The Strategic Review of Non-household Spicying and Supply Pipes

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1 Commission information paper CP27/09 This paper provides a further update on the review of wholesale activities. The initial review of processes suggests that transferring responsibility for trade effluent consent management, new connections and metering from wholesale to retail could be possible and bring substantial benefits to customers and retailers. These benefits could be both in price and service immediately and in terms of longer term innovation. Non-household septic tank emptying and supply pipe leakage can almost certainly be easily separated and transferred to retail- there are however some issues which need further consideration. These include the materiality of the activity and whether there is likely to be substantial interest from new entrants. Background As part of the next Strategic Review of Charges, the Commission intends to review the activities that Scottish Water classifies as wholesale activities with a view to increasing the scope of activities that Licensed Providers are able to offer. We have asked Scottish Water to review its own activities in its business plan and also have provided a list of 5 areas of activity that we expect to be able to transfer. In order to analyse Scottish Water s submission, we are undertaking preparatory legal and technical work. We updated the Commission in February on the legal position. This suggested that there were no material legal barriers to progress and that we could move to working on specific issues in each of the areas. Since the Commission meeting in February, we have three activities on which to report: SMC s review of retail and wholesale activities; discussions with Ofgem; and discussions with Gemserv. In May, the Commission will be asked to approve the approach to the transfer of wholesale activities to retail providers that we will outline at a high level in the draft determination. Review of retail/wholesale activities In order to help inform our review of Scottish Water s 2 nd draft business plan, we commissioned SMC to review the five areas that we had identified as Feb 09

2 2 candidates for reallocation between wholesale and retail. There were three main strands of SMC s work: A desktop exercise, setting out expectations of the detailed types of activity that Scottish Water undertakes in each of the 5 areas; Setting out process charts for each of these 5 areas; and Testing the process charts with licensed providers, Business Stream and Scottish Water. We will define the operational processes and the formal split of responsibility in work over the next several weeks. This will form the basis of our report to the commission at its May meeting. At this stage, there are three initial issues, which we would like to highlight. Ability to codify process At the outset, we recognised that we were investigating areas beyond that currently specified in market documentation. This may have meant that we were reviewing activities that were not well understood, even to the company itself. However, SMC was generally able to identify the types of activity that it would expect in each of the areas and these appear consistent with Scottish Water and Business Stream s view of the activities. Indeed, through the process of discussion with SMC, Scottish Water revealed that it had already codified many of the processes under consideration, having learned from its experience of retail separation. As a result, we now have detailed process maps in four of the five areas that can be used to develop the operational code. The fifth area Supply Pipe Leakage is discussed further below. Use of contractors A standard defence against competition by an incumbent monopoly is that it requires to undertake activities itself either to ensure statutory duties are carried out or to protect public health or the environment. As part of its work, SMC set out activities that it would expect contractors, rather than core Scottish Water staff, to carry out. It has tested this view with Scottish Water, who confirmed the view of SMC. Examples of such activities include: meter installation; Developer impact assessments (DIAs) as well as making the final connection; and trade effluent sampling.

3 3 This offers two interesting insights: firstly, legal arguments about requiring core staff to undertake the work are substantially weakened by the existing use of contractors; and secondly, the technical standards required to protect public health or the environment will already specified in contracts or terms of reference. Materiality of two areas: septic tank emptying and supply pipe leakage The SMC analysis shows rather clearly the potential of trade effluent management, metering and new connections. It is less conclusive in the other two areas: septic tank emptying and supply pipe leakage. We are beginning to question whether these areas are sufficiently material to the development of the market and encouraging innovation. It may be better to focus on the three most material areas (using the less material two areas in our inevitable necessary negotiation with Scottish Water). There are identifiable non-household septic tank activities that could fall within our description of retail activities. There would appear to be very few nonhousehold septic tanks, with on-site treatment facilities being more common for commercial premises not connected to sewerage system. Non-household septic tank emptying really only happens in the most rural parts of Scotland. As such we are beginning to question the scope for innovation and the likely interest of licensed providers. There are already private commercial organisations (eg Snowie) that will provide this service. We originally included the area of supply pipe leakage as a potential retail activity because Ofwat was consulting on its inclusion as a retail activity in its definitions for England and Wales. However, in its review, SMC found it difficult to set out specifically the activities that Scottish Water undertakes and that the level of activities was unlikely to be significant with regards to nonhousehold premises. We will do a little further work in this area but it may be that the costs transfer will be limited. Of course, just because Scottish Water does not do much in this area does not mean that there are not potential opportunities for retailers. Ondeo and other water management consultants have made reference to the opportunities to benefit customers by reducing supply pipe leakage. Discussions with Ofgem on new connections In January 2009, we met Ofgem s connections manager to discuss the connections process in the gas and electricity market. Ofgem s experience appeared particularly interesting as they had recently published a report on the state of competition in the connections market that compared the relatively favourable performance in the gas market with relatively poor performance in the electricity market. Ofgem has identified substantial scope for competition in new connections. There is not only competition for the interaction with the customer/developer

