FTI Consulting – Utility Week: Off Average?

FTI Consulting – Utility Week: Off Average?

Economic and Financial Consulting

September 13, 2013

The upstream competition provisions of the Water Bill raise the spectre of regional de-averaging of prices. Anthony Legg looks at what this could mean and for whom.

The Water Bill, currently on its journey through Parliament, includes provisions that will for the first time allow new entrants to supply water resources and dispose of sewage ("upstream activities"). The Bill will also remove the costs principle with the aim of increasing the profit margins available to new entrants, making entry to upstream markets more attractive.

Whether there is a vast number of potential entrants waiting in the wings is unclear, but these provisions raise the prospect of customers that are otherwise identical paying different amounts for their water and sewerage simply because the upstream activities they use are located in a different part of a water company's region. In other words, an end to so-called regional averaging of charges.

This possibility arises not only because new entrants might be able to supply water (or dispose of sewage) at a different cost to incumbents, but also because retailers could pay different amounts for the use of the network (to transport the water from source to tap), depending on whether the water is supplied by a new entrant or the incumbent.

The latter depends on the way that access prices are determined for the network. Under the Bill, Ofwat will need to issue guidance to companies on how to set their access prices, and while no such guidance can be expected for some time, it is likely that access prices will need to reflect the specific infrastructure actually used by the new entrant. And because the infrastructure (pipes, treatment works and so on) used by the new entrant will vary in design and condition, the cost of accessing the relevant pieces of infrastructure will vary within regions and is unlikely to be the same as the average cost that incumbents will be required to charge retailers.

The potential for new entrants to undercut incumbents, leading to loss of market share, is not the end of the potential problems for established water companies. Economically efficient access prices would reflect the marginal cost of access to the infrastructure. However, the costs incurred by the incumbent will also include a share of the fixed costs of operating and maintaining the network along with the sunk costs of investment in the assets in the first place.

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