Market architecture plan. Delivering an effective retail market for non-household customers

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1 Market architecture plan Delivering an effective retail market for non-household customers July 2014

2 About this document This document builds on the Market Blueprint, an initial consultation that Open Water published in January The market architecture plan (MAP) draws together discussions to date and summarises, as far as is possible, the consensus view, as well as highlighting areas of ongoing debate. It also highlights the relatively few occasions where thinking that emerged through the Open Water workshops that took place during the spring of 2014 directly contradicts a recommendation made in the Market Blueprint. Responses to the Blueprint will be published on our website (www.open-water.org.uk) in due course. Further complementary documents may be published by Ofwat on related matters, such as consumer protection, licence changes and other regulatory initiatives. We welcome comments from stakeholders at this stage. These comments should be sent to: John Parsonage Open Water 21 Bloomsbury Street London WC1B 3HF Or to: All comments should be received by 15 August They will be published in full unless the respondent indicates clearly that the response (or parts of the response) is confidential. We plan further open and constructive discussion with the industry over the coming months in order to finalise the market design. In particular, there will be a second series of workshops where the industry will seek to agree the detailed rules and processes that will underpin the market (for more information on the workshops, see Next steps page 17). It should be noted that at this stage no final decisions on the form or content of the non-household retail market have been taken. Similarly, the MAP should not be taken as reflecting the views of Defra or of Ofwat. We are not aware of any inconsistency between this document and the views of Defra or Ofwat. However, if there are any inconsistencies between the MAP and decisions that Defra or Ofwat take, then it would be their decisions that would apply. In such instances we would adjust the retail market design to align with Defra or Ofwat s approach. Finally, the processes described in this document may be relevant to companies wholly or mainly in Wales but it is recognised that the Welsh Assembly does not currently intend to reduce the 50 megalitre eligibility threshold for non-household customers to participate in the market. 2

3 Contents Key messages 4 Design principles 6 What company CEOs and their Boards need to know 8 Chapter 1: Introduction 19 The role of key parties and development of this document Chapter 2: Ensuring a level playing field 22 Measures to ensure a level playing field and arm s length operation Chapter 3: The operational rules 34 How a wholesaler should interact with retailers to ensure a seamless customer experience Chapter 4: The market rules 43 The role of central processes in supporting the competitive retail market Chapter 5: Setting retail margins, and retail and wholesale tariffs 54 The importance of getting right the gross retail margin when setting retail and wholesale tariffs Chapter 6: Timetable and critical path 72 What needs to happen, and the timeline for this The following appendices are published in a separate document, available at Appendix 1: Level playing field: The use of the Governance Code in Scotland Appendix 2: Draft operational rules for discussion Appendix 3: Draft market rules for discussion Appendix 4: Wholesale contracts Appendix 5: Glossary 3

4 Key messages Key messages Water Act 2014 The Act introduces significant changes to the water and sewerage sector that will transform the way in which the sector delivers services to customers. Competition is already possible in the water industry. However, the Water Act 2014, Ofwat s 2014 price determination and the continuing expansion of the retail market in Scotland may increase currently observed levels of market activity throughout the value chain. This document focuses on implementation of the competitive retail market for non-household customers. How this document aligns with Ofwat s strategy This MAP seeks to contribute to building trust and confidence in the water sector. Giving non-household customers the right to choose their water and sewerage provider empowers them to take decisions around price and the level of service they want. A more competitive environment is likely to lead service providers to increase the quality of their offering to customers. PR14 Ofwat is setting four 1 discrete and binding revenue limits in its determination (three for the water only companies 2 ). These take effect in April 2015 for five years. Companies will be expected to evidence that they are living within these revenue limits. This is likely to require the creation of units with separate profit and loss accounts and balance sheets. Ofwat will issue regulatory accounting guidelines for in the autumn. Level playing field Company Boards are responsible for ensuring that they comply with the requirements of a level playing field and competition law more generally. Ofwat will look to company Boards to gain assurance that a company is complying and that all of the rules are fully implemented. Ofwat will continue to have an active casework strategy. It will take targeted action if companies are found not to have acted in the interests of customers. Companies will have choices about how they organise their businesses in order to live within the new revenue limits and market arrangements. Greater separation can help demonstrate that neither the incumbent s wholesale nor its retail activity has an undue advantage. Boards may also decide to introduce compliance officers to help implement their assurance processes. As such, there are likely to be trade-offs between up-front and potential on-going costs and the level of compliance risk that a company may be prepared to accept. Some companies may consider that it is better that they pursue the option of exiting the non-household retail market. Setting wholesale tariffs Companies should pay particular attention to setting wholesale tariffs. They could inadvertently offer opportunities for cherry picking or open themselves up to accusations of margin squeeze. This will require them to understand the cost drivers of both their wholesale and their retail activities within the binding revenue limits set under PR These four revenue limits cover wholesale water, wholesale sewerage, non-household retail and household retail. 2. These three revenue limits cover wholesale water, non-household retail and household retail. 4

