Access pricing under the Water Act 2003

This entry was added to http://www.reckon.co.uk/headlines-franckblog on 2 November 2004.
Full blog table of contents available at Contents | viewpoint: Franck.

Ofwat released a consultation paper on access code guidance on 18 October 2004, and is holding a workshop on this topic on 5 November 2004. This arises from the provisions of Schedule 4 of the Water Act 2003 (which inserted sections 66A-L in the Water Industry Act 1991) governing the licensing of water retailers and the obligations of incumbent water companies ("undertakers") to provide common carriage and bulk supply to licensees.

This viewpoint highlights some possible adverse consequences of Ofwat's guidance on pricing. Whilst I recognise that a lot of work has gone into the development of this document, I — perhaps with the "fresh eye" of the outsider on this debate — suggest that some aspects of the proposed charging principles may turn out to be counterproductive in practice.

The efficient component pricing rule (ECPR) or "retail-minus"

The aim of the "costs principle" governing access pricing is to produce prices that fully compensate undertakers for the net losses that they unavoidably incur when providing a common carriage or wholesale supply service as compared with continuing to supply the final customer themselves.

This principle leads to a "retail-minus" rule, or what is known in economics as the efficient component pricing rule (ECPR). The ECPR applies to the case where an incumbent supplier is being displaced from part of its retail business by a new entrant, but retains a monopoly in some infrastructure provision which is required by any new entrant wishing to engage in any relevant retail supply. These circumstances virtually always correspond to the situation for water supply to industrial customers in England and Wales, to which Ofwat's guidance primarily applies.

In practice, this means that "access" prices for bulk supply and for common carriage are determined as the difference between the amounts that the incumbent would have been expected to earn as a continuing retail monopoly, less the costs (both capital and operating) avoided as a result of the replacement of the retail supply obligation with a contract to supply bulk water and/or common carriage. Ofwat's guidance uses the acronym ARROW ("costs that are Avoided or Reduced; or any amount that is Recoverable in some Other Way") for these avoidable costs, which include:

account management;
billing;
costs of any extra-statutory services (which will either be avoided or be expected to be recoverable separately, i.e. "in some other way", from the customer);
day-to-day running costs such as pumping; and
potentially some reduction or deferral of requirements for investment in water resources, at least in the case of common carriage without bulk supply (as the new entrant would take over responsibility for bringing water resources to the customer's area).

The economic case for the ECPR

The economic rationale for the ECPR relies on a static notion of economic efficiency: the new entrant is expected to be able to displace the incumbent if and only if it has lower costs for the ARROW components than the incumbent's ARROW costs.

Problems with the ECPR approach (1)

Whilst the ECPR has a reasonable economic basis, its implementation in practice faces a range of difficulties:

There are strong tensions between transparency and accuracy within the ECPR
Access codes must provide indicative pricing rates for bulk supply and for common carriage. These rates are necessarily derived on the basis of approximations and rules of thumb. Insofar as they affect actual prices, this may lead to distortions in that licensees seek areas of inaccuracy of the methodology in their favour, rather than areas in which they are more efficient than the incumbent. Even for negotiated rates, rules such as "it should be assumed that ARROW costs remain unchanged in real terms in subsequent years", which do enhance transparency, the distortion of incentives remain.

Neither ECPR nor Ofwat's guidance appear to constrain tariff structures
The ECPR only provides guidance on the total level of revenue that an undertaker can expect from a site: it does not constrain the structure of charges, and Ofwat notes that "the way in which final access prices are expressed in terms of tariff structure is a matter for agreement between the undertaker and the licensee". However, from a competition perspective, tariff structure is often at least as important as the level of charges: for example, tariff structures (often expressed as discounts) can be designed to create exclusionary effects.

The guidance does not take account of risks and depreciation
Ofwat appears to suggest that avoided or postponed capex should be taken into account in terms of interest charges only, disregarding risk effects as well as depreciation allowances on the principal. (Ofwat's use of phrases such as "deferred indefinitely" instead of "avoided" may appear to address the issue of the principal but is merely misleading.) This seems likely to understate the savings for the incumbent. In the extreme case where extensive new entry would remove the need for a substantial part of an undertaker's capex programme, Ofwat's rule appears to involve transferring asset risks from the incumbent to new entrants whilst allowing the incumbent to retain reimbursement of the capital cost that it no longer needs to incur, plus remuneration for the associated risk (being the allowed cost of capital plus depreciation allowances less the benefit of capital allowances less the cost of debt).

The guidance does not address demand-side effects
The draft guidance is based on a model of demand as an external amount not affected by competition or pricing. The extent to which new forms of supply, e.g. integrated water management services where the benefits offered by the incumbent include a reduction in demand, can be fitted within the guidance's framework is unclear to say the least.

The guidance may prejudge the relevant markets
Ofwat describes a water resource zone (WRZ) as "a geographically discrete area within which individual sources of water (and water treatment) can generally be assumed to be interchangeable", in effect prejudging the definition of the relevant market for water resources and for bulk supply that could be relevant in a Competition Act dispute.

The proposed rules may not prevent cherry-picking
The guidance identifies opportunities to avoid or postpone capex (rather than the relatively small avoidable energy and materials costs) as the likely driver of new entry in water resources and treatment and therefore in the demand for common carriage services. Coupled with a fairly generic pricing rule, not least because of Ofwat's assumption that water resource costs can be expected to be uniform within a WRZ, this feature seems likely to result in inefficient cherry picking of any projects where specific resources can be obtained with less investment than assumed at the WRZ level — rather than projects where a new entrant can expect to be more efficient than the incumbent.

