New research suggests that the impact of introducing household retail competition in the water sector could lead to pressure on existing cross-subsidies provided by incumbent companies to more vulnerable customers, if more higher margin households switch suppliers.

The report says that the categories who are net recipients of cross subsidies appear to be the households most likely to be in vulnerable circumstances, including:

• households in the bottom 30% of incomes,
• households most likely to experience debt with their water bills
• households currently protected by social tariffs
• households who live in relatively deprived neighbourhoods.

In November 2015 the Government asked Ofwat to provide an assessment by summer 2016 of the costs and benefits of extending retail competition to household customers.

The study was conducted by ICS Consulting on behalf of Water UK to inform Ofwat’s call for evidence with an assessment of the distributional impacts of introducing retail competition in water and “does not reflect or imply the policy of Water UK or the water industry.”

The evidence presented in the report is based on data for water companies representing about 12 million households, about just over half of the total households supplied with water and sewerage services in England and Wales.

Within existing water and sewerage charges there are a wide range of cross-subsidies between different categories of customer and services, which includes cross-subsidies for the differing costs of providing retail services for households.

Low income households have a higher retail cost to serve compared to high income households

The average cost to serve is relatively uniform across the different dimensions / drivers of retail cost. However, lower payment frequencies, payment by direct debit and low debt risk customers are associated with costs to serve below the average, while high debt risk customers and frequent payment customers are associated with actual retail costs to serve significantly above the average.

Low income households have a higher retail cost to serve compared to high income households and the overall average cost to serve.

According to the report, households who are mostly likely to be in debt with their water bills currently receive a benefit of £145 per household (typically higher cost to serve households). Households who are least likely to be in debt contribute on average £20 per household (typically low cost to serve households). The most recent Ofwat estimate of the cost of household bad debt is a similar £21 per household.

Households in the bottom 30% of incomes receive retail cross-subsidies equal to about £43 per household. Households in the top 30% of incomes contribute on average £17.

Households who pay by direct debit contribute on average a subsidy of £14. Households who do not pay by direct debit receive on average a subsidy of £19.

Introducing retail competition for households could potentially create new drivers to unravel these retail cross-subsidies, the report  says.

Retail cross-subsidies could come under pressure without action to mitigate switching impacts

However, the report is warning that in the absence of policy and regulatory measures to mitigate the distributional impacts of retail switching, the evidence suggests that these retail cross-subsidies, particularly to households in vulnerable circumstances could come under pressure.

The report suggests the overall cross subsidy recoverable from current retail charges could over time, and if not mitigated, reduce – which could in turn constrain the ability of incumbent companies to assist those households in vulnerable circumstances within the current financial and regulatory framework.

“Careful attention to these distributional impacts will therefore be required as part of any overall market design if household retail competition is introduced in the water sector”, the report says.

According to the report, current regulatory and business drivers mean that current household retail prices do not explicitly reflect the retail cost variations due to factors like billing frequency, billing method and customer debt. These wider cross subsidies could become more exposed under retail markets scenarios as new competing retailers seek to identify profitable retailing opportunities and establish and grow retail market share.

“Reasonable to anticipate that energy switchers most likely to become water retail switchers”

The report says the scale and distribution of the impacts will also depend on the strength of household engagement with retail markets in water.

The analysis has used evidence about household retail switching in other utility markets – principally energy – to develop ranges of impacts based on low to high switching scenarios. Under the low scenario overall 14% of water households are predicted to switch, whereas the figure is 32% under the high scenario.

According to the report, a key finding from the available empirical evidence for the energy sector is that switching in related markets strongly influences retail switching in other markets.

The report found that a strong determinant of the propensity to switch in energy is a propensity to switch in other markets- useful to know in the water context as it provides grounds for expecting “water switchers” to mirror switchers in other markets.

“It is reasonable therefore to anticipate that energy switchers are most likely to become water retail switchers”, the report says.

Saving level of about £100pa will see more rapid growth in customers switching suppliers

The evidence from energy sector experience suggests a saving level of about £100/year is a tipping point for many households – at this level the numbers of households switching retailers starts to grow more rapidly.

However, the report says that this level of saving exceeds the level of retail costs in water sector retailing and the more likely levels of around £10 to £20 annual savings in water will only encourage relatively low levels of households switching.

Similar to evidence from analysis of switching in other utility markets, the modelling suggests that households who pay their bills more frequently, households who are less likely to pay by direct debit and more generally households likely to be in vulnerable circumstances will tend to participate less, and hence benefit less, in water retail markets compared to other households.

Expectation is for above average retail margin households to switch

A key finding is that as retail switching increases the distribution of cross-subsidies will become more acute.  With retail competition the amount of cross subsidy recovered by the incumbent companies through their current retail charges is estimated to decline by between £25 million/yr (low switching) to £60 million/yr (high switching).

This reflects the expected market dynamic of the incumbent companies losing above average retail margin households to competing retailers- a pattern of retail switching which will impact directly on the distribution of current cross subsidies.  As a consequence, the incumbent companies will no longer be able to recover cross-subsidies which are currently allocated to less well-off and more vulnerable customers from the switching households. The switching households are the above average margin households who would be attractive to competing retailers.

The higher margin households tend to be in the higher income groups, live in the least deprived areas and are least likely to experience water debt. Similarly, the average cross-subsidy required by the subsidised households (typically those households in vulnerable circumstances) who remain with incumbents will rise.

Any design of household retail markets will need to consider ways to mitigate impacts

Understanding the actual costs of providing retail services to different household groups will be important to informing the consideration of overall costs and benefits, and the design of any potential household retail markets, the report says.

Any market design will also need to consider ways to mitigate the challenges of potential distributional impacts. According to the report, the challenges are similar to those observed in related utility markets and as such, “the experience of the recent reviews in the retail energy market will provide key learning points for policy makers.”

The report also says that significant increases in expected savings – and importantly savings significantly higher than current retail costs in water – would appear to be necessary to entice notably higher levels of switching behaviour. The much cited “tipping point” of £100 per year in the energy market literature would appear only feasible in the context of bundling bill savings across a number of product lines that included water and sewerage services.

Across a range of scenarios, whether high or low levels of switching, the report estimates that  the incumbent water companies would experience a reduction in their ability to recover the same level of cross subsidy within their current charges for retail services.

The report points out that under the present regulatory controls for household retail there is no automatic mechanism for rebalancing these reductions.

Click here to download Distributional impact of introducing household retail competition in the water sector