5 Key messages Market and operational rules There is a consensus across the industry that single sets of operational rules and market rules would be best. These rules will build on and improve the current Scottish rules, which should then be updated to ensure an effective market and a seamless customer experience. The combination of the Ofwat four (three) discrete revenue limits, demonstrating compliance with the level playing field and preparing to adopt the market and operational rules will significantly change aspects of each incumbent s current wholesale business. Critical path The retail market will open fully for non-household customers in April Companies will have to take strategic decisions about how and whether to compete once the non-household retail market fully opens. Whichever decision they take there are a number of smaller but time consuming tasks that will need to be addressed. Companies should already be actively addressing issues that will benefit non-household customers and ensure that the market operates effectively such as the cleansing of customer data. Next steps There will be several opportunities to discuss the ideas raised in this document during the summer, including workshops to agree the scope and content of the operational and market rules. Open Water will produce a third iteration of the MAP in the autumn of The bottom line for incumbent companies The new arrangements mean changes for both the wholesale and retail activities of the incumbent particularly with regard to the revenue limits and compliance with a level playing field. Companies will need to make strategic choices about how they intend to respond to the new framework as to how they organise themselves and whether and how they will compete in the nonhousehold retail market. Current incumbents can choose to exit the non household retail market subject to the agreement of the Secretary of State. Understanding wholesale and retail costs and their drivers could help a company set more appropriate wholesale and retail tariffs. Much frustration can be avoided if a company takes relatively simple steps now to ensure that their basic customer information is complete For example, it may be worth checking for its completeness, particularly with regards to names, addresses (both of site served and bill payer) and services provided. 5

6 Design principles Design principles At Open Water s spring workshops it was agreed that it would be helpful to identify the guiding principles for developing the non-household customer retail market that had emerged through the workshops and which underpin the development of this plan. The principles are as follows. The non-household retail customer market should fully open in April 2017 There is much to be done, both at the central Open Water programme level and by the companies, to prepare for full retail market opening in April It is important that we take all possible steps to make sure that this market opens successfully and operates effectively. In some cases this may mean that pragmatic choices have to be made as to what exactly needs to be delivered. Experience from Scotland suggests that market participants will want to make changes to market rules once they have experience of operating in the non-household retail market. Time and resources should therefore be managed judiciously, with a focus on the actions required for the non-household retail market to open fully in April To maintain trust and confidence in the sector there needs to be a level playing field Non-household customers should be able to have a free choice as to who provides their water and sewerage services. This means that all of the retailers serving non-household customers should have equal access to the same information as the retail arm of the wholesale service provider. It is for company Boards to provide assurance to Ofwat that they are fully compliant with the new industry rules. As part of that assurance process Boards may find it useful to consider the role that a compliance officer could play. Boards will need to make the right decisions for their companies based on their assessment of both the current and continuing costs and benefits of increased separation in their governance arrangements and increased transparency in how they interact with their own retail activity. Companies have a duty to comply with competition law as of today Of course, competition law will continue to apply. It covers more than just margin squeeze but also undue discrimination and the use of selective discounting or exclusive contracts. The framework that is developed must work for customers All non-household customers should enjoy as much choice as possible, and should be able to switch suppliers of services as they see fit. At the workshops there was a consensus that non-household customers who had negotiated a special deal should still be able to switch 6

7 Design principles supplier for the retail component. In addition, all non-household customers, regardless of their current bill or service, should be able to switch supplier if they so choose. This will have an impact on how retail and wholesale tariffs are set. We should start with what happens in Scotland The Scottish market arrangements have been in place for more than six years. During that time there have been many changes to the Operational and Market Codes. These changes allowed the market to respond to what customers and participants wanted. The English rules will need to be tested to ensure that they are fit for purpose in an environment where there are multiple wholesalers and to learn lessons where appropriate from other sectors. 4 There was a consensus view that we should not try to re-invent the wheel. There should be single sets of operational and market rules It was agreed that non-household customers should be able to resolve any operational issues by contacting their retailer. It was further agreed that a common process for dealing with issues did not mean that the way in which any issue was handled operationally need be the same. There was recognition too that there may be differences in the service levels that individual wholesalers may provide (subject to what Ofwat decides on wholesale charges and corresponding levels of service at PR14). Similarly, there was agreement that there should be a single set of market rules covering switching, settlement and the process for changing market rules. Such a common set of rules does not require companies to use a particular structure of tariffs. 4. There may also be changes resulting from differences in the regulatory regimes and the relevant legislation. 7

