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Comment: What could retail competition do for customers?

Domestic retail competition could provide an opportunity to look again at how we determine the price of water to the customer and make the entire system more reflective, responsive and equitable, writes Martin Osborne

by Martin Osborne, Technical Director, Water, WSP

If we introduce competition in the domestic water market, it provides an opportunity to improve the current charging structure to align with principles that all agree with; but do we know what those principles are?
I suggest three principles that are a useful test of the current and potential future relationship between water customers and their suppliers. Charges should be: a) reflective of the cost of providing service; b) responsive to customer wishes; c) equitable. But when these principles are in conflict, which of them should take precedence?

Reflective of the cost of service

Under the current system, the charges in each region reflect the regional cost of providing service and a regional target level of service. So having prices reflective of cost of providing service is accepted as a principle, but only at a regional level. The charge to an individual community does not directly reflect the cost of providing service to that community. This leads to some anomalies - for example, the Thames Tideway scheme will be paid for by the people of Purley in Berkshire, who neither contribute to the problem nor directly benefit from the solution; but not by the people of Purfleet in Essex who do.

However, switching models so the costs fall at the community level would have its own disadvantages – not least, in that communities would struggle to afford large “lumpy” expenditure when expensive key assets serving the community needed investment. (Some of the small water-only companies have already faced this challenge.)

So how about the alternative of a national charge based on a national cost of providing service? This would need to be aligned to the devolved nations and potentially further sub-divided with future devolution to the English regions. But it could be seen to be fairer and to align with customers’ feelings of identity. National frameworks for the cost of providing service are already in place for telecoms and other utilities. So why not water and wastewater?

So our current system is not designed to be directly reflective of the cost of providing service.

Responsive to customer wishes

As for being responsive to customer wishes, prices currently reflect the cost to provide the level of service that is desired by its customers, with the customers’ wishes gauged through willingness to pay surveys and focus groups. However, these surveys have difficulties in gauging true customer wishes. In effect, we ask customers who have not had any failure of service how much extra they would pay for someone else to have no failure of service. It is a challenging concept to respond to.

Customer wishes are also gauged uniformly across a water company’s region, although at least one water company analysed the willingness to pay results separately by operating area. They found significant differences, but they decided that it was politically unacceptable to actually respond to those perceived customer wishes with different levels of service and charges.

It is perhaps reasonable that a community should be deterred from opting for a lower level of service at a cut price - but should it be prevented from opting to pay more for a better level of service? If a community suffers from river flooding they are not only able, but officially encouraged to pay extra to get a higher level of protection. But if the community suffers from sewer flooding it cannot.

So the current approach is not designed to reflect customer’s wishes at an individual, group or community level.

Equitable

The principle of fair redress is an important part of our legal framework; that one who suffers a wrong is recompensed for it and one who commits a wrong pays compensation. However this principle is not built in to our current system of charging for water services. As an example, if a customer is flooded with sewage, the water company pays the customer a rebate of a few hundred pounds, that is likely to be much less than the damage caused. However, if a company floods more than its target number of customers, then all customers, including the 99% who have not been flooded, receive a rebate. The cost to the company of that penalty for a flooding incident can typically be £42,000, but the impacted customer gets hardly anything.
So our current system is not designed to be equitable.

So how could the introduction of a market for domestic water customers improve the system’s alignment with these three principles?

Competition will see service provision split into wholesale and retail components. This changes the relationship between customers and the wholesale business by introducing the retailer as an intermediary. A customer pays the retailer, and the retailer pays the wholesalers. This potentially gives a mechanism to move from charges based on a regional cost of providing service to ones based on a national cost of providing service. An individual retailer could be paying charges to 20 or more different wholesalers at different rates, with those rates set by Ofwat through the periodic review process.

What if, instead, the retailers paid the national standard wholesale tariff to a market operator, who paid the wholesalers depending on their regional cost of providing service, assessed through the periodic review process? The control that Ofwat has over charges and over the wholesale companies would be very similar to the current system. This would provide charges based on a national cost of providing service. It would be easier for the retailers, no more difficult for Ofwat or the wholesalers, and the market operator would simply move money around in line with the Ofwat tariffs.

The only question is whether we support the principle of a national cost of providing service, or if we prefer the current rather arbitrary regional boundaries.

To go with a standard tariff based on a national cost of providing service there should then also be a national level of service. This of course is almost impossible to deliver with conventional hard measures of service. Every street in the country gets a different level of wholesale service depending on the details of the local water and wastewater systems.

But if service was measured not as the lack of failures, but rather as the compensation paid when failure occurs, then an equitable system is possible. A national level of compensation could be defined based on a national survey carried out by, or on behalf of, the retailers. Rather than asking customers, “how much extra would you pay so that someone else isn’t flooded”, they would be asked, “if someone is flooded, how much compensation should they get.” Most customers would understand that.

When there is a failure of service affecting customers, the retailers pay the standard compensation to the customers and reclaim it from the wholesalers. Ofwat would need to monitor that retailers were paying their customers the compensation, but this is a similar role to their current one in monitoring GSS payments. Retailers should ensure that wholesalers pay them the standard compensation.

This then, has one of the real characteristics of a market where price and cost signals drive real levels of service provided by the wholesalers. If they are at risk of paying large amounts of compensation in an area, they will invest in the system to improve performance and avoid the payments.

With service defined as compensation for failure, the door is also open to each individual householder to have an individual level of service. They can opt to pay a higher charge to the retailer, and in return, when something goes wrong, the retailer pays them higher compensation. It is the retailer’s calculation as to how much extra they should charge customers to provide the extra compensation. It would drive improvements, since if a retailer has many customers in an area prepared to pay more for a higher level of compensation, then it becomes worthwhile for that retailer to fund the wholesaler to improve the real level of service to their customers and others in that area.

So the introduction of competition could be the trigger to put right a lot of what is currently wrong with charging for water services and give us a system that aligned with principles that we could support. The question remains - are we ready to make such a radical change?

-This article appeared in the October 2017 issue of WWT magazine.

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