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Go your own way

Ted Hopcroft

Utility Week

1 August 2014

The enactment of the Water Bill formally embeds the introduction of competition in water and sewerage services in the non-household retail market from 2017. Water companies have been immersed in the current price review, PR14, but must now earnestly address the challenges competition will bring.

The strategy in the water industry, like energy and telecommunications, is to create competition in business retail while (for now) maintaining monopoly provision in wholesale and household retail. The problem is that the monopoly parts of the business could wittingly or unwittingly discriminate in favour of the competitive retail part of the business.

Existing legislation allows for fines of up to 10 per cent of turnover or a competition investigation in the event of undue discrimination, and Ofwat is consulting on further changes. One of the key questions for companies is how to structure themselves to meet the requirements of no undue discrimination, ensuring a level playing field, and how this should build on the introduction for PR14 of four separate price controls (water wholesale, wastewater wholesale, domestic retail and non-domestic retail).

Experience from energy and telecoms suggests structuring of this kind will be a massive change for vertically integrated companies. Staff who have learnt to work collaboratively as one team over years, or even decades, will need to recognise that local issues cannot be prioritised, information cannot be shared and the same price and service must be provided to all. Computer systems that have been established to provide cross-organisation support will have to be separated or replaced.

Water companies need, with some urgency now, to resolve how they are going to meet compliance requirements while retaining the flexibility to adapt to the changing market.
There are broadly three mechanisms for demonstrating compliance: legal separation, functional separation and the establishment of a strong internal compliance and reporting function.

Legal separation is the “divorce” option. It requires the establishment of a separate legal entity, with separate boards, accounts, facilities, IT and workforces. The key advantage is that this creates a business free to address the market and fully drives home the culture change required. The disadvantage is that it maximises the amount of change and undermines any group benefits gained through years of business optimisation.

Of course, divorce can be hard initially but might ultimately let everyone move on. The separation of British Gas to create BG Group, British Gas and Transco was greeted with scepticism in some quarters, but each company has gone on to create its own distinctive and largely successful path.

Functional separation is the “conscious uncoupling” option. It typically requires the creation of a separately managed business in the core company. It will typically include a separate managing director, separate financial reporting, shared facilities (but with restricted staff access), separate staff who are “cap-badged” to a particular business and either separate IT systems or shared IT but with different instances of a system. It aims to balance retention of group benefits with flexibility for the new retail business. However, it may be the most complex to implement and could restrict the retail business.

This approach was the most favoured for energy and telecoms. BT retained its wholesale and retail businesses, but had to demonstrate clear separation. Most of the public electricity suppliers adopted this approach, but with many subsequently electing to sell either retail or distribution businesses. Some companies in both energy and tele­coms discovered the hard way that separate governance and the different speed of ­decision-making within the overall corporate structure had not been addressed.

The question, then, is who are you staying together for? Will two increasingly different businesses deliver shareholder value?

Internal compliance and reporting is the “stay together” option. This is the least onerous approach in terms of corporate change but potentially has a higher risk profile. Under this, companies would not separate, but would produce comprehensive reports of their interactions with their own and competitive retail to demonstrate non-discrimination. The key advantage is minimal change, although the reporting could become onerous.

The disadvantage is that it does not drive culture change, creates a potentially higher risk of undue discrimination and restricts flexibility. The licence regime in energy rendered this approach largely inapplicable.

When choosing between these different approaches, some key lessons can be learnt from energy and telecommunications.

First, companies must understand their strategy. In energy, some companies undertook minimal separation, but then decided to sell the networks businesses and incurred costs. Others imposed stringent separation and subsequently decided to reintegrate with concomitant cost.

Second, culture change is a significant issue. It is difficult, but necessary, to break some forms of internal collaboration and drive home that there is a new market regime.
Third, an IT strategy for separation must be established. IT is a major expense and has a long lead time. Companies must decide whether to split existing systems or use new separate systems. Where companies are currently procuring systems, these must support whatever form of compliance is chosen.

Last, it is important for the wholesale business to retain information about and a relationship with the end customer. In energy, initial separation meant the network businesses did not retain customer data to mitigate the risk that they might provide information to their in-area business. Time has shown that network businesses must have appropriate data and relationships.

Water companies must choose: separate, stay together or find a third way. History shows that this is one of the most important choices when preparing for competition and will shape the evolution of the business over the next two years.

Ted Hopcroft is a utilities expert at PA Consulting Group


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