8 What company CEOs and their Boards need to know What company CEOs and their Boards need to know Introduction Open Water is extremely grateful for the support of the incumbent companies, new entrants, Defra, Ofwat, the Water Industry Commission for Scotland (WICS) and many others over the past several months. This plan has been informed by a series of workshops that were held in spring The workshops were well attended by representatives from all of the companies (representing both their wholesale and retail activities) and by new entrants. There was a genuine commitment to open and constructive discussion. The debate was at times intense, although there was also considerable consensus in many areas. This approach is welcomed and is something that we will build on further over the coming months. Open Water listened carefully to participants views and in particular to the areas that seemed especially difficult, potentially contentious, or key to a company s understanding of the risks and opportunities of establishing the new competitive framework while implementing PR14. It is important that the sector delivers a market that gives customers trust and confidence. To achieve this, there will need to be a level playing field in the non-household retail market so that all participants can compete fairly. Perhaps most fundamental is the conclusion from the workshops that living within the four 5 separate and binding revenue limits that Ofwat will set at PR14, while ensuring the level playing field, will require companies to take important strategic decisions, and soon. The remainder of this section explains the four main areas of discussion at the workshops and their relevance for CEOs and their Boards. 5. Wholesale water, wholesale sewerage, non-household retail and household retail. Obviously wholesale sewerage does not apply to the water only companies. 8

9 What company CEOs and their Boards need to know Ensuring an effective retail market that works for non-household customers Discussions with stakeholders and at the workshops explored how retail businesses should interact with wholesalers in order to ensure an effective market and a seamless experience for non-household customers. The discussions encompassed who does what, how information is shared, and how the wholesaler gets paid. We also looked at how changes could be made by market participants to the operation of the market. Information and money flows Figure 1 sets out the flows of information and money that were discussed. Wholesalers Use & charge information Market operator Operational and service information Money Retailer Retailer Customer Customer Customer Customer Figure 1: Money and information flows It was agreed that: customers should not have contact with the market operator, but should simply choose their supplier and the services that they want, and pay the bill; interactions between wholesalers and retailers should be governed by a set of operational rules; settlement and information sharing should be governed by a set of market rules. The operational and market rules Codes are multi-lateral agreements that ensure that each market participant knows what is required of them and what they have the right to require of others. The rules set out in these codes play an important role in levelling the playing field by moving away from 9

10 What company CEOs and their Boards need to know negotiated access (where the final relationships between retailers and wholesalers may be materially different) towards predominantly regulated access (where the interactions are structured and common). This will benefit customers. At the workshops there was some debate on the extent to which the operational rules (the rules that glue the wholesale and retail activities back together) need to be common across the country. New entrants were supportive of this. A strong case was made, however, that the rules would have to reflect local conditions (local bye-laws or regulations, security rules and emergencies) and default levels of service that companies agree with Ofwat. It was generally accepted though that it should be possible to ensure that the basic rules and procedures could be the same. It was also agreed that the set of market rules would set out how switching and settlement would be handled. The rules would also set out the process by which all market participants (including the regulator) are collectively able to change how the market operates. Role of the market operator The market operator is the hub that centralises all of the market information. It typically has three main roles: governance of the market; registration of supply points to the responsible retailer; and calculating amounts owing from retailers to wholesalers and facilitating settlement. These roles can be to a greater or lesser extent contracted to third parties. There was a useful discussion about the role of the market operator at the workshops. Some participants considered that the market operator should play a more extensive role and that a high degree of standardisation should be required. There was an alternative view that the market operator could do less and that a greater number of transactions could be bi-lateral. There was general acceptance (albeit reluctantly from a small number of participants) that this latter approach could unduly limit opportunities for new entrants and, as a result, the benefits that could accrue to non-household customers. The approach of adopting common processes and procedures but respecting local conditions and service levels should ensure that there will be an appropriately regulated framework within which customers can choose the supplier that best meets their individual needs. This is important given that effective choice is likely to be key to maintaining the sector s legitimacy. The Market Blueprint had suggested that all operational matters go through the central systems. This could potentially complicate the development of the systems and lead to more standardisation of operations management than can reasonably be achieved before market opening. The workshops discussed an alternative approach, which made sure that the playing field could be levelled but did not, at least initially, extend the scope and complexity of the 10

