Financial Settlement Strategy

Transcription

1 Financial Settlement Strategy We are seeking stakeholders views on the questions set out in this consultation document. If you have any comments on the paper please contact: Publication Date: 2 January 2014 Response deadline: 14 February 2014

2 Contents 1. Executive summary Products and services in settlement Timing and frequency of settlement Payment terms and credit requirements Settlement and estimation calculation approach Roles and responsibilities in settlement 5 2. Introduction Programme background Document purpose and context 7 3. Defining financial settlement Defining financial settlement Calculating charges Processing payments between market participants Products and services Roles and responsibilities in financial settlement High-level responsibilities of market participants in settlement Collecting and distributing actual usage data Verifying actual meter reading data Storing actual meter reading data Determining usage data for financial settlement Calculating charges due Billing and payment handling Credit management The timing and frequency of financial settlement Ofwat s decision on payment terms Settlement timeline 21 2

3 5.3 Initial settlement, reconciliation and final settlement Error correction and dispute resolution Credit risk management Key enablers required to deliver financial settlement Market documents Market processes and data requirements Data access Governance of end-to-end settlement process 26 Appendix A: Consultation questions and approach 27 Appendix B: Glossary of terms 29 Appendix C: Customer expectations assessment 30 Appendix D: Working group comments 33 Appendix E: Detailed breakdown of products and services 40 Appendix F: Imbalance 42 3

4 1. Executive summary This document sets out our high-level design recommendations for how financial settlement activities will operate in the new retail water and sewerage markets in England. Readers are invited to comment on these recommendations and to respond to the specific consultation questions at the end of each chapter, and collected together in appendix A. Financial settlement is defined as: The calculation of charges and processing of payments between market participants to remunerate them for the products and/or services they have provided. 1.1 Products and services in settlement All products and services that one market participant provides to another will need to be paid for. For the purposes of this document, we have characterised the products and services into three groups. Continuously delivered services where charging is volume based and either metered or estimated, such as a metered water supply. Continuously delivered services where charging is time based, such as a standing charge for meter provision or unmeasured supplies. Event-based services where charging is based on the number and type of events, such as a meter exchange. 1.2 Timing and frequency of settlement Ofwat s information notice published in November sets out decisions that: the settlement period for continuously delivered services will be one calendar day; and the billing period for all services will be one calendar month. For all types of service, we recommend that the market operator (MO) should issue initial settlement calculations for a billing period (calendar month) five business days after the end of the billing period, for all calculated charges due between all market participants. For continuously delivered services, whether volume based or time based, we recommend that, following initial settlement, there should be two resettlement runs, two and eight months after initial settlement, and full and final settlement after 13 months. For event-based services, we recommend that there is only one settlement run, and so the initial settlement will be the full and final settlement. 1.3 Payment terms and credit requirements Ofwat s information notice sets out decisions that: standard payment terms are 30 days from the last day of the billing period, or 15 days after the invoice is deemed to be received, whichever is the later; and 1 Available at: 4

5 a retailer needs to have either a letter of credit from a guarantor with a defined minimum credit rating, or an agreement with a wholesaler to use an escrow account. We recommend that the credit rating requirement for standard payment terms should be the minimum investment grade rating that is, Standard & Poor s (BBB-), Fitch (BBB-), or Moody s (Baa3). Future work will recommend what amount of credit should be posted by a debtor. Market participants may negotiate non-standard payment and credit terms. In order to ensure transparency and a level playing field, we recommend that there should be a requirement to publish details of such agreements and to make them available to all other market participants. 1.4 Settlement and estimation calculation approach The charges due will be based on wholesale charges schemes. For continuously delivered services where charging is volume based and either metered or estimated, reflecting that (i) the market settlement period (a calendar day) is more frequent than meter reading for most services and service points, and that (ii) meter readings may not be available at the time of settlement, we recommend that the following approach should be taken to determining the consumption value used in settlement. Daily metered service points should use actual meter reading values. When daily metered values are unavailable, historical service point consumption data should be used to estimate consumption. Non-daily metered service points should use a combination of periodic meter readings, a yearly volume estimate (YVE) and consumption profiles. Consumption for a settlement period should be based on: o interpolation between two periodic meter readings using consumption profile factors; or o for settlement periods after the latest periodic meter reading, a combination of the YVE and consumption profile factor will be employed. Future high-level design work will consider the process for calculating the YVE and the consumption profiles. 1.5 Roles and responsibilities in settlement The party providing the service should be responsible for determining how much service has been provided, including taking meter readings, and providing this information to the MO. With respect to meter readings, we recommend that the wholesaler should be responsible for any verification of meter readings that retailers provide. For standard agreements, we recommend that the MO should: retain meter readings to use in settlement, and perform any necessary adjustment or aggregation of this data required to perform settlement; determine estimated usage in the absence of actual data; and determine charges due between market participants. We recommend that it should be mandatory for market participants to use these MO services for all agreements, except for non-standard agreements where the MO systems and processes would require change to deliver the services. In such 5

6 circumstances, we recommend that the party providing the service should be responsible for determining charges due. The party providing the service is responsible for billing and collections. Future high-level design work will recommend responsibilities for determining the quantity of credit to be posted by a retailer. 6

7 2. Introduction 2.1 Programme background The UK Government s Water Bill 2 was introduced into Parliament and published on 27 June The Water Bill is designed to address the current and future challenges faced by the water and sewerage sector in England, which were described in the Water White Paper 3. Among other things, the Water Bill is designed to: increase customer choice; improve service provision; stimulate innovation; and drive more sustainable approaches to managing our scarce resources. The Government s key reforms are: the introduction of retail competition for water and sewerage services to nonhousehold customers in England, which will be in place from April 2017; and the introduction of competition in the upstream sector, which will take place at a later date (after 2019). The Open Water programme has been created to facilitate the implementation of the proposed reforms. 2.2 Document purpose and context This document is part of a suite of materials being published throughout They set out the Open Water programme s recommendations for the high-level design for the new competitive water retail market for non-household customers in England. These materials are: The market blueprint, which describes the present and future market arrangements and the different roles in the new market arrangements, and summarises the programme s recommendations for the high-level market design; a series of documents on strategy and high-level design (of which this is one), which set out in more detail the programme s recommendations in areas such as registration and switching, financial settlement, and industry governance and performance management; and supporting discussion papers and option analyses, which have informed the documents listed above. The intended audiences for the high-level design papers are: the strategy, regulation and change teams within incumbent and new entrant water companies in England; Ofwat; potential providers of services and systems to a new central MO and/or to water companies; and 2 Water Bill Water for Life Market reform proposals. 7

