Retail competjtjon: The story so far, the journey to come November - PowerPoint PPT Presentation

1 Retail competjtjon: The story so far, the journey to come Retail competjtjon: The story so far, the journey to come November 2011 www.watercommission.co.uk

2 Retail competjtjon: The story so far, the journey to come Companies, investors and customers stand to benefjt from an Anglo-Scottjsh retail market if we build appropriately on Scotland’s experience. • We need to think big to address the clear challenges that lie ahead; there is a need to improve business fmexibility and Collaboratjon not effjciency and allow space for innovatjon. rivalry • Achieving this will require much more collaboratjon between companies, more targeted regulatjon and real engagement between companies and their customers. • Measured, small steps will deliver progress and avoid alienatjng either the investor or the customer. • Why should a customer have to deal with up to 20+ suppliers? Businesses want • Why should more tailored, un-regulated value-adding services not be available? choice • In Scotland, customer choice encouraged innovatjon, led to more tailored services for all types of business and the public sector, and, even three years later, contjnues to reduce costs. • Environmental benefjts, including water and effmuent management. An Anglo-Scottjsh • Cost reductjons in retail actjvitjes to the benefjt of customers and investors. market • Implementatjon costs kept low. (building appropriately on Scottjsh experience) • Investors worry less about regulatory risk. • Implementjng any market framework takes tjme. Tried and tested • A bespoke market for England could increase complexity in its implementatjon and its operatjon. implementatjon • Our approach, based on practjcal experience and involving many interested partjes in Scotland, would simplify and de-risk implementatjon. It would be supported by customers, some companies, many investors and the Scottjsh Government.

3 Retail competjtjon: The story so far, the journey to come ➜ • Collaboratjon not rivalry • Businesses want choice • An Anglo-Scottjsh market • Tried and tested implementatjon

4 Retail competjtjon: The story so far, the journey to come Economic regulatjon of the water industry has been very successful. Our success in Scotland results directly from the framework put in place by Government at the privatjsatjon of the industry in England and Wales. • Ofwat’s regulatory framework, which we adopted in Scotland, had a number of useful incentjve propertjes. These incentjve propertjes encouraged Scottjsh Water to: • Reduce costs; • Invest to improve services; and • Improve service levels. Scotland England and Wales £105 lower than they would otherwise £110 lower than they would otherwise Average household bills have been have been* £4.3 billion since 2002-03, or £220 per £90 billion since 1989**, or £190 per billed Capital invested billed household per year on average household per year on average 35% reductjon from levels in 2002 Broadly fmat in real terms since 1989*** Operatjng costs * Review of Ofwat and consumer representatjon in the water sector , Defra, July 2011, page 63. ** Financial performance and expenditure of the water companies in England and Wales 2009-10 , Ofwat, November 2009, page 5. *** Future water and sewerage charges 2010-15: Final determinatjons , Ofwat, November 2009, page 96, Figure 11.

5 Retail competjtjon: The story so far, the journey to come But there are now new challenges facing the water industry. • Industry fjnancing: There is an ongoing need to fjnance investment, but company balance sheets are now stretched and, in Scotland, available public expenditure may be more limited; • Walker Review (2009): Afgordability and legitjmacy of household water charging is a growing issue. Upward pressures on bills because of stretched balance sheets are likely to reinforce this issue; • Climate change and carbon mitjgatjon: UK commitment to reduce carbon emissions by at least 34% by 2020 and at least 80% by 2050* (In Scotland, 42% by 2020 and 80% by 2050**); • Pitu Review (2008): Flooding and resilience of the water network needs atuentjon; and • Cave Review (2009): Innovatjon and competjtjon in water markets should be a part of the solutjon by contributjng to effjciency and more sustainable outcomes. *DECC website, available at htup://www.decc.gov.uk/en/content/cms/emissions/carbon_budgets/carbon_budgets.aspx. ** Low Carbon Scotland: Meetjng the Emissions Reductjon Targets 2010-2022: The Report on Proposals and Policies , Scottjsh Government, March 2011.

