Martin Cave and his team are charged with reviewing whether there should be competition in the water sector. Here he presents his initial findings.

Over the past five months, I have been engaged in an independent review of competition and innovation in the water industry in England and Wales commissioned by The Department for Environment, Food and Rural Affairs (Defra), the Treasury and Welsh ministers. The review team has the task of developing proposals for changes in the legislative and regulatory environment that will benefit consumers - and especially will protect vulnerable consumers - and further environmental sustainability.

We are due to report at Budget in 2009, with our emerging findings later this year. Our call for evidence has generated many useful responses, and we would like to thank all those stakeholders who have contributed. Responses on innovation only closed on 15 September and have not yet been analysed. These are therefore some tentative views on the costs and benefits of competition and our approach to evaluating them.

There is general agreement that so far the forms of direct competition, as implemented by Ofwat and the companies, have not created much beyond a degree of disillusion about the scope for head-to-head competition in the water sector. Ofwat, which is also assessing the scope for competition in the water industry, has already consulted on some new and radical proposals, and we have benefited from its reflections. In Scotland, Wics has already introduced retail competition for business customers, and is considering how to build on it.

The competition issue in England and Wales is integrally linked both to the sector's existing challenge of delivering large capital programmes on the basis of sustainable and low-cost finance, and to newer issues relating to climate change, including the prospect of increasing resource scarcity, and the Water Framework Directive, including the need for catchment-based management of resources.

Test
Our test for competition is therefore whether it will benefit end users, especially vulnerable households, work with the grain of the environmental challenge and sustain the efficient financing of the sector.

My provisional thoughts are that it could. This is based in part on the generally - if not universally - beneficial effects of competition in other liberalised sectors, but also the flexibility and efficiency with which the right market-based solutions can deliver environmental outcomes. But for a number of reasons, a step-by-step approach is required. First, there is little international experience of head-to-head competition in the water and sewerage industry. Such as there is - in Scotland and Australia - is of short duration. There is therefore limited evidence on the impacts of competition. Second, some important contributory factors such as household metering and clarification of abstraction arrangements are not yet in place. There are also valid concerns that certain forms of competition could cause bills for some vulnerable customers to rise. Fourthly, it is crucial to sustain investor confidence so as to ensure the continued efficient financing of the sectors's large investment needs.

An incremental approach allows the government, Parliament and other stakeholders to take stock at specific break points. A "test and verify" approach makes sense where there are so many uncertainties around the ultimate outcome, and costs and benefits are difficult to ascertain in advance.

In other words, we need to think about sequencing and progression: the order in which different customer groups and activities are exposed to competition and the criteria
for moving forward. A possible sequence might be as follows.

One megalitre market
Start with retail water and sewerage competition for business customers using more than, say, one megalitre a year. This probably requires the legal separation of the incumbents' retail activities and certainly a wholesale pricing regime which differs from the current but flawed "costs principle". Having retailers legally separated from the networks - say by 2012 - should provide a structure that better supports the promotion of water efficiency, by aligning the retailer's interests more closely with the customer than with the network.

After several years - say by 2014 - consider whether it is likely that small firms and households would benefit. The answer to this question is not a foregone conclusion. Switching arrangements for 27 million customers will be expensive, and it may be that separation alone and the spill-over effects of competition elsewhere will confer significant benefits on small customers.

As soon as possible, begin a root and branch reform of the abstraction licensing and discharge consent regimes, to promote efficiency in water use and in the management of discharges in the face of climate change. Over time, this could include: supporting the Environment Agency's current programme of establishing time-limited abstraction rights and bringing supply and demand of licences into balance, developing a charging structure which better reflects environmental and social costs, switching to a system of assigning rights by auction and, ultimately, the creation of tradable rights.

Moving away from command-and-control in assigning rights should promote economy and efficiency. It would also permit, though not require, upstream entry. When this process is complete - and this may take one or even two decades - and provided competitive markets can be achieved, prices for abstraction will reflect the scarcity of water. They will also encourage the development of alternative solutions such as demand management measures and the cross-border movements of water.

Scarce resources
It may transpire that water resources are not as scarce as supposed. If they are, however, the system has a market-based response mechanism to cope with severe water shortages. Recognition of scarcity rents for abstraction could raise production costs, but only to the extent that they reflected environmental costs or cost advantages associated with the quality or location of the water. Revenues generated in the process, for example through the sale of abstraction rights, could, in principle, be used to provide focused protection for vulnerable customers or to secure environmental benefits.

Depending on the success of such measures, there may be benefits from going further and introducing competition elsewhere upstream. Alternatively, it may be that customers and the environment are best served by the status quo.

One approach to further competition might be to establish an independent procurement agency, which might be part of the incumbent water company operating in a credibly "separated" mode and subject to non-distorting incentives, could act as a "single buyer" of raw or treated water and wastewater services, responsible for delivering them to retailers at a uniform wholesale price - as under the retail competition regime described above.

Alternatively, for customers not subject to retail competition, a separated "single retailer" could be established with the duty to supply water and wastewater services to customers. These customers would pay a regulated retail tariff.

Competition models
In effect these are models of competition "for" the market and would begin with competition for the provision of incremental assets. Eventually, abstraction, treatment and disposal could progressively become a more broadly competitive activity.
The institutional framework for such a regime might come into effect in preliminary form in, say, 2015. The timing would depend on when a potentially contestable abstraction market might come into effect.

Later on - say 2020-25 - and probably in respect of large business customers, the single buyer regime might be replaced by a common carriage regime under which suppliers of raw or treated water would deliver to their own customers or other retailers at cost-based prices for access to the networks. This would have to be achieved in a way that prevented cherry-picking, sustained efficient financing and which protected other customer groups.

The above is not a blueprint but an illustration of an approach to the problems of sequencing and progression. It should deliver efficiency gains for customers and greater flexibility in responding to the impacts of climate change on the environment. When combined with appropriate charging regimes for end users - the subject of the Walker review - it also offers the potential to protect vulnerable customers. Such an approach, with safeguards against stranding assets, transparently appraised at each stage, should offer investors the stability and certainty they require. With the additional prospect of reform to the special merger regime where competition is effective, it would allow companies and investors better to manage risks, develop innovative financing approaches and to reap the rewards from new opportunities.

Challenges
Undoubtedly there are major challenges along the way. These start with the setting of the "retail margin", which competitors will need to justify entry into retailing. If it is set too high, inefficient entry may occur and network development will come under strain. If it is set too low, as at present, even efficient firms can be excluded.

The difficulties involved in upstream competition are also significant. Major challenges are likely in designing an appropriate single buyer regime and finding ways with common carriage arrangements of preventing small customers assuming too many of the fixed costs of the monopoly activities. But progression will not occur unless there is a confidence that these - or other currently unforeseen ones - are solved.

We will be discussing these issues with stakeholders and trying to refine a set of interim conclusions on competition. We are confident that competition, where it takes hold, will itself introduce innovation, in ways which we cannot anticipate, particularly where water is priced appropriately.

However, the review is also concerned about possible barriers to innovation in the highly capital-intensive non-competitive activities and also whether there are public good arguments for promoting research and development across a wider range of activities. These issues will also be addressed in our November interim report.

Martin Cave is professor and director of the Centre for Management under Regulation at Warwick Business School. He has been commissioned by the government to lead a review of competition and innovation in the water markets.

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