwat states that: “While we were reviewing our price setting tools, many stakeholders told us that the way we treat capex and opex separately has become complex and burdensome. We have also heard that our approach may create perverse incentives, ranging from a bias towards capex to a rigid, technical and inflexible approach from companies that are driven by the detailed mechanisms we use. Others have perceived that our overall approach may encourage ‘gaming’ or ‘padding’ of business plans by companies that may consider it in their interest to inflate costs in their original submission.

But while Ofwat propose to move to a total expenditure model as the way forward they then qualify the statement by suggesting that a lot more work is needed to work out how it can actually be done and that it might not be possible to implement it in the next regulatory period!

Its clear that the water sector remains highly attractive to investors, what is not clear is whether Ofwat has got the balance right between the need to sustain investment while delivering an affordable service. With the harsh economic environment – it is likely pressure from customers to rebalance the equation will increase.