Chairman ONCC Competition Group

COMPETITION SOON FOR WATER?

There is currently much discussion on competition in the water industry in the press and at high profile conferences, creating a build-up of interest that should result in some action to improve the lot of water customers.

The main driving force is probably the success of competition in reducing prices and improving customer service levels in the other utilities. But specific factors encouraging competition in water now are the advent of the Competition Act in March 2000, which Ofwat has said it will use to further competition, and government support for competition, with John Prescott’s review of competition in the industry awaited.

The Ofwat National Customer Council (ONCC) supports competition in the belief that it should provide significant advantages for all customers, both industrial and domestic. ONCC has recently issued a leaflet, aimed at cutting the bills of business customers, with a strongly pro-competition message

If competition in water is to become a reality, the current system of abstraction licensing needs rethinking, which the government is in the process of doing. Competition would be encouraged if water rights were more easily transferable. In particular it is hard for new entrants to get access to water.  This paper contributes to the debate on competition by summarising the position on abstraction, as well as posing some of the problems that changes could throw up.   

GOVERNMENT CONSULTATION

In June 1998 the Department of the Environment, Transport and the Regions (DETR) produced The Review of the Water Abstraction Licensing System in England and Wales.   Consultation Paper (referred to below as Consultation). The Environment Agency issued its response (Response) in September 1998, and in March 1999 DETR published its own follow-up document Taking Water Responsibly:   Government decisions following consultation on changes to the water abstraction licensing system in England and Wales (Decisions).   These documents are technically dense and difficult  for those not conversant with the system, and there is at least one more to come. Following the replies to the consultation document, the government has stated in Decisions that it has commissioned research on the use of economic instruments, and this "will be completed later this year" (1999).   So we wait to find out what the government will propose on economic instruments in water abstraction.    

BACKGROUND FACTS

Virtually all significant water abstraction is licensed, and the Environment Agency has currently issued about 48,600 licences in England and Wales:

Total authorised abstraction for 48,600 licences:                                                    24,614,000

Actual abstraction for 48,600 licences:                                                                   13,111,000

Use by: public water supply                                                                                      6,370,000

                hydropower                                                                                              3,289,000

                fish farms, cress and amenity ponds                                                           1,583,000

                industry                                                                                                    1,339,000

                agriculture                                                                                                   184,000

                remainder                                                                                                    345,000

(Annual effective rainfall                                                                                          77,000,000)   

(Figures from Consultation, for 1996)

The figures for actual usage show that only about 53% of the authorised volume is actually extracted, representing some 17% of the annual rainfall. The dominance of the public supply in abstracting water, and the relatively small use by agriculture, are apparent.

The abstraction licences granted are largely licences of right, originally granted prior to 1965, and are generally valid until revoked.   Licences granted more recently may have time limits on them.   

Abstractors are charged by the Environment Agency, but only at a level sufficient to recover the Agency’s costs in carrying out its water resources function, and not primarily with reference to resource scarcity or to environmental considerations. The actual unit charges range from  £7.01 (Yorkshire) to £17.48 (Northumbrian) (1999 prices) per megalitre per annum.  The charge is for the licensed volume, not the actual abstracted volume, so there is currently no incentive to take less water than allowed by the licence.

There has been little trading in licences under the present system (Response cites "around a dozen"), probably because  in general an abstraction licence for ground water requires occupation of the land, though inland water may be licensed to someone with right of access.

GOVERNMENT DECISIONS 

The government’s follow-up paper (Decisions), makes three key  decisions relevant to trading in licences:

All future licenses should conform to Abstraction Management Strategies, developed by the Environment Agency. They should normally be limited to 15 years, but with a general presumption of renewal if no environmental damage ensues.   There is an aspiration that "truly responsible abstractors should have little need of persuasion that voluntary conversion to time-limited licences is an essential ingredient of their environmental credentials".   If renewal is not to be allowed, at least 6 years notice of likely non-renewal should be given.

Where abstraction is currently damaging environmentally sensitive areas, voluntary action by abstractors is to be sought, though the Environment Agency may have to pay compensation in some cases.   However, legislation to stop compensation after 2012 is proposed.

The only precondition for abstraction should be right of access to the point of abstraction, not ownership of the land.

As already mentioned,  Decisions also stated that the government had commissioned research on the use of economic instruments in paying for abstraction of water.

ECONOMIC INSTRUMENTS

Economic instruments might encourage the more effective use of water whose abstraction is allowed by regulation, by providing those in the market with economic incentives to act in accord with the public interest.