11 What company CEOs and their Boards need to know central systems. This would include ensuring that there are defined and fully enforceable service standards covering the interactions between retailers and wholesalers. Governance of the market The market operator will arrange and may chair the rules or code panel. Market participants can bring forward suggested changes to the market arrangements. There have been many such changes in Scotland since 2008, but relatively few of these changes have been major. Typically, changes to a market are agreed by the regulator or are agreed automatically provided they are in line with market principles set out by the regulator. To protect customers interests, it is likely that Ofwat will continue to monitor the market and operational rules and ensure that they are appropriate, as WICS has done in Scotland. The expectation is that incumbent businesses and new entrants will work together to ensure that the market works for all non-household customers. They will be able to make changes to the market rules where there is majority support. Such changes will have to be consistent with the principles that Open Water understands Ofwat is to publish. This process has worked effectively in Scotland. Registration There are likely to be many more service points than there are buildings or end customers. However, each needs to be registered to a retail supplier. The market operator maintains the defined list. There has been some discussion about whether a customer should be able to switch retailer for different services and supply points or should be limited to a water and a waste water provider. It was recognised that the registration system that is used to maintain a definitive record of which retailer supplies which customers has to be kept at the supply point level. It was also recognised that at some premises there may be different bill payers (for example, tenants and service agents may have responsibility in certain situations). New entrants have pointed out that it was for customers to choose. They explained that they neither targeted specific supply points nor were aware of any customers who had asked for them to do so. The customer s interest here has to be paramount and it would appear to be very difficult to justify any limit on a customer s ability to switch. Settlement The market operator processes the meter reads and other service information provided by the retailers. This allows it to use the wholesale tariffs of the appropriate wholesaler to calculate amounts owing by each retailer to each wholesaler. 11

12 What company CEOs and their Boards need to know A level playing field One of the key issues in designing the market will be making sure that retailers from out of area and new entrants are able to compete with the retail arm of the incumbent business. In other words, that there is and is seen to be a level playing field. At the workshops, participants discussed the reasons why this is such an important issue, and considered what actions were necessary to deliver a level playing field. This area was not specifically covered in the Market Blueprint. It was agreed that it would be possible for incumbent companies to take inappropriate advantage of their position. This could involve, for example, allowing its retailer access to: unit prices for services provided that could not be replicated by another retailer; information either about operational matters or about customer service levels (that could not be accessed by another retailer); financing at less than commercial rates; and governance advantages such as management expertise, or opportunities to cut costs by working with customers in particular areas. All participants agreed that perception could be as important as the reality. It was agreed that to address these advantages it would be necessary to put in place an arm s length relationship between the incumbent and its retail arm, and that this would be likely to require: changes to company governance, redefining roles of staff, set-up of a wholesale facility to serve retailers, changes to cost allocation rules and processes, and changes to general IT and communications systems. Importantly, it was agreed that there would also need to be a change in culture. Participants recognised that although this would be difficult it could potentially bring benefits. Those representing retail activities explained that operating in a market required them to take decisions more quickly and perhaps with less certainty as to their outcome than would be desirable in a wholesale water and sewerage business. Workshop participants discussed some tests as to whether the incumbent s retail arm could reasonably be said to be operating at arm s length from its wholesale arm. These were as follows: Are the retail activities a viable and sustainable stand alone business (given its licence conditions)? Is each service broadly cost reflective? 12