All the above issues can be seen as consequences of the first point, the tension between transparency and accuracy. For example, different assets have different depreciation and risk profiles, and estimating the incumbent's actual saving would necessarily involve detailed analysis and controversial judgments on a case-by-case basis. If any such issues were to come to a dispute under the Competition Act, it is likely that all manners of complicating factors such as option values and the impact of investment on ability to supply other related markets would be raised and debated.

Problems with the ECPR approach (2)

Perhaps the most powerful argument against the ECPR is that it fails to recognise the key dynamic benefits of competition, and may therefore misdirect managerial effort and competitive constraint towards areas which do not bring the benefits of greater competition and may have little or nothing to contribute to the public interest. This is for two main reasons:

ECPR prevents pro-competitive entry
Whilst superficially attractive, the rule that entry is effectively only possible for an entrant with lower costs than the costs that the incumbent would avoid may in fact prevent pro-competitive entry, even if the ARROW cost estimates were accurate. This is because effective competitive pressures would be expected to lead to innovation that reduces costs (and/or improves services) both for the incumbent and for entrants, and to pass through these improvements to customers without enabling a new entrant to retain the benefit. Thus, an entrant that could exert such competitive pressures but does not have lower prospective costs than the incumbent would not have sufficient profit prospect to be able to enter, and the main potential benefit of the competition that it could have provided is lost.

ECPR encourages anti-competitive conduct
ECPR also risks encouraging several forms of anti-competitive conduct, including changes in management and/or accounting practices within incumbents to reduce the actual and/or apparent avoidable costs of contestable activities, as well as possibly facilitating collusion by making it in both the incumbent's and the new entrant's best interest to co-operate rather than compete: in cases where ECPR makes entry possible, it is best for both parties if the incumbent subcontracts the would-be entrant to perform the tasks that it can do more efficiently than the incumbent, sharing the benefits between them and leaving no benefit to the customer and no competitive pressure or customer choice in retail markets.

It may seem somewhat paradoxical to argue that ECPR is anti-competitive when it is essentially the rule used to determine access disputes under competition law. But such paradoxes do happen: there is nothing absurd in the suggestion that an ex ante regulatory rule that merely reproduces the outcome of competition law cases may be suboptimal. Indeed if it were not so we would not need any Ofwat guidance or other ex ante regulation for access prices in the water industry.

(A countervailing point sometimes advanced as a benefit of ECPR, particularly in the telecoms sector where it is compared to cost-based pricing rules, is that it is relatively favourable to competition in infrastructure. But this does not appear relevant in the current policy context in water.)

Possible alternative rules

Giving the problems highlighted above, it seems natural to consider potential alternatives to the ECPR.

A popular alternative would be access charges based on the costs of the "upstream" infrastructure or bulk treatment activity, perhaps using a long-run average incremental costing methodology. However:

Prices based on costs only have an efficiency justification if the supplier can vary the volumes supplied — not very likely for water distribution infrastructure.
Reconciling cost-based access charges with a vertically integrated industry structure leads to intractable competition policy issues, and sometimes even to the (anti-competitive) absurdity of imposing a "price floor" on the retail charges of the incumbent!

Thus, such an approach would be unsuitable, at least for the water industry as currently structured.

The other obvious candidate is a return to "relying on the Competition Act 1998" — leaving it to undertakers to assess how to comply with the "special obligation" to protect the competitive process that results from any dominant position that they hold (including in markets with no past transactions such as those for common carriage); and leaving it to others to complain if they are not satisfied with the conduct of an undertaker. But this has proved a source of (presumably costly) litigation.

Thus, absent major structural changes in the industry, it is difficult to imagine that any pricing rule or guidance would offer a way out of the use of inaccurate and distortionary rules of thumb. Within the space of pricing rules, ECPR is probably the least bad and Ofwat's draft guidance represents a reasonable implementation of it.

Is there a way out of the impasse?

In summary:

ECPR is probably the last bad of the possible pricing rules, and the draft guidance seems to make a reasonable fist of implementing it.
However, any practical implementation of ECPR will lead to inefficient distortions.
Furthermore, ECPR does not recognise the true benefits of competition, and may prevent them from being achieved.
The "free market"/"rely on competition law" approach has been tried and found to benefit lawyers more than water consumers.

Given this, there are some fundamental alternatives that ought to be considered, based on lessons from other sectors:

The "energy" approach: decisive structural reform along the lines of the electricity and gas sectors. This would involve a policy decision that some activities are monopolies and others are competitive, and a robust process of structural separation to remove the risk of exclusionary behaviour and free up the competitive businesses from the influence of the price controls imposed on infrastructure monopolies. But what are the underlying monopolies in water? Structural reform would cost a fortune to implement, so it would be unfortunate to get it wrong.
The "telecoms" approach: strong ongoing regulatory pressure and price controls on the monopolies. In my view, this has not been very successful in telecoms (slow and patchy development of competition, high regulatory intrusiveness and costs) and can be expected to suffer from the same issues in water.
The "media" approach: ex ante enforcement of competition law obligations, without prescriptive pricing rules. BSkyB is a pretty good monopoly in some areas, and the BBC is hardly a free-market animal, yet there is strong and dynamic competition in many aspects of the sector, supported by voluntary "open access" policy for some key infrastructures. But it would be reasonable to argue that the strong drive to spread digital TV — a new technology — has little direct equivalent in the water sector, and that the dynamics of the industry would be so different as to make the media approach ineffective in water.

Relevant documents

Ofwat's overview of the access code guidance consultation (Word format)
http://www.ofwat.gov.uk/aptrix/ofwat/pu…ess_code_guidance_cons181004.doc
Ofwat's consultation on access code guidance (Word format)
http://www.ofwat.gov.uk/aptrix/ofwat/pu…code_guidance_overview181004.doc