View this page on Reckon Online

Reckon home page

Access pricing under the Water Act 2003

This entry was added to 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:

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:

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:

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:

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:

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

Relevant documents

Other links

Entry added by Franck on 2 November 2004

There may be comments and notes on this page. You can contribute by using the "Add a comment" button above. Advice on making contributions (including trackback) is in the Guidelines.

Last changed by Franck at 6:41 AM on Tuesday 21 June 2005.

Reference for this page:
Reckon Open "Access pricing in water | viewpoint: Franck" 2005-06-21T06:41:31