13 What company CEOs and their Boards need to know Does the wholesale arm of the incumbent treat the incumbent retail operation and all other retailers without preference? In other words, is there seen to be a level playing field? Have governance arrangements been put in place that are appropriate to these obligations? How does the industry evidence its compliance? One of the key themes that emerged during the workshops was how companies should evidence their compliance with a level playing field. At the workshops the point was also made consistently that decisions on structure are for the companies to make, but that the companies are even now subject to competition law. It was further outlined that the new framework is likely to increase the number of interactions and opportunities that may potentially fall foul of competition law. Ofwat s approach comprises three initiatives: It expects company Boards to be responsible for ensuring that their company competes fairly. They will need to provide assurance to Ofwat on their compliance with all of the required rules. Companies should expect that the level of assurance required will vary according to the extent of separation. As such, Boards may wish to consider the effective use of compliance officers. It will continue to use its casework strategy actively where it believes that this is necessary and appropriate to protect customers. It is considering specifying the information that each company should make available to the market operator. The workshops went on to debate the options, trade-offs and risks associated with ensuring compliance. The following points were agreed: An approach that was agreed with Ofwat would not necessarily protect a company from further challenge. Ofwat would have to examine any complaint as to the effect of the alleged behaviour on the market. There was no one size fits all solution. There was a balance between higher up-front transition costs to ensure compliance and lower on-going compliance costs. Demonstrating compliance is critical and this involves trade-offs: on costs, risks and people, against longer term benefits. This debate is summarised in Figure 2 overleaf. 13

14 What company CEOs and their Boards need to know Legal separation Governance separation None Closer to current vertically integrated model Financial and operational transparency Safer in compliance terms Marketbased transactions Operational implications High initial transitional costs (restructuring, process and asset separation) but low ongoing compliance costs Relatively low initial transition costs but higher ongoing costs (additional governance conditions, reporting requirements) Lower initial transition costs but very high ongoing costs due to heavier regulatory requirements Figure 2: The options and trade-offs on demonstrating compliance 14

15 What company CEOs and their Boards need to know Financial and funding issues that companies will have to face In the workshop sessions covering financial and funding issues we explored: the link between the competitive market and PR14; and the importance of setting wholesale tariffs, the interactions with the gross retail margin, and the impacts if the margin is too high or too low (for a particular class of customer). To understand fully the financial and funding issues associated with market opening it is essential to have a clear understanding of the link between market opening and the price review. At PR14 Ofwat is setting separate and binding revenue limits. After that point companies will not be able to move resources between these different controls. As such, each business segment will be treated as a separate profit centre for the purposes of regulation. This could have implications on the management of cash flows for the different revenue capped activities. At the workshops it was explained that the difference between retail and wholesale revenue would need to be converted into a gross retail margin for each service and class of customer. For companies to set their margin correctly requires an understanding of retail costs to serve, including issues such as bad debt, frequency of billing, and the likelihood of call centre contact. They will also have to understand the underlying costs of their wholesale business by class of customer and by service provided. A number of issues were identified: Current retail tariffs are not generally cost reflective for individual classes of customer. In Scotland, WICS had to work hard to manage incidence effects. This may complicate the allocation of gross retail margin between classes of customer and services provided. There is currently an opportunity to address any retail tariff rebalancing that is necessary because charges generally are falling in real terms. Improving understanding of wholesale costs by classes of customer and service will be important for the companies (for example in explaining tariffs to retailers, and in managing the impacts of reforms to abstraction and upstream activities). Retailers that have experience of operating in the Scottish market will have a heightened awareness of the retail costs to serve of different customers with different services. Arriving at the correct gross retail margin will therefore be critical for companies. This is because too high a gross retail margin offers an opportunity for retailers to cherry pick. Too low could lead to a company facing accusations of margin squeeze. We understand that companies will need to set wholesale tariffs for in the coming months. Setting tariffs that are fully fit for purpose for market opening in April 2017 will likely require a more detailed understanding of the drivers of costs. There may be scope for companies to allocate wholesale costs with fixed and capacity drivers so that there is broad cost reflectivity at both the wholesale and the retail levels. It is recognised however that some companies may feel unsure about how to set a gross retail margin and how to use wholesale tariff setting as a way to improve cost reflectivity. 15

16 What company CEOs and their Boards need to know Maintaining momentum It will be essential to maintain the momentum given the number of activities both centrally and by individual companies that need to have been completed prior to market opening in April Several stakeholders (including Defra, Ofwat, Open Water and the companies) are responsible for activities that are part of the critical path to market opening. It is important to understand how these relate to each other and to gain a shared understanding of what will be required. It should be noted too that shadow operation is scheduled to begin in October 2016, allowing six months for the market s systems and processes to be embedded. Incumbent companies will have to take a number of steps to live within the discrete revenue controls and within the requirements for a level playing field and arm s length operations. Many of the key decisions need to be taken in the next few months because of the people, process and system changes that will be required in the wholesale businesses. At the spring workshops it was agreed that incumbent companies should focus on decision making and action to: identify and start putting into effect the changes necessary to ensure arm s length operation; and improve their understanding of costs and services and to develop appropriate price and service packages. These issues will need to be progressed very expeditiously if companies are to be ready. There was a real sense that, given these requirements, companies have to be making strategic decisions in quick order. Workshop participants also recognised that while options may, to some extent, depend on price review decisions and the work on market design, progress could still be being made as market design continues. 16