8 anyone with an interest in the reform of the water industry. This document is structured as follows. Chapter 3 defines financial settlement, explains its role and characterises the products and services it will deal with. Chapter 4 defines high-level responsibilities for the various financial settlement activities. Chapter 5 sets out the timings and frequencies of these activities and recommends how the resulting credit risks will be managed. Chapter 6 gives an overview of key enablers of financial settlement. In addition to the standard appendices: o o appendix E sets out a detailed breakdown of product and services; and appendix F considers what types of charges for imbalance might be needed once upstream reforms after We have developed the design recommendations set out in this document with consideration of their impact on and response to wider issues, including how they would: ensure a level playing field for market participants; support market consistency both within England and between the English market and the markets in Wales and Scotland; reflect customers expectations of how they hope to see the retail market operate; align with the later introduction of upstream markets; and strike an appropriate balance between scale and complexity, deliverability and the benefits they will generate. In drafting this document, the Open Water team have reviewed and considered the market designs and associated codes for, and met market participants from: the Irish and British electricity markets; the British gas market; and the Scottish water market. We have also met with market operators and experts in these markets such as Ofgem, the Central Market Agency (CMA), the Water Industry Commission for Scotland (WICS), Elexon and Electralink. The recommendations out in this document have been discussed by: an industry working group; Ofwat s Choice and Trading Arrangements Programme Board members; Open Water s Programme Delivery Board; and Open Water s High Level Group. Feedback from these groups has been considered and reflected in the recommendations made. Throughout this document, we ask a number of questions and seek stakeholders views on these. We list all of the questions in appendix A. Please provide your responses to the consultation questions and any other comments or queries you may have regarding this paper by 14 th February 2014, to [email protected]. We provide an accompanying template for responses on the Open Water website to help this process, which we strongly encourage respondents to use. We will, however, accept responses in other formats if necessary. 8

9 We will be running a workshop on 29 th January for representatives from water companies to discuss the content presented in all of the high-level design papers. Details of this session have been shared with water companies, and for more information please contact [email protected]. A second iteration of this document will be issued in early summer This will include any changes necessary to align with additional strategy and high-level design papers, which will be published in early summer 2014, and will also reflect any changes made in response to consultation responses received. The recommendations set out in this document are intended to facilitate wider discussion about the changes. Following the consultation, the updated blueprint will act as a recommendation to Ofwat, for the relevant regulatory decisions in due course. 9

10 3. Defining financial settlement Key recommendations made in this chapter Financial settlement is defined as: The calculation of charges and processing of payments between market participants to remunerate them for the products and/or services they have provided. The approach to financial settlement for different products should be set in relation to whether the product is: continuously delivered and measured/continuously delivered and unmeasured/event based; and standard or non-standard. 3.1 Defining financial settlement We define financial settlement as: The calculation of charges and processing of payments between market participants to remunerate them for the products and/or services they have provided. This chapter briefly expands on the components of this definition. 3.2 Calculating charges The financial settlement system we are designing consists of wholesalers and retailers (together, market participants ) making payments to each other, and a central MO. This is distinct from customers paying retailers. Therefore, there are two sets of charge calculations. First, there is the calculation of the charge for each customer of a retailer for the wholesale services that the customer has used. Second, there is the calculation of charges for each retailer for the services that each wholesaler has provided to the customers of the retailer. Figure 1 below shows both the financial flows and the flows of physical product. Although the physical product flows straight from the wholesaler s distribution network to the customer, we assume it passes momentarily through the hands of the retailer. 10

11 Figure 1: Charge calculations The two sets of charge calculations are necessarily connected. The total wholesale charge from one wholesaler to a retailer is the sum of the individual wholesale charges of that retailer s end customers who receive services from the wholesaler in question. This document is primarily interested in the financial settlement of the charges between wholesalers and retailers. It addresses the financial settlement of these charges only other aspects of wholesale contracts will be addressed in the wholesale contracts strategy as part of the second iteration of the market blueprint. However, we consider some aspects of the end-customer charges here for example, responsibility for estimating customer usage. Other aspects of customer contracts will be addressed in the customer contracts strategy as part of the second iteration of the market blueprint. Ofwat is also carrying out further work on charging. The key questions about charge calculation are as follows. What charges should be calculated, and by whom? How should those charges be calculated? When should charges be calculated? We answer the first two questions in chapter 4; we address the third question in chapter Processing payments between market participants The second aspect of financial settlement is the processing of payments between market participants. This is the process by which the provider of the services is paid for the delivery of the services. The main questions in relation to this aspect of financial settlement are as follows. What are the roles and responsibilities of the parties involved in the billing and payment process? What are the payment terms? We address the first question in chapter 4, and the second question in chapter 5. 11

12 3.4 Products and services In order to assess what the best approach to financial settlement is likely to be, we must consider the products and services that are going to be financially settled. In the water and sewerage market, these products and services can be considered in the following three groups. Continuously delivered services where charging is volume based and either metered or estimated (measured), such as a metered water supply. Continuously delivered services where charging is time based, such as a standing charge for meter provision or unmeasured supplies. Event-based services where charging is based on the number and type of events, such as a meter exchange. In the Scottish market, continuously delivered services are called direct services, and event-based services are called indirect services. In addition to this distinction, products and services are also differentiated by whether the product is standard or non-standard. Sometimes retailers will need non-standard services to meet a particular customer request or to provide an innovative service (for example, demand management) and we want to facilitate this. We set out this categorisation of charges in Figure 2 below. Figure 2: categorisation of products and services At this stage in the market design process, we have identified that this differentiation of different types of products is necessary, but we have not identified which products would fall into the standard and non-standard categories. We will set out principles for identifying whether a product is standard or non-standard in the second iteration of the market blueprint. Products and services can be further sub-divided into a number of product types. As the main distinctions between products are those outlined above, this extra level of granularity is not discussed here, but is presented in appendix E. 12

13 The main questions for financial settlement in relation to products and services are as follows. Does the responsibility for calculating charges differ by product, and if so, who calculates charges for different products? How should charges be calculated for each product type? Is there any difference in the settlement timeline for different product types? We address the first two questions in chapter 4, and the third in chapter 5. Consultation questions: FS 3a: Do you agree with our definition of financial settlement? FS 3b: Have we identified the important categories of products for financial settlement in section 3.4? 13