Regulation should provide the framework, while economic incentives could drive allocation, since an abstractor who actually pays the price for water will be better informed than any regulator could ever be about the costs of varying the abstraction.  

Also, as mentioned above, while the present pricing system provides an incentive to keep to the licensed level of abstraction, there is no incentive to reduce actual abstraction below this level.   In addition, the present price paid for raw water is relatively low.  Consultation states that in 1996/7 the average charge was 0.3 pence per cubic metre for raw water, which was sold on to domestic customers after purification and distribution for an average of 60 pence per cubic metre. Paying a higher initial price for water would surely encourage conservation.  

Consultation suggested two main economic instruments: incentive charging, and the trading of abstraction authorisations.   In economic terms these are very different. Incentive charging imposes the "external" costs (generally those relating to the environment or to the general public) of an abstraction on the abstractor.   Trading of authorisations, on the other hand, should allow those who value authorisations the most to have them, achieving efficient allocation.   Both incentive charging and trading can be used in parallel.  

Incentive charging is supported by the Environment Agency  (Response), for instance to reduce water uptake where it is being used inefficiently, and to reduce unused but authorised abstractions, etc.   Presumably the Agency would like to set high prices for water it did not want used, and lower prices elsewhere.

This would probably mean that, unlike at present, the Agency would recover more money than required to cover the cost of regulation, and the Agency suggests that this excess could be returned to the environment by funding improvements.   The difficulty with incentive charging is that it requires a central controlling agency to set a price on all abstraction licences and to judge what is wasteful.   While no doubt desirable, incentive charging will not in itself stimulate competition for water or new entry.

The trading of abstraction licenses should encourage both competition and new entry. It is viewed with caution by the Environment Agency: "We are more cautious about developing more open markets in abstraction licence trading until existing concerns about abstraction licences and catchment policies are resolved as part of the setting up process"  (Response). 

Both incentive charging and trading of licences, require an initial price  to be set. Consultation stated that in economic theory the price of abstraction should be equivalent to the value of not abstracting. Ie: for surface water, it should equal the monetary value of the environmental benefit of the in-stream flows that are removed by abstraction.   There is no agreed way to calculate this, and Consultation suggested two practical mechanisms: "grandfather rights" and an auction.   Grandfathering means "allocation pro rata to existing licences or to actual abstraction in a base year", and is open to the obvious objection that it favours incumbents.   An auction is a true free market mechanism but, due to the previous long period of cheap water it might be difficult, at least at first, to be sure that it was setting a valid price.   Also, big companies may dominate the market.

The trading of licences of itself should actually reduce tap prices, since access to supply would be liberalised, and licenses would presumably only be purchased by those who thought they could do better than the existing suppliers at the current prices. Incentive charging, on the other hand, would necessarily increase the cost of raw water itself, since the Environment Agency would be charging for it, with scarce water costing more than readily available water.

Water companies, judging from the past, would no doubt wish to pass the increase on to their customers. In terms of economic theory it would be desirable to have scarce water costing more than plentiful water but it is, of course, completely unacceptable for customers to pay more for receiving exactly the same water that they get today.

So, if incentive charging were applied to the companies, it could perhaps be argued that the water companies should be relieved of an equivalent amount of their environmental spend, which should be met from the increased revenue derived by the Environment Agency. It is possible that this could be seen as a one off payment for those currently unresolved environmental problems connected with over abstraction.

WHAT COULD BE DONE NOW?

Once the government has announced its intentions on economic instruments these will be subject to consultation, and will probably ultimately require legislation, which is unlikely to be passed quickly.  

Could the Environment Agency further the government’s aim of promoting competition by acting ahead of legislation?   Licensing the abstraction of water is complex, and ONCC has no prescriptive answers or expertise, but it would ask the Environment Agency to further the government’s interest in achieving competition in the water industry by adopting as flexible an attitude to licensing as possible.   Could the Agency perhaps look at its existing powers to deal with new entrants, or with those wishing to trade in abstraction licences, or with those not using licences, so as to further the competitive agenda, and hence customers’ interests?

The Competition Act, which comes into force in the spring of 2000, should also be helpful.   Ofwat’s draft guidelines on the application of this Act  suggest that there may be circumstances where reliance on protected rights to prevent abstractions by others could be an abuse of a dominant position.   Incentives for anti-competitive behavior will exist, and will need to be monitored by Ofwat, particularly since incumbents are likely to be dominant in holding licences.

ONCC awaits the government paper on research into the use of economic instruments in water abstraction with interest, and hopes that there will be a movement towards more competitive behavior in abstraction as soon as possible, perhaps with some new entrants coming in to the industry.