17 What company CEOs and their Boards need to know Next steps The successful opening of the full non-household retail market will require active and continuing dialogue. The links between different activities and initiatives is illustrated in Figure 3. Non-household customers Non-household retail revenue limits Retailers Improving customer information Market operator Wholesale draft and final determinations Market and operational rules Wholesale businesses Household customers Household retail revenue limits Household retail businesses Customers Ofwat Incumbent companies Open Water Figure 3: Links between different initiatives The Open Water programme Open Water intends to consult extensively through further workshops and ongoing dialogue. It will also be running a series of detailed working sessions over July and August to allow industry representatives to respond to this MAP and to engage with the detailed design of the rules. It is hoped that these workshops will generate a clear way forward in most areas, particularly given the agreed principle to start with the Scottish codes and amend as necessary to allow for the greater number of wholesalers in England and other relevant experience. Ofwat Overall Ofwat will want to ensure that a fully opened non-household retail market delivers for customers in a way that will give them trust and confidence in the sector. Ofwat will establish the regulatory framework including changes to companies licences to support full non-household retail market opening. 17

18 What company CEOs and their Boards need to know As with PR14, Ofwat will be placing the responsibility on company Boards to offer it appropriate assurance concerning compliance with the new framework. Where this assurance is not in place, it will regulate companies differently to ensure that the customer interest is protected. The industry codes or rules that are developed through OWML, in collaboration with the industry, will need to be approved by Ofwat as being fit for purpose. This will include an assessment of the extent to which customers are protected and ensuring that there is a level playing field, particularly with regard to the sharing of information between market participants. Ofwat will continue to pursue its casework strategy and will take targeted action where appropriate. Finally, Ofwat will also specify the reporting (financial and otherwise) that will be required. This information will allow Ofwat to monitor performance and ensure that companies are living within the four (three for the water only companies) discrete revenue limits. The companies There are a number of critical decisions that the Boards of companies will need to take. Each incumbent company in England will need to satisfy itself that its wholesale business can be ready for full market opening in April There are also strategic questions that will need to be addressed such as whether a company wants to be a leading retailer across the Anglo-Scottish market or whether the company wishes to concentrate its activity on wholesale and household customers. Open Water is keen to maintain a dialogue with CEOs and their senior teams so that their views are heard and incorporated into the market design. The joint iterative process continues, and Open Water looks forward to working with companies to deliver an efficient Anglo-Scottish retail market for non-household customers in April Open Water Open Water has contacted companies on the detailed rules workshops that are taking place in July and August Further information will be available on the Open Water website (www.open-water.org.uk). Open Water will also seek to arrange a series of ongoing events with non-household customers. Please check the website for further information. The MAP We welcome comments from stakeholders at this stage. These comments should be sent to: John Parsonage Open Water 21 Bloomsbury Street London WC1B 3HF Or to: All comments should be received by 15 August They will be published in full unless the respondent indicates clearly that the response (or parts of the response) is confidential. 18

19 01. Introduction Introduction The role of key parties and development of this document Background The Water Act 2014, amongst other important reforms, puts in place a framework for the development of a competitive retail water and sewerage market for non-household customers in England from April Open Water has been working with water and sewerage companies and water only companies, new entrants, Ofwat, WICS, the UK and Scottish Governments and other interested parties over a number of months to develop a high level design for the arrangements to facilitate the delivery of a fully competitive non-household retail market. The ultimate aim is to create an effective market offering a seamless experience for non household customers across England and Scotland. A retail market for non-household customers was introduced in Scotland in April A number of parties have been involved in developing the framework. Their roles are outlined below. Delivering a retail market: key stakeholders Defra Defra is responsible for setting the policy framework and strategic direction for reform of water markets in England. It is also responsible for establishing the necessary framework of primary and secondary legislation, including the Water Act 2014 and regulations governing exit from the non-household retail market. It will issue Government guidance on Ofwat s rules about charges. Scottish Government The Scottish Government has responsibility for all water and sewerage policy issues in Scotland. High Level Group (HLG) The HLG was established by the UK, Welsh and Scottish Governments in order to act decisively and to drive the market reform process forward. It is not constituted as a formal decision-taking body and will operate within the policy steer that Ministers provide. It was agreed that it should work towards ensuring that non-household customers across England and Scotland can enjoy a seamless experience in an effective retail market. Open Water Open Water is the name of the overall programme of work to improve outcomes for customers and the environment. This includes matters relating to the introduction of retail competition and upstream markets. This current iteration of the MAP is an Open Water document 19