14 4. Roles and responsibilities in financial settlement Key Ofwat decisions summarised in this chapter The MO will have a role in the centralised calculation of charges for financial settlement. The MO will not have a role in billing or payment collections. The party providing the service is responsible for billing and payment. Key recommendations made in this chapter The MO should calculate charges for all standard products. They should calculate charges for all non-standard products unless there are reasonable practical reasons not to do so. In cases where the MO does not calculate usage and charges for nonstandard products, the parties to the contract will make their own arrangements. The MO should retain meter readings for use in settlement, and perform any necessary adjustment or aggregation of this data required to perform settlement. The MO should determine estimated usage in the absence of actual data. The party providing the service should determine how much/many of a service has been provided for eventbased services such as meter exchanges, and submit this information to the MO for use in calculating charges. It should be mandatory for market participants to use the above MO services for all continuously delivered and event-based services in the market, except for nonstandard agreements where the MO systems and processes would require change to deliver the services; these should be managed bilaterally. The MO should not be responsible for performing on-site verification of meter readings. Future work will recommend what role the MO should have in relation to credit management. 4.1 High-level responsibilities of market participants in settlement It has been agreed that the MO will have a centralised role in collating and communicating usage data, and using this to calculate charges for financial settlement. The Open Water High Level Group endorsed this recommendation in July and September and Ofwat s Board approved it in November. Centralising the calculation of charges avoids inefficiencies arising from duplicated systems, hence reducing costs of market participation and therefore barriers to entry. It also helps to create a level playing field for market participants by removing the scope for information asymmetries and anti-competitive behaviour, and should reduce the potential for disputes for example, when a supply switches between retailers. It is also consistent with the primary functions of the market operator in the Scottish retail market (the CMA). 14

15 4.1.1 Standard products and services As discussed above, the MO will have a role in calculating charges. We recommend that the MO calculates charges for all standard products and services, including eventbased services. In Scotland, retailers submit their customers meter readings to the MO, which then uses this data to calculate usage and charges for direct services. However, the wholesaler (Scottish Water) and not the MO calculates charges for indirect services, on the grounds that it has the record of work carried out. Notwithstanding this precedent, in England there are multiple (about 20) wholesalers and we recommend that they submit details of work done to the MO, so the MO can calculate charges centrally for both continuously delivered and event-based services. This will increase efficiency, consistency, and transparency of charge calculation Non-standard products and services For non-standard agreements, if the charge calculation is relatively straightforward and can be easily accommodated by the MO systems without increasing costs, these charges should also be calculated by the MO. However, it could be costly for the MO to modify its systems to deal with complex nonstandard agreements. In this case, it is better for the parties to the agreement to be responsible for all aspects of its implementation. Therefore, we therefore recommend that the MO should calculate non-standard charges unless there are reasonable practical reasons for the MO not to. In the case where the MO does not calculate usage and charges, the parties to the contract will make their own arrangements. 4.2 Collecting and distributing actual usage data Being able to settle a transaction of any form is reliant on a determination of how much of the service has been consumed. These services can be considered in three groups, which we described in section 3.4. For continuously delivered measured services, Ofwat has determined that the retailer is responsible for providing actual meter readings 4. For continuously delivered services where charging is time based, we have considered whether determining how much service has been provided should be the responsibility of the MO, retailer or wholesaler. We recommend that the MO should determine such data, except for non-standard services where it is impractical to do so. The main reasons for this recommendation are that: centralisation should remove duplication of activity and systems and hence reduce costs of market participation, and in turn reduce barriers to entry for new entrants; having a single party performing this activity should reduce the potential for disputes for example, regarding when a supply switches between retailers; and allowing dispensation for non-standard services should remove potential for the MO to constrain innovative agreements in the market. 4 Source: Ofwat price review methodology, 15

16 For event-based charges, we consider that only the party providing the service, such as the wholesaler performing a meter exchange, will be able to advise what services have been provided. 4.3 Verifying actual meter reading data It is common practice in competitive utility markets to confirm that meter readings provided to settle the market are accurate, primarily through carrying out verification visits to a sample of sites. We have considered whether verifying meter readings should be the responsibility of the retailer, wholesaler, the MO, or another third party. We recommend that the wholesaler should be responsible for such verification work, because: meter reading inaccuracies only materially impact the wholesaler, and hence the wholesaler has the greatest natural incentive to verify this data; and the wholesaler will have a metering field force for its domestic customers, and accordingly should be able to provide this service at best value. Once upstream competition is introduced, it is possible that other market participants will also feel the impact of inaccurate meter readings for example, as a result of imbalance mechanisms. At that point, we recommend reconsidering whether it is appropriate to centralise meter read verification, so as to provide an impartial market assurance service to all market participants. 4.4 Storing actual meter reading data Retailers will be responsible for retaining meter readings for example, to evidence how bills issued to customers were calculated. In addition, we recommend that the MO retains the master record of meter reading data provided to them and used to determine financial settlement charges (see later sections on MO settlement responsibilities), to ensure auditability of MO settlement services. 4.5 Determining usage data for financial settlement How usage should be calculated The recommended financial settlement strategy for the market includes a daily settlement period (the smallest period of time for which usage charges are calculated) for continuously delivered services. The charge calculation for the initial settlement for all settlement periods within a calendar month will occur early in the month following the month in which the service was consumed. As not all services are metered, and because services that are metered are not all measured daily, the following approaches should be taken to determine consumption values for settlement periods. Daily metered service points should use actual meter reading values. When daily metered values are unavailable, historical service point consumption data should be used to estimate consumption. Non-daily metered service points should use a combination of periodic meter readings, a yearly volume estimate (YVE) and consumption profiles. For periods between two meter readings, consumption profiles should be used to interpolate usage over the period. For the period after the last available reading, a YVE and consumption profiles should be used to estimate usage. 16

17 Non-metered service points should use a combination of the YVE and consumption profiles. In addition, it may also be necessary to perform the following transformations to consumption data to enable financial settlement. Aggregation of consumption at the service point level to some higher level for example, as happens in the gas market to then enable settlement at a gas distribution zone level. Adjustment or uplifting of consumption for example, as happens in electricity markets to uplift measured consumption to account for losses in the distribution network. The losses in water are significant and further work is needed to decide how these will be accounted for Who should calculate usage For each of the above activities we have considered whether the retailer, wholesaler or MO should perform them, and whether the responsibility should change for different services and types of agreement. We recommend that the MO should be responsible for estimating usage for all customers. Potentially, this is complex. By centralising estimate calculation there should be efficiency gains, as individual market participants will not need to perform this activity. This will also result in more consistent estimation across all customers, as the risk that different market participants interpret estimation rules is removed. We will consider in the detailed design how the YVE and consumption profiles are calculated. 4.6 Calculating charges due The next step in financial settlement is to combine usage data with charging schemes to determine the financial payment due between the two parties. We have considered whether the retailer, wholesaler or MO should perform this activity, and whether the responsibility should change for different services and types of agreement. Our recommendations are that responsibilities for this activity should be the same as for the determination of usage data (as described in section 4.5). The MO should calculate charges due for both continuously delivered and eventbased services performed under a standard agreement. The MO should calculate charges due for both continuously delivered and eventbased services performed under a non-standard or bespoke agreement unless there are reasonable practical reasons for it not to. The MO should be permitted to offer to carry out changes to its systems and processes to enable usage calculation for such agreements, on a commercial basis. Otherwise, the retailer and wholesaler should be responsible. We describe the main reasons for these recommendations in section Billing and payment handling Financial settlement concludes with an invoice being issued, the debtor making a payment, and the creditor processing that payment and managing the debt in the event of late or non-payment. 17

18 We have considered whether these activities should be managed bilaterally between counter-parties, principally wholesalers invoicing individual retailers and retailers paying each wholesaler, or whether payments should be routed through the MO that is, the MO invoicing retailers, retailers paying the MO, and then the MO paying wholesalers. We have concluded that these activities should be managed bilaterally and the MO will not offer such services. The main reasons for this recommendation are that: centralisation would require development of additional payment handling systems, which already exist within retailers and wholesalers; centralisation would impose additional credit and investment risks on the MO, which would still exist for wholesalers, and as such drive up credit management costs in the market; and Ofwat s decision on default payment terms removes information asymmetries and prevents anti-competitive behaviour as regards billing and payment handling. 4.8 Credit management To mitigate counter-party credit risks, market participants will have to post cash or a letter of credit. Future high-level design work in early 2014 will evaluate roles and responsibilities and recommend if the MO should perform any credit management activities. Consultation questions: FS 4a: Do you agree that the MO should calculate charges for all standard products, and for all non-standard products unless there are reasonable practical reasons for the MO not to do so? FS 4b: Do you agree that the MO should retain meter readings for use in settlement? FS 4c: Do you agree that the MO should perform any necessary adjustment or aggregation of meter readings data required to perform settlement? FS 4d: Do you agree that, for the purposes of financial settlement, the MO should determine estimated usage in the absence of actual data? FS 4e: Do you agree with our recommendation for how estimated usage should be calculated as set out in section 4.5.1? FS 4f: Do you agree that it should be mandatory for market participants to use MO services for standard products and services? FS 4g: Do you agree that it should be mandatory for market participants to use MO services for non-standard products where the MO provides services for the nonstandard product? FS 4h: Do you agree that the MO should not be responsible for performing on-site verification of meter readings? FS 4i: Do you agree that the party providing an event-based service such as meter exchanges should determine the quantity provided? 18

19 5. The timing and frequency of financial settlement Key recommendations made in this chapter For all types of service, the MO should issue initial charge calculations for a billing period (calendar month) five business days after the end of the billing period, for all calculated charges due between all market participants. For continuously delivered products and services, whether volume based or time based, following initial settlement there should be two resettlement runs, two and eight months after initial settlement, with full and final settlement after 13 months. For event-based services, there should be only one settlement run, and so the initial settlement run will be the full and final settlement. The minimum credit rating for the standard credit requirements should be: Standard & Poor s (BBB-); Fitch (BBB-); or Moody s (Baa3). 5.1 Ofwat s decision on payment terms Ofwat is setting separate price controls for wholesale and retail activities for the existing companies for the period Among other things, this creates increased transparency and helps new retailers to compete on a level playing field. So that they could prepare separate regulatory business plans for wholesale and retail, companies needed a clear definition of: wholesale and retail activities for example, meter reading is a retail activity; and payment term assumptions, since this affects working capital requirements for both wholesale and retail. Ofwat published a consultation on the second point in October , and in November published an information notice setting out its decisions 6. We have summarised the decisions below. 5 wnload#

20 Ofwat s decisions at a glance Setting of payment terms Wholesalers must offer standard terms to everyone. Non-standard terms can be offered where a wholesaler and retailer agree with each other to do so. Wholesalers must publish any non-standard terms they agree. Scope of products and services Payment terms apply to all products and services provided between wholesalers and retailers. These payment terms do not cover services that the wholesaler provides directly to end-customers. Settlement period One calendar day our working assumption is that this will be midnight to midnight. Details of payment terms Billing period Payment period Credit requirement Standard term: One calendar month. Standard term: 30 days from the last day of the billing period, or 15 days after the invoice is deemed to be received, whichever is the later. Standard term: a retailer needs to have either: a letter of credit from a guarantor with a minimum credit rating that will be set out in the market documents; or an agreement with a wholesaler to use an escrow account. Additional safeguard for deviation from standard term: a wholesaler needs to: offer proportionate credit and collateral arrangements; and explain clearly the rationale for credit decisions. These payment terms are consistent with typical retail payment terms for nonhousehold customers, minimising the working capital requirements for new retailers while leaving the cash flows of existing companies broadly unaffected. Services provided directly by wholesalers to end-customers rather than retailers may have non-standard payment terms, perhaps in line with existing payment practice, and this might include developer service charges such as for capacity checks. 20

21 5.2 Settlement timeline The diagram below sets out an indicative settlement timeline. We have included definitions of the components on the timeline in the glossary (see appendix B). This timeline is starts with a billing period, comprising a number of settlement periods. At the end of the billing period, the MO calculates charges, and sends these to the market participants. Once wholesalers have issued invoices based on these charges, the retailers have until the end of the payment period to make the payment. We recommend a billing period of one calendar month, with the MO being required to issue charge calculations for each day in the month by the fifth working day after the end of the billing period. The wholesaler will then issue the invoice as quickly as reasonably practicable. As noted in section 5.1, Ofwat has decided that the invoice falls due and is payable 30 calendar days after the month end, or 15 calendar days from the date of the invoice, whichever is later. This gives the wholesaler an incentive to issue the invoice by the 15th day of the following month. For example, the deadlines for the forthcoming billing periods would be as in the table below. Note that the date for the wholesalers issuing invoices below are the latest dates that invoices can be issued before the due date of payment is delayed. Where the 5th, 15th or 30th day after the end of the billing period is a non-working day, the next working day should be the relevant date. Billing period 21 MO issues charge calculations Wholesalers issue invoices Invoices fall due for payment January February February March 2014 February March March March 2014 March April April April 2014 April May May May 2014 May June June June 2014 The market code should include late payment terms (such as the 3% above base rate interest for late payment currently in the water supply licensing or WSL common contract) as an incentive to pay on time. There needs to be an escalation procedure if the retailer s failure to pay persists. A precedent exists in the provisions for default by non-payment by non-household customers: Section 61 of the Water Industry Act 1991 (WIA91) in conjunction with a supply agreement allows the appointed company, after serving notice, to remove the

22 meter, which effectively disconnects the supply. (Schedule 4A of the WIA91 sets out the exclusions, which include any dwelling which is occupied by a person as his only or principal home.) However, it would not be appropriate to disconnect a customer because of its retailer s failure to pay on time. 5.3 Initial settlement, reconciliation and final settlement Continuously delivered services Charges for services such as water supply and wastewater removal often depend on usage. If the relevant meter readings are not available, usage and charges have to be estimated. For these services, the initial settlement is necessarily an imprecise estimate. These estimates can be updated and made more accurate after meters have been read. Therefore, we recommend that there should be an initial settlement and then a reconciliation re-settlement of charges. This is intuitively the case for continuously delivered and measured services. It is less intuitive, but nevertheless the case that this should also be true of continuously delivered unmeasured services. This is because more up-to-date data on factors affecting charges, such as changes to rateable value, can become available after the initial settlement has taken place. Therefore, we recommend that there is an initial settlement, and reconciliation for both continuously delivered measured and unmeasured services. At some point in time, charges need to be finalised to keep the process manageable and so that market participants can finalise their accounts. Typically, small non-household customers have their meters read every six months, while larger users have their meters read monthly or daily. However, sometimes a meter reading may be missed so it may be two months for monthly reading and 12 months for 6-monthly reading before usage can be determined reliably. Therefore, we recommend that usage is reconciled and charges are re-settled two and eight months after initial settlement (in line with Scotland), with full and final settlement after 13 months (subject to any dispute and appropriate resolution thereof). So, for example, at the same time as the initial settlement for January 2019 there would be first reconciliation for November 2018, second reconciliation for May 2018 and final settlement of December Event-based services For event based services the rational for having resettlement of charges is less clear. The purpose of having re-settlement for continuously delivered products is that all the information on usage is not available at the time of charge calculation for initial settlement. For event based services on the contrary, all information about what services were delivered in the billing period should be available at the end of the billing period. Only errors in data, rather than missing data, would result in the need to recalculate charges. In order to give companies a strong incentive to provide the correct data first time, we therefore recommend that for event based services, the initial settlement is also the full and final settlement (subject to any dispute and appropriate resolution thereof). 22

23 5.4 Error correction and dispute resolution Once an invoice is issued, the payee may dispute some of the charges and this needs to be resolved. Similarly, the parties may agree that there has been an error. If errors are corrected and disputes resolved within the payment window between the invoice being issued and payment falling due, it may be possible to correct the charges and pay the correct amount on time. Otherwise, there may need to be an interim payment on account and a subsequent resettlement. The details of these processes are yet to be determined and will be included in version two of the Market Blueprint. 5.5 Credit risk management Ofwat s information notice published in November sets out two methods of credit risk management; the debtor should have or obtain either: a letter of credit or parent company guarantee from an entity with a minimum credit rating set out in market documents; or an agreement with a wholesaler to use an escrow account. Ofwat has not proposed what the level of the minimum credit rating should be, or how the escrow account would work. We recommend that the credit rating should be: Standard & Poor s (BBB-); Fitch (BBB-); or Moody s (Baa3). This is the minimum investment grade rating. It provides some assurance while not raising unnecessary barriers to entry. We recognise that we and Ofwat have to date only considered the quality of credit required, and not the quantity. An alternative idea is to use data from Dun & Bradstreet 8, which assesses both creditworthiness and how much credit should be extended. We would be interested in views on this idea. The second iteration of this market blueprint will recommend a preferred approach to the amount of credit, and the details of an escrow account as an alternative credit guarantee. Consultation questions: FS 5a: Do you agree that the MO should issue calculated charges five business days after the end of the billing period? FS 5b: Do you agree that, for continuously delivered products and services, there should be initial settlement, re-settlement after two and eight months and final settlement after 13 months? FS 5c: Do you agree that for event-based charges there should be one settlement run, and no resettlement? FS 5d: Is a credit rating requirement of Standard & Poor s (BBB-), Fitch (BBB-), or

24 Moody s (Baa3) appropriate for market participants letter of credit or parent company guarantee? 24

25 6. Key enablers required to deliver financial settlement Key recommendations made in this chapter The market rules for financial settlement should be set out in the market documents. The data requirements for financial settlement will be considered in detailed design. The governance arrangements for the financial settlement process will be developed in the market governance and performance management strategy. 6.1 Market documents The recommendations set out in this and subsequent versions of the financial settlement strategy will be implemented through the market documents. These include licences, codes and related documents. Ofwat has also said that it will update the current access code guidance to reflect the payment terms that it has set. This will be done by 1 April The form of these market documents, and hence how rules for financial settlement and other areas, will be set out will be developed in the second iteration of the market blueprint. Bilateral arrangements for non-standard products and services will fall outside of central settlement hence will not go through the MO. However, these bilateral arrangements will still be subject to the rules set out in the market documents. In the second iteration of the market blueprint, we will set out principles for categorising products as standard or non-standard. We will ensure that the drafting of the market documents takes account of all market participants and arrangements, and not just those that involve the MO. 6.2 Market processes and data requirements The market processes carried out as part of financial settlement will include standard data processes, data flows and structures. The requirements to provide this data should be set out in the market documents and will specify: what data is required; from which participants; and when. The high-level structure of the market documents will be set out in the codes architecture. The details of the data requirements will be considered as part of detailed design. 6.3 Data access The two main issues for data access are as follows. First, how do we ensure that all the parties that need data can access it? Second, how do we ensure that parties that should not have access to information cannot access it? 25

26 We consider that making the MO the holder of the master record of data, including meter readings, will enable all participants that need data to have ready access to it. They will only have one organisation the MO to deal with and hence one system. So, this should make accessing data efficient, provided that the rules around data access are set up to take account of all participants data needs. Where non-standard arrangements are in place between market participants, we would expect data needs to be considered as part of these agreements. On the second question how do we avoid inappropriate data access we are aware of the issue and will consider this issue as part of the systems architecture and data model. 6.4 Governance of end-to-end settlement process Governance arrangements are required in addition to obligations on participants to protect the integrity of data that forms the basis of the settlement process (and therefore the basis of the financial transactions that occur). These arrangements will include details of: how the settlement process is governed; who is responsible for end-to-end governance of the settlement process; who is responsible for ensuring MO governance; audit of the settlement process/data; and the dispute resolution processes. We will consider these issues as part of the second iteration the market blueprint, in the market governance and performance management strategy. 26

27 Appendix A: Consultation questions and approach Consultation questions We are seeking views in relation to the following questions posed throughout this document. FS 3a: Do you agree with our definition of financial settlement? FS 3b: Have we identified the important categories of products for financial settlement in section 3.4? FS 4a: Do you agree that the MO should calculate charges for all standard products, and for all non-standard products unless there are reasonable practical reasons for the MO not to do so? FS 4b: Do you agree that the MO should retain meter readings for use in settlement? FS 4c: Do you agree that the MO should perform any necessary adjustment or aggregation of meter readings data required to perform settlement? FS 4d: Do you agree that, for the purposes of financial settlement, the MO should determine estimated usage in the absence of actual data? FS 4e: Do you agree with our recommendation for how estimated usage should be calculated as set out in section 4.5.1? FS 4f: Do you agree that it should be mandatory for market participants to use MO services for standard products and services? FS 4g: Do you agree that it should be mandatory for market participants to use MO services for non-standard products where the MO provides services for the nonstandard product? FS 4h: Do you agree that the MO should not be responsible for performing on-site verification of meter readings? FS 4i: Do you agree that the party providing an event-based service such as meter exchanges should determine the quantity provided? FS 5a: Do you agree that the MO should issue calculated charges five business days after the end of the billing period? FS 5b: Do you agree that, for continuously delivered products and services, there should be initial settlement, re-settlement after two and eight months and final settlement after 13 months? FS 5c: Do you agree that for event-based charges there should be one settlement run, and no resettlement? FS 5d: Is a credit rating requirement of Standard & Poor s (BBB-), Fitch (BBB-), or Moody s (Baa3) appropriate for market participants letter of credit or parent company guarantee? Consultation approach Please provide your responses to the above consultation questions and any other comments you may have regarding this paper by 14 th February 2014, to [email protected]. We provide an accompanying template for responses 27

28 on the Open Water website to help this process, which we strongly encourage respondents to use. We will, however, accept responses in other formats if necessary. In addition, we will be running a workshop on 29 th January for representatives from water companies to discuss the content presented in all of the high level design papers. Details of this session have been shared with water companies, and for more information please contact [email protected]. 28

29 Appendix B: Glossary of terms For a full glossary of terms used in this document please refer to the Open Water programme Glossary of Terms, available at 29

30 Appendix C: Customer expectations assessment Open Water has previously identified that to achieve the objectives of water market reform it is critical to ensure that customers expectations of a competitive water retail market are understood and considered in the market design. To achieve this, work has been undertaken 9 with the objectives of: Understanding what customers expectations are of a competitive water market; Identifying whether customer expectations will be met through market design, or left to market competition and innovation; and Where the need for market design has been identified, agreeing what the Open Water programme will deliver, what will be delivered elsewhere, and what expectations will not be met. The customer expectations defined through this work have been considered in the relevant strategy and high-level design documents. An assessment is provided below as to how well we consider the design outlined in this document meets the relevant expectations. Customer expectation Assessment Commentary To be protected in the event of my retailer ceasing to trade For a timely meter reading to be used when my product or service commences That a retailer cannot refuse to offer me, or take me on, on their standard tariff and contract High High High See registration and switching strategy; in addition: section 5.1 explains our assumption that customers will generally pay in arrears in line with current practice and hence they will not be at credit risk from the failure of their retailer; and section 5.8 explains how credit risk will be managed and this should reduce the likelihood retailers defaulting and customers needing a new retailer. See registration and switching strategy; in addition, if for any reason the meter is not read when the service commences, an estimate could be used. It is envisaged that retailers will all be required to have default tariffs and contracts as a standard minimum where a non-standard 9 Document available at: 30

31 For my present retailer to be obliged to extend my contract and present tariff rates if they are disputing my moving to a new retailer For a timely meter reading to be used when my product or service ends To be able to access historical site consumption and other data, for a reasonable period of time, independent of whether I have changed supplier, at no cost to me To be able to query standing information regarding my sites (such as meter locations) at no cost to me To receive deemed contract notification in a reasonable timeframe 31 Medium High Low/Medium Low/Medium Low contract is not in place with a customer. The programme will explore this as part of its high-level design work on customer tariffs and contracts in early The current retailer will be obliged to offer them, as a minimum, their default terms and conditions until the issue is resolved. The programme will explore this as part of its high-level design work on customer tariffs and contracts in early See registration and switching strategy; in addition, if for any reason the meter is not read when the service commences, an estimate could be used. The central database will hold a record of meter readings and other service point data. As we explain in chapter 7 of the registration and switching strategy, the customer s current retailer will be able to interrogate the central database for the portfolio of service points they currently serve. This central register information will not be directly available to customers; they will need to contact their retailer to access this on their behalf. Retailers may choose to offer this type of information as part of the service they offer to their customers. Further work will be carried out as part of detailed design to consider data storage, access and sharing. The central database will hold this information. See previous answer for how the customer may be able to access it. It is envisaged that retailers will all be required to have default tariffs and contracts as a standard minimum where a non-standard contract is not in place with a

32 Where planned disconnections/limitations are for customer service reasons (such as debt) to have sufficient time to rectify before disconnection Low customer. The programme will explore this as part of its high-level design work on customer tariffs and contracts in early This relates to the retail service offered by retailers. The programme will explore it as part of its high-level design work on customer tariffs and contracts in early

33 Appendix D: Working group comments Open Water held a working group on 24th October 2013 to provide water industry experts with the chance to provide early feedback on the high-level principles, processes and switching scenarios outlined in this strategy document. We captured the group s comments and questions, which are set out below. The accompanying commentary identifies where these are referenced in the strategy document and/or where they will inform future detailed design work. Working group comments and questions Definition of settlement The definition of settlement (see below) should be changed by replacing compensate with make an appropriate allocation to or remunerate as part of the definition: The calculation and processing of financial payments between market participants (usually between the retailer and wholesaler, but also the centralised market facilitation provider) to remunerate them for the goods and/or services they have provided. Scope of financial settlement What is the scope of this work stream? Is it just the role of the MO or is it the entire end-to-end process? Financial settlement is a key issue for wholesalers and retailers and they have financial interest in making it work properly. Who does what is secondary question. Do we need standard charges that is, not numerically the same, but a standard methodology? Where is application for indirect services covered? Should disconnections be included in the settlement strategy? Is water supply licensee (WSL) combined supply, where carriage and commodity are supplied by different people, within the MO remit? Commentary We accept this, since market participants are complying with relevant codes and contracts, whereas compensate suggests a remedy for wrong-doing. The Open Water scope is the full end-to-end process for market participants (wholesalers and retailers). Overall, this work is about where the cost and effort sits not whether there is cost and effort at all. Customers paying retailers is outside the scope and the MO will not deal with customers. This depends on Ofwat s charging rules, which are still to be set and will themselves be dependent on Defra guidance. This falls under the operational services strategy. No, this falls under the operational services strategy. No, but if one company provides both carriage and commodity, this is included. Working group 33

34 If imbalance is not looked at, someone needs to be accountable for the decision to park it for now. Should metering be a specific topic, as it is fundamental to the customer experience and successful market? Otherwise, there is a risk that metering elements or key activities might be missed. Meter readings are fundamental to accurate settlement what are the incentives for timely meter reading/penalties for late/no reading? We need to ensure that on day one of market opening all meters can be read and are being read. There should also be a process in place for those meters that cannot be/are not being read. In Scotland, there are still lots of meters that cannot/are not being read this falls under the topic of meter inter-operability. If meter stock needs to be upgraded, there is a potential impact on PR14 because significant investment might be needed. We need rules on what metering is acceptable. It is important to check the accuracy of the meter, not just meter reading. There is a materiality question around this issue could this put off new entrants? Who is responsible for meter reads used for sewerage billing? Are charges payable to the MO for its services part of settlement? These could be included under rules relating to a particular product rather than separate from other charges. What if someone defaults on their MO bill? How should disputes about how charges have been calculated be resolved? One idea was to pay at least same amount as previous month and then reconcile in next invoice. Materiality tests are important, and the MO has to have robust codes and audit process to inspire confidence and trust. Level playing field Option B3 for the scope of MO services increases members endorsed this view. The upstream strategy will ensure that issues such as imbalance are taken into account. This will be addressed in the metering strategy in the second iteration of the market blueprint. Automatic meter reading (AMR) will be addressed in the second iteration of the settlement strategy. This will be addressed in the metering strategy in the second iteration of the market blueprint. This will be addressed in the metering strategy in the second iteration of the market blueprint. Open Water is not going to make any recommendation on standardising metering stock as it is outside Open Water s remit. This will be addressed in the metering strategy in the second iteration of the market blueprint. Usage will be calculated based on meter reads for water. This will be addressed following the MO workshop. The CMA in Scotland was suggested as a model. It was confirmed this will be in the market governance and performance management strategy document that we will publish later in Attendees were asked to respond to Ofwat s level playing field 34