4 4 and for making the connection itself, but also for maintaining and operating the connected asset base (similar to the inset appointments process in the water industry in England and Wales) (what we have seen as a potential Section 29E opportunity). Ofgem contrasted the position of National Grid Transco with that of the Electricity Distribution companies, with the former apparently being less obstructive to the development of competition. A useful lesson that we can draw from Ofgem is that it is possible to define the technical standards required to make physical connections. There also appears to be a market for such activities, with a number of developers competing in the gas market. Ofgem now expects to be able to implement similar competition in the electricity market. Ofgem is not yet convinced that competitor ownership of parts of the network offers benefits to the end customer. At this stage, our proposals on new connections (absent a section 29E application) are limited to the interaction with the customer/developer and making the connection itself. Ofgem s experience in allowing ownership and management of local networks may be useful. Ofgem has a connections forum that we are considering attending on a regular basis. Ofgem also provided a contact with one of the developers that has been particularly useful in assisting it in developing thinking on connections competition. Discussions with Gemserv We met with Gemserv last week to discuss metering competition and smart metering within the gas and electricity markets. We met David Thorne who runs Gemserv s Gas & Metering and Regulatory teams. David was able to discuss metering competition from both the commercial and regulatory perspective having previously worked for Centrica, Ofwat and OFFER. Gemserv s view was that the focus for effective competition within the market must be accurate information and not necessarily asset division e.g. ensuring that any database of meter assets and responsible companies is kept up to date and accurate. The success of the introduction of competition within metering services occurred because of the clarity of message from the regulator Ofgem stated clearly that competition would benefit customers and was to be encouraged, and pressure for competition from the commercial side. Gemserv s view was that without pressure from both sides, competition is unlikely to bring the benefits sought. All parties that wish to provide metering services contract direct with the network operators and must sign-up to the meter operator code of practice. The code of practice is managed independently (by Gemserv) and periodic

5 5 reviews (both desktop and technical) are carried out on the signatories to ensure compliance. Smart metering is likely to bring benefits to customers long-term, but the challenge will be cost (in gas and electricity the cost/benefit of smart meters is only positive when the industry is taken as a whole i.e. inclusive of social benefits such as environmental costs) and the harmonisation of technology e.g. ensuring that smart water meters can be integrated with smart gas/electricity meters and vice versa. The key lesson view we have taken from Gemserv is that competition in metering is likely to bring benefits. However, to ensure that these benefits flow, it is necessary for strong regulatory action in defining, setting up and monitoring the frameworks. We are continuing to discuss some of the issues with other contacts in Gemserv. Our current view In May, the Commission will be asked to approve the approach to the transfer of wholesale activities to retail providers that we will outline at a high level in the draft determination. At this stage, our work on the legal and technical issues suggests that progress could be made in all five areas. However, there may not be a significant cost transfer in making retailers responsible for supply pipe leakage (although there could be PR benefits for the Commission in recognising and addressing the issue) and competition in septic tanks may not prove to be particularly attractive. Metering, trade effluent management and new connections are both feasible and material for licensed providers. We will report on our final conclusions in May.