20 01. Introduction Ofwat Ofwat is charged with overall responsibility for the market architecture. As such it is Ofwat s role to agree the structure of licence amendments, codes, rules and agreements that will underpin the market. In setting four discrete revenue limits for each water and sewerage company, Ofwat has defined the scope of the non-household retail contestable market. WICS WICS is the economic regulator of the water industry in Scotland. It established a framework to allow non-household customers in Scotland to choose their supplier, and this has been in place since It is now supporting Ofwat in its implementation of a framework for choice in England that will allow for a seamless experience for customers located on either side of the border. Open Water Market Ltd (OWML) Supporting the Open Water programme, OWML is a company limited by guarantee and is currently the vehicle through which work on market reform is funded. It is charged with managing the design of the market. There are three classes of member: funding members (the water and sewerage companies whose appointments are wholly or mainly within England, not including the new appointments and variations); non-funding members (retailers acting out of area or new entrants to the market in England, and Scottish Water); and the economic regulators (Ofwat and WICS). Development of the MAP This document brings together several Open Water initiatives. Open Water has worked with industry and other stakeholders over the last several months to build a common understanding of what needs to be done in order to ensure an effective retail market opening in April This work began with the development of the Market Blueprint, published for consultation in January Open Water also organised a series of workshops in the spring of 2014 to identify the key issues the companies and their Boards would need to consider. The workshops were successful in building awareness and in starting to develop a consensus on an appropriate way forward. All of the discussion papers, summary slides and notes of the workshops will be published on the Open Water website. A number of guiding principles for developing the non-household customer market also emerged through the workshops (see page 6). These principles encapsulated broad areas of agreement. Open Water looks forward to working with the incumbent wholesale and retail companies and with new entrants and other stakeholders over the coming months as we work towards the next iteration of the MAP in the autumn of

21 01. Introduction Market Blueprint Responses Scottish codes Spring 2014 workshops Market architecture plan Delivering an effective retail market for non-household customers July 2014 Working groups Figure 4: Development of the MAP 21

22 02. Ensuring a level playing field Ensuring a level playing field Measures to ensure a level playing field and arm s length operation Introduction The water industry is subject to UK and European competition law today as well as to sector-specific requirements. It is therefore important to ensure that there is a level playing field such that a new entrant would face no barriers in trying to compete on its merits with the incumbent service provider. The transparency that will be brought about by fully opening the non-household retail water and sewerage market to competition may well bring an increased focus on both regulatory and competition law compliance. Each of the companies will need to consider the right approach for them in relation to compliance with competition law. There is no silver bullet, so the measures referred to in this chapter are not, and cannot be, prescriptive. Individual company Boards will need to think carefully about the opportunities and risks for them associated with different options for achieving the level playing field. It is expected that different companies may adopt different organisational structures. In this regard it is worth remembering that the perception of new entrants can be as important as the actuality. Ofwat will look to company Boards to gain assurance that a company is complying and that all market rules are fully implemented. It will continue to have an active casework strategy, and will take targeted action if companies are found not to have acted in the interests of customers. The choices that companies take around how they organise their businesses will influence the level of assurance that Ofwat will require. Company Boards may also decide to introduce a compliance officer to help implement their assurance process. Some companies may choose to exit the market either immediately on, or after, market opening allowing another service provider to deliver services to these non-household customers. At an industry level, the key will be the willingness of market participants to find solutions that give new entrants confidence to enter the retail market for non-household customers. This will help ensure that the expected benefits to customers can be realised. A level playing field will first and foremost require a common understanding of the advantages that the retail operation of an incumbent water and sewerage company or water only company enjoys. New entrants will rightly expect action to be taken where these advantages may represent an undue barrier to entry. Link with the price review process The discussion of a level playing field is closely related to the price review process. PR14 will introduce four (three for water only companies) discrete and binding revenue controls on all incumbent companies. Similarly, it is impossible to engage fully with the price review 22

