*A little-known Ofwat consultation on bulk supply pricing could make or break water competition. Stephen Tupper urges Ofwat to raise its game.*

Even the most seasoned observer of regulation in the water sector could be forgiven for not paying much mind to Ofwat's consultation paper, published in March, titled Bulk supply pricing - a consultation on our policy principles. It is neither an eye-catching title nor a mainstream subject.

But looks can be deceptive. Guidance established on the back of this slender document could be the key to the success of much of Ofwat's ambitious plan for the final phase of liberalisation of the water market in England and Wales. That plan involves the separation into two parts of all water companies and the creation of a fully competitive market - for "large" users in the first phase.

Essentially, Ofwat wants to explain to operators in the water market how the price for a supply of water should be calculated. It is doing this, ostensibly, because it is a crucial part of the commercial arrangements for most, if not all, inset appointments, supplies by licensees and bulk water purchasing deals between incumbents. Inset appointees and licensees rarely, if ever, have access to their own independent sources of supply.

*Ofwat arbitration*

Consequently, they have to buy the water either from the local incumbent or a near neighbour. When they do, most of the ensuing negotiations are about the price.

In the event of a breakdown in communications, the parties can approach Ofwat and seek a determination in accordance with Sections 40 and 40A of the Water Industry Act 1991. Given this dynamic, Ofwat felt that some guidance on pricing might be in order.

This, however, is only half the story. The more intriguing second half relates to rules that have not yet been written. Responding to Martin Cave's report into competition and innovation in the water industry, Ofwat endorsed his recommendation that the current method for determining the price of a water supply to an in-area competitor - the "costs principle" as set out in Section 66E of the Water Industry Act - should be repealed and Ofwat awarded the power "to determine access prices ex ante".

The new government has announced a review of Cave's conclusions with a view, potentially, to pursuing his recommendations. Ofwat may, therefore, get its wish and become the front-line arbiter of price in a comprehensively restructured and competitive water market.

*Little of substance*

At present this method putatively covers between one and three "real" events a year, of which barely a handful have ever gone for Section 40/40A resolution by Ofwat, but it has the potential to become one of the most important parts of Ofwat's regulatory literature. Given its potential significance, therefore, it is disappointing that the consultation says little of any real substance on this complex topic.

The consultation's key message is that prices should reflect costs (purchasers should pay no more for their supply than a price that comprises the actual cost incurred to provide the supply plus an appropriate margin). The problem is that in the water world, many large users generally pay a cost-unreflective "high" price while many household customers pay a cost-unreflective "low" price. If large users start getting picked off by new entrant water suppliers keen to exploit the difference between a true cost-reflective price and the one that large users are paying, what will happen to the prices paid by the subsidised household customers? De-averaging for customers outside the tariff basket may well lead, eventually, to de-averaging for those within.

*Elephant in the room*

This problem is the proverbial elephant in the room. In its consultation document, Ofwat suggests that this problem will ameliorate as price disputes are determined and a clear path will emerge to address these issues. That is optimistic. Whether the policymakers recognise it or not, water is not like any other utility.

The chances that any competing infrastructure will be built is somewhere between remote and non-existent. There are no wannabe competitors out there champing at the bit to provide a "new" kind of water - there is only one kind and it is closely regulated by EU directives. And there is little or no expertise anywhere else in the world that one could turn to for help in trying to unpick the complex cross-subsidies in the water industry without doing potentially serious socio-economic harm to ordinary water users.

This all means that competitors will have to deal with existing infrastructure owners with little or no certainty - at least if the consultation document is anything to go by - as to the eventual outcome on the one issue that really counts: price.

To reduce uncertainty, and encourage more enthusiastic competition, the guidance that emerges from this consultation will have to be much more explicit. If not, many will simply not attempt to enter the new market for fear of wasting transaction costs, or worse, being saddled with an unprofitable water supply arrangement.

Ofwat, however, has rightly identified a potential problem. In its published response to Cave, it said: "Setting any new access pricing arrangements in primary legislation risks being as restrictive and damaging as the existing costs principle. A more flexible solution is required." In other words, the more thorough the guidance the more likely it is that it will start to resemble the Section 66E formula that it will replace.

*Acid test for competition*

There is another possibility: perhaps this is one circle that cannot be squared. Ofwat appears to be convinced that the benefits of introducing more competition will outweigh the costs associated with full separation of retail and supply functions. It may be right in terms of the raw numbers but will it work in practice? This guidance may prove to be an acid test of Ofwat's ambitions.

If Ofwat can come up with a guidance document that provides would-be competitors with enough information for them to be relatively confident about what it is going to cost them to obtain supplies from the local infrastructure owner without simply rehashing Section 66E, then the move to a more competitive market may be successful.

If it cannot, or if it sticks with the kind of cursory statement of first principles set out in the consultation, then perhaps this should be seen as one circle too far.

Stephen Tupper is a shareholder in Greenberg Traurig Maher.