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The times they are a-changin'

Laura Frudd and Ted Hopcroft | the water report | 1 december 2016

The successful launch of shadow operations for the introduction of non-household (NHH) retail competition is a clear demonstration of the sector’s determination and ability to adapt to and embrace significant change. Indications for PR19 suggest an even greater industry shift is approaching, with the introduction of upstream competition, licence modifications, new price controls and the transition to far more thorough customer engagement anticipated. This may, in turn, be followed by the introduction of Household (HH) competition. 

Given these challenges and future uncertainties, companies need to assess the different ways the market may evolve and review their strategies to ensure they can optimise their position in the future water market environment.

Future scenarios

One effective way to address uncertainty is to use scenario planning to explore potential developments. Following the global financial crisis, PA research shows that most companies adopted one of two very different approaches; either a tactical ‘wait and see’ mindset, with subsequent cost-cutting, or a less frequent strategic mindset, which recognised this event was something different to a normal recession and planned accordingly. Companies that adopted the strategic approach had a 10% higher shareholder return between 2007 and 2010 than those who adopted a tactical response. 

We have considered scenarios for the water sector, using the period to 2022 as a timescale. This is sufficiently distant for the PR19 changes to have become embedded, but close enough for reasonable assumptions to be made. 

Any scenarios must consider the implications of two critical developments. The first is the balance between regulatory and market drivers. The introduction of NHH competition marks an important step towards a self-regulating market. The scenarios need to explore whether this evolution will continue or whether a perceived need for continued strong regulation will limit market activity.

The second key consideration should be the extent of aggregation and disaggregation within the industry. There are two aspects to this. Firstly the extent to which the industry functions will disaggregate into separate companies, for example Ofwat’s Water 2020 consultation already suggests a future market-based approach to sludge treatment and disposal and water trading. Secondly the extent to which companies themselves will merge and consolidate. 

We have created four scenarios that reflect these aspects and the different degrees of change they could bring as shown below.

Steady as she goes

In this scenario, although the regulator pushes ahead with changes, these are largely incorporated within the current mode of operation or structure of the industry and most companies opt to remain consolidated, albeit through legally separate entities.  

Companies operating in each region continue to comply with their wholesale requirements and now offer HH services through legally-separated companies (associate retailers). Whilst some have left the retail market due to limited margins, most continue to operate and have now merged their NHH and HH services into a single retail service provider. 

There has been some limited market consolidation and re-aggregation, but in general, other than the continued evolution of retail, there is minimal change. In the absence of significant market activity, the regulator remains highly active in protecting consumers. 

This scenario could arise as a result of a lack of switching following the 2017 NHH market opening, or through low margins in the household market. These factors would deter entry to new retailers, or mean the few that enter the market cannot maintain a successful business. On the wholesale side, the introduction of Water 2020 is far less radical than might be anticipated and largely incorporated within current structures.

Know the ropes

In this scenario, the key factors driving change are scale and speciality. Competition in both retail and wholesale has had an impact, but there is a tendency towards aggregation and consolidation as the financial markets drive a series of mergers and acquisitions to maximise market impact and achieve economies of scale. 

In retail, there has been a significant shift in the provision of services to an active and thriving market as a result of lessening regulatory pressure, enabling a more pronounced responsiveness to competition and customer choice. However, initial expansion in the market has now resulted in a series of mergers and acquisitions as retailers unable to adapt to this new and competitive market, or operate within the available margins, have exited.

In wholesale, services continue to be supplied by current providers, but the introduction of upstream competition has tended to drive consolidation and increased scale. There is a trend for companies to maintain all elements of the value chain, albeit as separate legal entities where required. The early mergers, such as South West Water and Bournemouth Water and Severn Trent Water and Dee Valley Water have proven successful and encouraged the regulator and CMA to view consolidation positively. 

This scenario is very similar to the path followed by the energy industry. On the ‘retail’ side, an early flurry of small new entrants gave way to consolidation as they were largely either acquired or failed, leading to the emergence of the ‘Big 6’ energy suppliers. On the distribution side, fourteen regional companies consolidated down to six major providers of network services.  

Dead calm

Following the formalisation of Ofwat’s Water 2020 vision, the value chain has been further disaggregated, with water trading and sludge treatment and disposal entering a new “competitive” market.

Wholesalers have accordingly separated their water and waste treatment capabilities into separate, associated, businesses. Many have taken measures to better understand their processes and associated costs for providing these services and, to an extent, to commercialise their own approach. 

However the disaggregation has proven challenging as the crucial need to balance technical, commercial and consumer factors, has created the need for continued strong policy and regulation to protect consumers. This has consequently limited the required freedom to act purely competitively. This lack of incentive for new companies to attempt to adapt and compete, combined with geographic challenges, means there has been very limited uptake in the market.

On the retail side, early activity has given way to a stagnant market as available margins prove a barrier to competitive pressures and the market stabilises around established retailers.

A compliant but ineffective market may be observed if control over the services is too restrictive or margins are too low to generate interest from within or outside of the current market.

Uncharted waters

This scenario outlines a radically different industry. In this world the remaining monopoly is a consolidated water and sewerage distribution network, which sources services from a myriad of highly specialised providers based on the best deal. These providers compete within the water sector to offer their particular service or skill, alongside offering related services in other sectors. Upstream, fundamental change such as the introduction of catchment managers may emerge. 

Some undertakers move their traditionally regulated assets into non-regulated businesses, which are then operated on their behalf through a number of these specialists as sub-contractors. Other specialists run their own multi-sector sites and actively compete for business. 

The introduction of this business model and the subsequent efficiencies and innovation realised through commercialisation of the value chain has driven substantial disaggregation. For example, a traditional sewage treatment works is now split into a number of separate industries which each focus on getting the best performance from their particular part of the process. These may include:

  • nutrient removal – there is a new focus on nutrient recovery from the water component of wastewater as materials become increasingly scarce, in particular phosphorus;
  • energy production - sludge is now viewed as a product to be used and companies combine it with waste through co-digestion to maximise income and energy output;
  • sludge recycling – an ever increasing demand from agriculture drives a market in delivery of nutrient-rich soil enhancer and top soil to local landowners. 

Wessex Water provides an example of how this scenario could work. They have operated a functionally separated sludge treatment company since 2009. This successfully competes to treat sludge at its own sites rather than sites operated by the integrated utility.

This scenario relies on a significant shift in the sector, which could be realised if appropriate policy and sufficient incentives are in place to drive the market. This may include removing some of the barriers to entry, for instance revising the common carriage arrangements for sewerage, and the introduction of an independent contracting entity to buy and sell upstream services.

Planning for the future

These scenarios are by no means an exhaustive account of the way the industry may develop but highlight some of the broad changes which may emerge.  Companies will need to develop their own scenarios both to test their views of what the future may look like and consider what they would prefer that future to look like. They can then use that insight to understand their desired role in that future and whether they intend to take measures to influence the outcome. 

Similarly the regulator needs to consider scenarios such as these, which could be beneficial for consumers and which would be detrimental. For example, Know the Ropes represents a path taken by the energy industry. This has generated benefits for consumers, but also been subject to continual debate leading to a CMA enquiry over the last few years. The regulator should examine this and ensure lessons are incorporated. In achieving the right balance between regulation and market drivers, the regulator has a very difficult line to tread between preserving the excellent quality and delivery record of the industry and establishing the basis for radical change. 

The water industry has an exciting if uncertain future ahead. However those companies which undertake effective scenario planning will be able to take a more strategic view of that future and adapt their plans, making them far more likely to succeed.

Laura Frudd and Ted Hopcroft are water experts at PA Consulting Group 

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