23 02. Ensuring a level playing field without also considering the behavioural and organisational changes that will come about as a result of the full introduction of retail competition for non-household customers. Companies will be expected to evidence that there is no cross-subsidy between the separate revenue limits including household and non-household retail customers and between these retail elements and the two (or one for water only companies) wholesale revenue controls. Companies will therefore also be expected to operate sustainable arm s length retail businesses with no cross-subsidy between the wholesale and retail activities. Ofwat will consult in the autumn on changes to its regulatory accounting guidelines to ensure that the companies are reporting separate profit and loss results for each of their revenue controls. It is vital that incumbent companies recognise the full implications of these new controls and are fully prepared to live within them from April This approach to setting revenue controls is fully consistent with the development of the new non-household retail market. Strategic options for incumbent company Boards In preparing their strategy for the new market arrangements, companies will need to reflect not only on what they need to do to demonstrate their compliance with Ofwat s discrete and binding revenue limits, but also on how they intend to participate in the new retail market. Are they going to seek to win customers out of area? Or will they restrict themselves to a purely defensive strategy of retaining the customers they already serve? Moving out of area is likely to require changes in the way in which the current business is organised 6. Such changes may well help a company demonstrate its compliance with the levelled playing field and with the new revenue limits. Wessex Water and Bristol Water separated their respective billing services into a joint venture company (BWBSL) in They consider that BWBSL s separate governance structure has created the right environment and culture to ensure a strong focus on customer service. They also attribute their leading position on customer satisfaction and their low cost to serve to this separate ring-fenced joint venture company. More recently, Thames Water has said that it plans to publish separate profit and loss accounts for each of the four business areas covered by the new controls. Another example of a company that has made an early start in its preparations for non-household retail competition is United Utilities. In 2012 United Utilities appointed a new Director of Business Retail, who reports to the Chief Executive. In 2013 the company began to move to three business units (wholesale, domestic retail and business retail), each with their own profit and loss accounts. A separate business retail division is now established and the move to separate core customer management systems is well underway. In turn, this has led the wholesale division to review its own capability to manage interactions with retailers in line with current and future market rules. United Utilities is now looking at the extent to which further separation of operational processes and third party contracts may be appropriate for the new market arrangements. 6. Potentially using the exit provision allowed for in the 2014 Act to consolidate all of a company s retail activities in and out of area. 23

24 02. Ensuring a level playing field For some companies that perhaps do not have the desire to compete out of area there is the option to exit the non-household retail market and potentially to realise value for their shareholders. At the other extreme, some companies may wish to create a more independent (and potentially more flexible) structure that allows them to respond quickly to market opportunities. Business Stream, the legally separate Scottish Water subsidiary, may be such an example. It has independent non-executive directors, fully separated (and ringfenced) financial management and a compliance officer who reports on the company s compliance with its Governance Code. Well implemented, and rigorously adhered to, it is likely that such a structure would offer substantial reassurance that the principles of a levelled playing field are being observed. The initial and revised Governance Codes for Scottish Water and Business Stream are reproduced in Appendix 1. Why a level playing field is important to customers An effective market requires participants to be able to trade on their merits. Market participants that make the best offers to customers will gain market share. A market participant should not be able to leverage its legacy position in the market to the detriment of new competitors. If a participant were able to do so, then new entry would be discouraged, resulting in fewer attractive offers for customers, reduced innovation and less efficient service delivery. This could mean that the potential benefits from full retail market opening are reduced and even that costs for customers are increased. In a sense the playing field can never actually be truly level; however, what we can do collectively is make sure that the industry takes a series of actions such that each participant is able to compete appropriately. In this sense it becomes more about overcoming undue advantage than trying to make all things equal. It is perhaps helpful to consider a horse racing analogy: in the Oaks all of the horses are female, carry the same weight and are the same age. The playing field is demonstrably level and the winner is, without question, the best horse of her age on that day. Other horse races are handicaps, where each horse carries a different weight such that the handicapper hopes they will all cross the line at the same instant. In other words, by weighting down horses that would otherwise have had a better chance of winning, the playing field for all of the horses in the race is levelled, allowing each to compete. Non-household customers Non-household customers value choice as it allows them to pay for the services they want and to make trade-offs between levels of service and the prices they pay. These choices can only really be made if the playing field has been levelled such that market participants are able to compete appropriately (without worrying about any undue advantages enjoyed by the incumbent retailer). New entrants Perception is of course as important as the reality. New entrants will perceive the retail arm of the incumbent business as having all of the advantages. This is likely to be the case whether retailers are organisations that are new to the sector or are out of area retail activities of current incumbents. Incumbents will have to work hard to address this perception. 24

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