Water Act. New Water Act receives Royal Assent

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1 New Water Act receives Royal Assent On 27 June 2013, the Water Bill was introduced into the House of Commons. The Bill received Royal Assent on 14 May 2014 and the Water Act 2014 (the Act ) is now on the statute books. The Act is ambitious and represents the most significant reform of the water industry in England 2 since its privatisation in Through the Act the Government is pushing an ambitious agenda for a sustainable, resilient and customer-focused water sector. Key reforms are a long term ambition and there are real opportunities for stakeholders to get involved and to influence the shaping of the reforms in practice....the measures that the government is proposing are good news for customers, the environment and the economy. And we are changing the way we regulate to complement and support the Bill. Together, our changes and the Bill will boost the UK economy by over 3 billion. The Bill will mean better services for customers, more efficient use of water resources and greater resilience in the face of drought and population growth. Regina Finn, Former Chief Executive, Ofwat Key measures for reform The Act includes a package of measures to introduce market reform and emphasises the need for the changes to be evolutionary in nature balanced carefully against the priorities of maintaining a stable and regulatory environment. Key measures include: introduction of competition in the non-household retail market the current water supply licensing regime in England will be replaced by removing the current thresholds which determine when a large non-domestic customer can switch supplier opening up of the upstream market, making it much easier for new businesses to enter the water market to provide new sources of water or sewerage treatment services regulating access to the water and sewerage market through new authorisations and the use of market codes reform of the special merger regime under which a merger needs to be referred to the Competition and Markets Authority (CMA) establishing a cross-border market between England, Wales and Scotland introduction of a sewerage retail licensing regime in England that will apply in parallel to the water supply licensing regime provisions relating to the bulk supply of water (aimed at encouraging water trading), to help join up the national supply network by making it easier for water companies to buy and sell water from each other encouraging the development of small-scale water storage by making it easier for owners of small-scale water storage to sell excess water into the supply system putting in place measures to tackle unsustainable abstraction by changing the way water company schemes restoring sustainable abstraction are funded provision of enabling powers to streamline the environmental permitting regime by including three more licensing regimes: abstraction and impoundment licensing, fish pass approvals and flood defence consents provisions to address the availability and affordability of flood insurance provisions to make it easier for developers to connect new developments to the water and sewerage supply new statutory duties for Ofwat, being a primary duty to further the resilience objective and a general duty to secure that incumbents do not unduly discriminate in favour of their own retail businesses The Act s measures mainly cover England and Wales (only two measures extend to Scotland).

2 Why is market reform needed? At present, Ofwat s economic regulation 3 is the principal driver for cost efficiency within the sector. Although this approach has delivered savings, Ofwat s regulatory approach coupled with the rigid nature of environmental regulation has resulted in limited dialogue between consumers and water companies. The Water Act 2003 put in place a very limited retail market under the Water Supply Licensing ( WSL ) 4 regime enabling some very large users of water to switch suppliers. However, the current WSL regime does not provide the correct incentives to facilitate competition. Reform is needed to overcome the barriers to competition. One of the most important reforms introduced by the Act is the opening up of retail competition in England (and cross border to Scotland). Essentially, water and sewerage non-household customers (regardless of how much they use) will be able to choose who provides their water and sewerage retail services. The benefits of increasing competition in the water industry have already been seen in Scotland, where retail competition for nonhousehold customers has been in place since No threshold for switching retail supplier exists; therefore any non-household customer in Scotland can switch their water and/or sewerage services to another retailer. There are now eight licensed retailers in the Scottish water and sewerage markets and since the market opened; about 5% of the market has switched supplier and about 50% of the market have renegotiated their water and sewerage services 5. As a result many have received price discounts and additional services such as water efficiency advice. What are the barriers to competition? Inertia to cultural change the complex regulatory framework has created a culture of dependency. The current industry structure is not fit for purpose, for example, due to the: small size of the WSL market requirement on new suppliers to agree prices and terms on an individual basis with the incumbent water companies requirement on parties wishing to provide upstream services to the WSL market to also provide the associated retail services absence of arrangements equivalent to WSL for sewerage services current application of the Cost Principle that deters entry by new licensees because it would be unprofitable. There is a lack of interconnection between water companies and low activity in water trading. Ofwat s existing price control mechanism rewards capital and operating efficiency differently and leads to companies favouring capital (capex) over operating (opex) expenditure the so-called capex bias i.e. building big sewers rather than investing in operational efficiencies. It is hoped that opening up the market to competition will lead to innovation from new appointees, e.g. increased grey water recycling and greater engagement with customers about efficient water consumption. Trading in the upstream market should reduce the need to abstract water from rivers in areas of stressed water supply. Competition should also increase efficiency in investments with capital being targeted where it is really needed. Looking forward, the ambition is for the benefits that are achieved in the non-household sector to flow over into the water companies household retail arms. 3 Ofwat, the Water Services Regulation Authority, was established to regulate the total revenue that water companies are permitted to recover from their customers. Ofwat has a duty to protect consumers by promoting competition. Economic regulation seeks to provide this protection by mimicking the effects of market competition through the RPI-X regime. The Costs Principle is the methodology for calculating the access price that an entrant must pay for the use of the incumbent company s network. 4 Up to 2011, only one customer had changed their retailer under the WSL regime. The Government increased the size of the WSL market by lowering the annual water consumption threshold at which non-household customers can switch retainer from 50 million litres to 5 million litres. However, there is still only very limited competition. 5 The New Retail Market for Water and Sewerage Services A Discussion Paper prepared by the Open Water Programme dated 25 June 2013.