6 Retail competjtjon: The story so far, the journey to come And there is a contjnuing need to improve outcomes delivered to customers and our environment. It is not the once and for all challenge that was originally expected. • “Investment will remain high in the second half of the 1990s, it could revert to more Expectatjon normal levels in the early years of the next century”* • Investment in public health and environmental improvements has contjnued at Reality high levels** Annual investment Industry
gearing

 80% (Total
debt
as
a
percentage
of
RCV)
 60% 40% 20% 0% 1990-91 1991-92 1992-93 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 1993-94 2003-04 ➜ • Challenges around improving resilience, reducing carbon and meetjng the Water Framework Future challenges Directjve will further stretch balance sheets and put an upward pressure on customer charges. Sustainable outcomes require new approaches. * Future charges for water and sewerage services: the outcome of the Periodic Review , Ofwat, July 1994, page 24. ** Future water and sewerage charges 2010-15: Final determinatjons , Ofwat, November 2009, Figure 9, page 67, Figure in 2007-08 prices.

7 Retail competjtjon: The story so far, the journey to come The fjnancing constraints on the industry have the potentjal to alienate customers and/or investors. • Equity fjnance may be needed to help pay for future improvements. Over tjme companies may consider it prudent to reduce their currently high leverage. This could put an upward pressure on bills. • A greater portjon of capital investment will likely need to be fjnanced directly from customer bills (partjcularly to pay for the growing capital maintenance burden). Potentjal undesirable responses that could occur • Politjcal and/or customer pressure to keep bills down could lead the economic regulator to view the cost of capital as an easy short term palliatjve, or alternatjvely; • Pressure to maintain returns could force price increases that would likely have a negatjve impact on willingness to pay for future improvements. But the regulator can mitjgate this risk • Allowing the company to earn a higher return within a lower cost envelope (e.g. from initjatjves such as asset ratjonalisatjon that reduce the overall cost base). • Engaging customers in price settjng to improve legitjmacy and willingness to pay for environmental improvements. • Committjng that all NPV positjve projects will be allowed to meet their planned payback.

8 Retail competjtjon: The story so far, the journey to come We believe regulatjon needs to evolve to meet these future challenges. • Customers (and other stakeholders) are not suffjciently engaged in price settjng. Customers • Price settjng is a black box; • Lack of customer involvement in price settjng raises concerns about the legitjmacy of water charges; and • De facto, regulators decide what customers want. • The fjxed fjve year price control and delivery cycle may be both too short and too long: Investment • Too short: Initjatjves with long-term pay-backs (pay-back > length of the price control) are unlikely to be implemented because savings would be likely to be passed to customers before the investment reached pay-back; • Too short: Large capital projects are unlikely to divide neatly to fjt the fjve year delivery cycle – which could lead to ineffjcient procurement and exacerbate the stop-start delivery cycle; and • Too long: Flexibility may be required if prioritjes change within the fjve years. • There is an inherent, de facto, bias towards capital solutjons and there may be a bias against potentjally more creatjve and innovatjve solutjons. • Potentjally lower cost or lower carbon solutjons may be crowded out because returns are earned only on capital investment; and • Regulatjon can seek risk eliminatjon; it should, however, reward efgectjve risk management. • Settjng an average cost of capital may lead to sub-optjmal outcomes. Finance • We need to recognise that if we want companies to be more innovatjve or pursue longer-term benefjts on behalf of customers and shareholders they will require difgerent returns on capital; • Time horizons of investors are unlikely to match the length of the price control. Re-estjmatjng the cost of capital every fjve years increases regulatory risk and the cost of capital; and • The marginal cost of capital may be higher than the average – partjcularly for large or innovatjve projects or opportunitjes for asset ratjonalisatjon.