35 transparency and is a step towards creating a level playing field, but more is needed. Its operation needs to be properly audited and checked as in Scotland. Products and services in centralised settlement The difference between continuously delivered products and services (water, sewerage) and event-based ones (meter exchange, bursts, etc, was raised. Some members questioned including indirect services in centralised settlement or suggested that the initial focus should be delivering centralised settlement for continuously delivered services, as there is enough to do without worrying about eventbased services. Special agreements why you would put them through the MO all the work to calculate charges, etc, is already being done. But if customers with special agreements want to switch it will be easier if the agreements are included inside the MO systems from the outset. What continuously delivered services would be appropriate for central settlement? Members asked for more detail on what sits below water and wastewater services. Potable water and foul sewerage and surface water drainage should be included in central settlement. Non-potable and other are more debatable; the criteria should include the size of the market and the volume of things going through settlement focus on the higher volume things first. Some companies do supply non-potable in bulk and so it does therefore make sense to have a non-potable tariff structure. The Scottish experience was that it is difficult to add things in later, so if we think we want non-potable water included in the market we should include it now. Does other need to be separate just include in potable water charge? discussion document. The question of legal separation was parked as it is outside Open Water s remit. This document explains that it is for the reasons of efficiency, consistency transparency and trust that Open Water has recommended centralised settlement for all standard services. This will help create a level playing field for all market participants. The experience in Scotland is that it would have helped if the CMA did this for meter exchange. Special agreements will be considered in 2014 as part of Open Water s work on contracts, in the wholesale contracts strategy and the customer contracts and tariffs strategy. Sections 3.4 and 4.1 discuss which products will be considered as part of central settlement. This will be developed further in the second iteration of the market blueprint, which will develop principles for what is a standard and non-standard charge. Agreed. This is consistent with Open Water s starting assumption that everything should be central unless there is a compelling reason for it not to be. 35

36 If trade effluent and developer services are in the market, they need to be in the central settlement system. Plug-in arrangements, whereby wholesalers would do some of the calculations, might be useful. Surface water drainage (SWD) some companies charge separately and this provides signals and increases customer awareness. For others do they need to change their charging systems? If you do not put it into the market what do you do with it? If companies have different ways of calculating it, how do you deal with that? Retailers would want single bill why move away from this? Forcing the whole industry to adopt one approach would involve a lot of pain. But companies have to offer a rebate for SWD, so they must know what their SWD costs are. The timing and frequency of settlement Standard payment terms Should terms be standard across regions or across the market? Daily usage estimates for small- and medium-sized enterprises (SMEs) are likely to have a broader range of inaccuracy than households as these customers usage patterns are more variable. Do the standard terms apply from 1 April 2015 (price control) or 1 April 2017 (competition)? It may not matter, as if the terms are better, someone will want to change immediately. There will be a one-off cash impact in moving from daily billing to monthly. Could billing Period be up to one month rather than one month? Why wait five days to invoice why not day 0 where possible? The second iteration of the market blueprint will consider these services. How charging for SWD is developed will be considered in Ofwat s work on charging. There was agreement there should be the same standard payment terms for all products. A settlement period of one day was endorsed, although it was noted that if more time granular products are developed in the future, a shorter period could be advantageous. Ofwat has determined that they will be the same across the market. Differences between actual and estimated usage should be reconciled following a meter reading. Ofwat has confirmed that these will apply from 1 April Ofwat has decided that the billing period will be one calendar month. We are recommending that the MO must issue calculated charges by the fifth working day after the end of the billing period. 36

37 Why is payment 15 days after invoice? They are currently 14 days after invoice, following a lengthy consultation. This is a commercial environment so why not 7 days? All companies being billed on the same day of the month could put a strain on the MO s systems. An option could be not to bill everyone on the same day and stagger issuing of bills across the month. Trade effluent charges are based on samples not estimates and so may not be charged for until a long time after the activity of treating trade effluent takes place. Wholesale tariffs need to recognise that retailers may not get the cash for trade effluent until much later. Alternative payment terms If someone has a clever idea for alternative terms, they can negotiate them but they must then be offered to everyone. However, wholesalers have a licence obligation not to show undue preference and might be reluctant to negotiate away from standard published terms. If everyone agrees that it is sensible, it could become a second set of standard terms. The degree of flexibility needed depends on the goods and services concerned; for the commodity (water or sewerage) terms should be firm, but should terms for other services be flexible? Will anyone really want to negotiate terms with an incumbent retailer for core services? Credit risk management Is the need for a bank guarantee a barrier to entry? Invoices will be issued by market participants subsequent to this. This is what Ofwat has decided. The principle of payment N days after invoice was endorsed as it gives an incentive to get invoice out quickly. Ofwat has determined that they will be the same across the market. Calculating charges is unlikely to have a material impact on the MO s ability to issue charges concurrently. Getting data in is the key to how quickly the MO can operate. There is further work that needs to be done on trade effluent settlement, which will follow in version two of the market blueprint. Varying payment terms is just one way we can deviate from standard services. Ofwat has decided that market participants are free to negotiate alternative terms provided they offer them to everyone. This is for the market to decide; these terms could be incorporated in market codes. This is for the market to decide. This is a matter for customers and retailers and outside Open Water s remit. (Ofwat has aligned payment terms in the market with the existing terms for nonhousehold customers, to avoid retail competition affecting wholesalers cash flows.) Companies will be able to use an escrow account as an alternative 37

38 to a bank guarantee. What incentives would be given to comply with payment terms? Suggestions included interest charges, some other form of financial penalty, or withholding the licence a carrot and stick approach. Need a recovery process including disconnections. Role of the market operator in settlement Verifying meter readings What is the procedure for ensuring accuracy of meter readings? What happens now, and is there a problem? Is there an onus on the retailer to do it right in the first place? If responsibilities for meter reading/frequency/performance are well defined, a second man-in-a-van is not required. Do we need to verify meter readings at all, since customers check their meters? Elexon does it in electricity market but in the Scottish water market the CMA does not. For Elexon, verification means all meter-reading kit is tested. Tolerance is also tested for meter readings as a second tier of checks. This provides an independent review of metering systems installation correct, etc. The sample size is about 1% of half hourly meters. Elexon also check process for staff checking that businesses have a qualification process in place. Would the MO employ people to do it? There are inherent physical problems in checking meters. It is difficult to simplify it is different from electricity. Determining usage data who is responsible for various aspects of the information needed to estimate volumes for settlement? In particular, who would be responsible for estimating annual volumes, assigning customers to standard usage profiles, aggregation and adjustment (for example, for losses)? Determining usage data how is it done? Where there is no meter reading we must have a deemed demand. Companies already have systems for doing this and we should learn from the industry s collective wisdom. Compliance with market documents, and hence payment terms is likely to be a licence condition. Verifying and validating meter readings is discussed in chapter 4 of this document and in the MO target operating model. This should be the MO s responsibility. It should only be done once, to avoid duplication of activities and hence costs and customer and retailer confidence needs to be considered. This approach was endorsed. The approach recommended in this document, using a similar approach as in Scotland for water and as in electricity, was generally endorsed. We will work with the industry to develop the detail in the market documents. 38

39 What are the aggregation rules for multiple meters for one settlement? How should we calculate losses and reflect them in charges? Is there a way to ensure an appropriate allocation between contestable and noncontestable segments? The contestable segment is a small part of the total and it would be impossible to isolate its losses. Where there is no meter there needs to be some way of calculating charges. This is part of detailed development. Calculating charges for losses will be considered in Ofwat s work on charges. In this case, there will be a timebased charge, based on some property of the premises such as rateable value for water supply or surface area for drainage. 39

40 Appendix E: Detailed breakdown of products and services Standard services may be further categorised according to the diagram below. Standard services Continuouslydelivered Event-based Water Sewerage Operational services Potable Foul Non-potable Surface water drainage Other Trade effluent Continuously delivered services can be further broken down into: measured/unmeasured; large user; or special agreements. Water Other includes such services as: field troughs; drinking bowls; and outside taps. These are all offered as distinct services in the Scottish market. Operational services includes: metering; developer services; and 40

41 a number of other activities. This area is being assessed through the operational services (previously entitled site works) working group. It should be recognised that this may not be the complete list of all products and services required, which might also change over time as the market develops. Therefore, it would therefore be helpful if the MO had a degree of flexibility to accommodate different services and charges. Non-standard services may be categorised in the same way, but new sub-categories may emerge. 41

42 Appendix F: Imbalance Introduction Within a network, retailers are expected to buy the volume of water they sell to their customers. In the retail only market to be introduced in 2017, retailers buy all the water their customers use at a single wholesale price for each location. This appendix considers the types of charges that may be needed to buy and sell water on a network when there is upstream entry, following commencement of the relevant clauses of the Water Bill around 2020, and perhaps to some extent before then. Comparative overview of markets In electricity and gas markets upstream production, transportation through a network and downstream consumption are separate and network users are expected to put in the same amount they take out for their customers. To the extent they fail, there is an imbalance between inputs and outputs and the network user is required to buy or sell sufficient of the commodity to correct this imbalance. This is called cash-out and the counter-party is the system operator (SO). The SO (not itself having access to the commodity), may also have to buy or sell on the day to keep the system as a whole balanced. The SO s net costs or revenues from this buying and selling are shared between users according to their use ( cost neutrality ) and perhaps with the system operator to give it an incentive to minimise the overall costs. When upstream entry begins (and for some considerable time thereafter), the majority of water will continue to be provided by the existing vertically-integrated companies with a smaller amount provided by upstream entrants. This may be described as a single buyer for most of the water required, with a marginal bilateral market between upstream entrants and retailers; it is evolutionary and not the big bang change seen at liberalisation in electricity and gas. We envisage that market participants will buy and sell water to cash-out their individual imbalances and perhaps to help with system balancing. The purpose of this appendix is not to decide the terms of this buying and selling but to indicate what types of charges may be needed, so that the initial design of the MO can take into account likely future requirements. There could also be a facility for them to trade between each other on the system. At this stage of market development, system balancing will rely mainly on the incumbent s own resources and we consider it unlikely there will be any need for a cost neutrality arrangement for sharing out the net costs of system balancing. Design objectives for the charges When we come to design the charges, likely objectives include the following. Cost recovery. To recover balancing costs from those who that cause them, and cover the costs of those that agree to take actions to help balance the system. Incentives. To provide incentives to each market participant to improve its balancing performance, thereby driving down balancing costs overall, and, when required, help overall system balancing. 42

43 Proportionality. For water and sewerage markets, given the early stage of market development, balancing arrangements should be simple and practical for example, it may not be appropriate to copy arrangements in developed markets such as electricity and gas. Imbalance cash-out Upstream entrants will put water into the system upstream to meet the needs of particular customers but inevitably 10 the inputs and outputs will not match. Therefore, the relevant market participant will be required to buy from or sell to the incumbent water company, to come back into balance. The buying price at the customer service point may be the standard wholesale price for retail-only entrants. A higher price would provide an incentive for the upstream entrant to provide the whole requirement. However, since for each customer a retailer may opt for retail-only supply or obtain water from an upstream entrant, this might just encourage artificial churning of customers between the two arrangements (the customer would see no change). As the input is only meant for identified customers, any excess breaches the rules of the game and the selling price for this excess may well be below the standard wholesale price. If the buying price is the wholesale price, market participants can avoid selling at a poor price by ensuring retail demand exceeds upstream inputs by a comfortable margin. Therefore, an attractive and simple option is for all water to be bought or sold at the wholesale price for the retail only market. If there are different buy and sell prices, there is an argument for a central dead band when the imbalance is small relative to throughput. Therefore, the most complicated charging structure likely to be required involves three prices: buy, neutral in a central dead band, and sell. System balancing It is also possible that upstream entrants who have surplus water available might occasionally sell some to the incumbent company to help them operate their system. Similarly, a retailer could provide additional water by agreeing a temporary interruption of use with its customer. Conversely, if there is too much water, other market participants could buy it and reduce inputs or restore an interrupted demand. The prices and quantities will be those agreed by the parties in each case. There may be a central system for other market participants, both upstream and retail, to post offers and bids that the incumbent company may accept. Commodity market As part of the upstream strategy, further consideration should be given in due course to the merits of the MO operating a central commodity market accessible to all market participants. The MO could be responsible for calculating the charges arising from these trades. Sewerage 10 Because (i) customer demand is not determined until later and (ii) the input may not equal the target amount for reasons including the vagaries of metering and plant operation. 43

44 Although discussed in terms of water, similar requirements (mutatis mutandis) apply to sewerage but with one particular difference: under a disposal authorisation a market participant may also remove matter from the sewerage system without having a corresponding input. This means there is sanction for being long that is, abstracting/discharging and perhaps treating a greater quantity than relevant customers use; it may then be considered unreasonable to penalise any deemed sale of the excess to the system by setting a price below the normal wholesale price. 44