3 Importantly, the Government has now committed to allow incumbent water or sewerage companies, with the consent of the Secretary of State (SoS), to voluntarily exit from the retail market this is known as retail exit, seen by many as essential to allow the retail market to operate properly. The retail services would then be provided by one or more retail licensees and is likely to lead to a consolidation of retail businesses. Amendments tabled at the third reading of the House of Lords set out extensive legislative drafting on retail exit and provide the SoS with broad ranging enabling powers to introduce Exit Regulations. Retail exit is a complex issue and it will be important to ensure that effective checks and balances are built into the Exit Regulations to protect both non-household customers that are subject to a transfer and household customers that remain with the incumbent. The Government proposes to carry out a full consultation on retail exit later in Price review and risk-based regulation ( RBR ) Alongside the wider reforms, the regulation of the water sector is changing. In July 2013 Ofwat published Setting price controls for final methodology and expectations for companies business plans (the Methodology ). This price review ( PR14 ) is ground breaking and it introduces important new measures to improve the price control framework so as to improve efficiencies and further develop competition. The new outcomes approach firmly embeds customer engagement in the business planning process. Water companies will be held to account for what they deliver for their customers rather than the way that they choose to deliver it. Outcomes expected of a water company include what the company is proposing to deliver for consumers including how it has engaged with customers in developing its proposals and how those proposals reflect customers views and priorities, how its proposals deliver the best long term sustainable solution for consumers and secure value for money, and how it has met and intends to meet its statutory requirements. Ofwat, in its Methodology, provides that it will assign each element of each water company s business plan to one of three processes enhanced, standard or resubmission which determines the level of scrutiny and challenge by Ofwat of that element. Each company will also be scored as falling within one of the three categories of enhanced, standard or resubmission which determines procedural, reputational and financial benefits 6. Enhanced elements of a business plan will be those that pass all tests. Standard elements will be those that fail at least one test but are still good quality and have no serious shortcomings. Ofwat will give a resubmission rating to those elements where there are serious weaknesses. Resubmission elements will receive the most intense scrutiny and challenge and the company would need to revise its business plan and resubmit it to Ofwat. Ofwat will publish its assessment of each company s overall business plan quality and this brings with it reputational risks. Water companies were required to submit their business plans on 2 December Only two companies delivered consistently to achieve pre-qualification for enhanced status. Ofwat will publish final determinations for all companies on 12 December RBR will mean that going forward water companies are likely to face reduced regulatory control but at the same time will have to take on greater responsibility for the management of their businesses. Boards of water companies will have greater ownership and accountability for their business plans and how well they deliver against their proposed outcomes and the protection of the environment in the long term. Companies will have more flexibility to innovate and put in place efficiency measures to secure cost savings and greater returns, however, the penalties for failure to comply with statutory requirements and failure to score highly against Ofwat s RBR tests will be higher with reputational and financial risks. 6 Table 4 on page 77 of Ofwat s Methodology document sets out a summary of the risk based review tests that Ofwat uses in carrying out its enhanced, standard or resubmission determinations. The tests are made against water company s proposals for outcomes, costs, risk and reward and affordability and financeability.

4 PR14 A Modernised Approach Setting of separate price controls for the wholesale and retail business arms aimed at targeting regulation where it is most needed Moving towards the integrated treatment of opex and capex, with a new totex approach aimed to resolve the existing issue of capex bias and to provide water companies with greater flexibility to innovate and outperform the price control Measures to boost efficient water trading and reducing abstraction from stressed water sources Increasing the transparency of network capital and operational costs (the current price review mechanism applies a single price cap for all activities undertaken by the appointed water company and there is very little transparency with regards to the costs in the different parts of the value chain) Increased emphasis on water companies engaging fully with their customers. Ofwat wants to put customers at the centre of the industry. There is a new outcomes focused approach and a move away from the dependency on the regulatory framework. Implementation of retail competition In September 2013, Ofwat published two discussion documents: (1) A level playing field for the water market 7 (considers the tools that are required to ensure that a level playing field exists between all companies to avoid the risk of anti-competitive behaviours); and (2) Water market governance arrangements 8 (considers the codes that are needed to ensure that there are agreed rules around market operation). The Open Water Programme ( OWP ) 9 will support the Government in delivering the wholesale and retail market reform elements of the Act. Steered by a High Level Group, the OWP will work on the development of market codes, facilitate and co-ordinate industry change and provide support and guidance. On 2 January 2014, the OWP published version 1 of its market blueprint summarising its recommendations for high level market design 10. Be prepared and make the most of the opportunities The Act amends the Water Industry Act 1991 and introduces changes to other legislation. It consists of six parts, 83 clauses and 12 schedules and the provisions, particularly in relation to market reform, are complex. Key points to consider include: if you a water company assess the implications of the reforms on your business and the wider water sector. The introduction of competition will allow new players to enter the market. Existing and new companies will need to compete with each other and strive to deliver the best package so as to keep and win new customers. review, interpret and understand the operation of the provisions in the Act and what this will mean for compliance. if you are a water company how will you maintain your market share and work the market to your benefit, obtain cost savings and attract new customers? How will the reforms impact on the negotiation of contracts and the access price? If you work in the supply chain, where are the opportunities for you to give water company clients the competitive edge? If you are a water and sewerage customer, how should the market be set up to allow you to make the greatest savings from improved efficiencies and competition? are you a potential new entrant into the market? If so, how do you tap into the opportunities that will become available under the new market model? How will you engage with the incumbent undertakers and work together to innovate, lower bills, increase resilience and remain profitable? are you a developer? There are provisions in the Act that seek to make it easier for developers and inset appointees to connect new developments to the water mains and sewerage systems. assess the impacts of PR14. If you are a water company, how does your business plan take into account the new statutory duties in the Act? Next steps The Government remains committed to a start date of April 2017 for retail competition with the upstream market not opening until

5 there will be a need for transitional arrangements and the need to consider the impact on existing contracts and licence arrangements. engage with the HLG and the OWP to input your views and to respond to consultations. This is particularly important with regards to the practicalities of retail exit for non-household customers. What types of safeguards will be required to protect both household and non-household customers? Regardless of the final form of the market model, rules will need to be developed to ensure the effective operation of the market e.g. who is eligible for the competitive market? What services can be switched? How will disputes be dealt with? What contract terms will be needed between the wholesaler and the retailer? There may also be a role for a market operator and transitional arrangements. Consideration is required as to the impact on existing contracts and licence arrangements. Key Contacts Pinsent Masons Water Group has long standing experience of advising on legislative reform in the water sector and on complex water legal regimes, both within the UK and internationally. We have advised a number of water companies on their entry to, and the operation of, the water and sewerage retail market in Scotland. If you would like to discuss these or any other issues, we would be delighted to speak to you. Gordon McCreath Partner T: +44 (0) M: +44 (0) E: gordon.mccreath@pinsentmasons.com Eluned Watson Associate T: +44 (0) M: +44 (0) E: eluned.watson@pinsentmasons.com This note does not constitute legal advice. Specific legal advice should be taken before acting on any of the topics covered. Pinsent Masons LLP is a limited liability partnership registered in England & Wales (registered number: OC333653) authorised and regulated by the Solicitors Regulation Authority and the appropriate regulatory body in the other jurisdictions in which it operates. The word partner, used in relation to the LLP, refers to a member of the LLP or an employee or consultant of the LLP or any affiliated firm of equivalent standing. A list of the members of the LLP, and of those non-members who are designated as partners, is displayed at the LLP s registered office: 30 Crown Place, London EC2A 4ES, United Kingdom. We use Pinsent Masons to refer to Pinsent Masons LLP, its subsidiaries and any affiliates which it or its partners operate as separate businesses for regulatory or other reasons. Reference to Pinsent Masons is to Pinsent Masons LLP and/or one or more of those subsidiaries or affiliates as the context requires. Pinsent Masons LLP For a full list of our locations around the globe please visit our website: