Water industry regulator Ofwat has launched a new consultation on credit arrangements between wholesalers and retailers for the new business retail market which opens for competition in April 2017.

Launching the consultation, Ofwat said that while the arrangements are part of its work on the Open Water programme, there are also important linkages to how price controls are set and the Water 2020 programme.

The regulator is now seeking stakeholder comment on its preferred approach – Ofwat intends to set out its finalised proposals in a decision document to be published next month.

The consultation paper says credit terms are an important aspect of the new market arrangements and seek to manage the financial risks of retailer default in the new market.

Looking to provide an efficient allocation of risk between wholesalers and retailers

Ofwat said in particular it needs to ensure that the credit and collateral arrangements in the new market represent a fair and efficient allocation of risk:

“We are seeking to introduce a set of regulated credit and collateral arrangements to support the retail market, given the market power of wholesale incumbents in any negotiation over these terms and the incentive and opportunities that they may have to create barriers to entry into that market.“

“In an effectively competitive market where multiple buyers and sellers exist, we would expect some risk sharing to be agreed between the two parties. We want to try and mimic this competitive market arrangement and provide an efficient allocation of this risk.”

Ofwat is seeking to strike a balance between the following two key issues:

1. The need to ensure that the credit terms promote competition in the new retail market for the benefit of customers – any disproportionate credit and collateral costs could act as a barrier to entry for new entrants with a chilling effect on the levels of rivalry and choice in the new market for customers.

2. The need to ensure that credit terms allow wholesalers to remain financeable and mitigate undue costs from misallocation of risk and so continue to efficiently deliver the essential wholesale services customer rely on .  Specifically, if credit arrangements do not adequately address the risks that wholesalers are exposed to under the new arrangements then they could potentially, in extreme circumstances, impact on the financial viability of the wholesaler and the delivery of essential water and wastewater services.

Retailers to provide 50 days of collateral to wholesalers to cover the risk of retailer default 

Ofwat’s overarching policy objective is to establish an efficient allocation of risk and to implement a solution that meets that objective. In UK electricity and gas distribution under the Distribution Connection and Use of System Agreement (DCUSA) provisions, retailers provide 60% of the collateral arrangements and wholesalers are subject to 40% of these risks. Ofwat said it considers that this “may represent an efficient balance of risk” – the regulator is proposing that retailers provide 50 days of collateral to wholesalers to cover the risk of retailer default .

The following six credit options have been put forward by Ofwat in the consultation paper:

1. Cash: Cash is the most secure form of collateral. It involves the retailer placing a defined amount into a secure bank account established by the wholesaler. The retailer will be responsible for depositing funds equal to 50 days of supply into the account before any service is provided by the wholesaler. In a case of default, the wholesaler will be able to withdraw from the account.

2. Letter of credit: A letter of credit is a financial instrument in which an issuing bank agrees to make a payment to the wholesaler if certain contractual conditions are not met by the retailer. The retailer will obtain an irrevocable standby letter of credit with a collateral coverage equal to 50 days of supply from a bank which holds an investment-grade credit rating. Banks in turn may require other forms of security, such as a parent company guarantee.

3. Third party guarantee: This option involves a guarantee of payment or performance of obligations of the retailer by a parent company or third party guarantor. Under this option, the retailer is required to obtain a guarantee from a guarantor before any service is provided by the wholesaler. The guarantee must cover the cost to the wholesaler of any recovery of unpaid wholesale charges equal to at least 50 days of supply. A credit threshold is typically applied to the provider of the guarantee (the parent). As a result, guarantees are considered less secure than cash, as they carry the associated credit risk of the guarantor.

4. Insurance: This option involves a surety bond issued by an insurance company on behalf of a retailer, guaranteeing the performance of the retailer’s obligations. Surety bonds are not one-size-fits-all financial instruments and can be tailored to the specific circumstances of the retailer and wholesaler.

5. Unsecured credit: This option consists of an unsecured allowance as a proportion of otherwise collateralised charges and liabilities. The amount of the allowance is usually calculated based on the financial standing of a retailer (i.e. their creditworthiness) or their history of making full and timely payments.

6. Pre-payment: A pre-payment involves payment in advance by the retailer of the estimated cost associated with delivering a service by the wholesaler, equal to one calendar month. In addition, a balancing payment is required once the actual cost of providing the service is known.

The regulator is also proposing to introduce an additional, seventh option that would provide more flexibility for participants to tailor credit arrangements to their specific needs and preferences without affecting the other six regulated options. This could take the form of a bilateral agreement, where terms would be negotiated by the parties.

Possibility of wholesale risk sharing mechanism 

One of the other options Ofwat has also put forward is the possible introduction of a wholesale risk sharing mechanism to supplement the credit arrangements.  In some other utility sectors, arrangements have been introduced that would allow wholesalers (or network businesses) a recourse to recover additional revenue through price controls in the event that a retailer defaults and goes into administration with outstanding debts owed to the wholesaler.

In the event of a retailer default, this mechanism would allow the wholesaler recourse to Ofwat to either re-open its wholesale price limits in-period or receive a true-up to its price limits at the end of the price control period where the retailer had outstanding debts to the wholesaler that were not adequately covered by the collateral provided in the credit arrangements.

Ofwat: such a mechanism should not be required

However, Ofwat said it did not consider that such a mechanism should be required and that its analysis suggested that this level of risk would not have a material impact on wholesalers even in the event of a significant default. The regulator is nonetheless seeking views from stakeholders about whether such a mechanism would be appropriate now ahead of PR19, saying that “in the future, once there is some experience with the operation of the market we may revisit this decision, for example during the 2019 Price Review (PR19)." 

For the orderly operation of the market, Ofwat is proposing to treat a retailer in default with one wholesaler as being in default with all wholesalers, and the credit support options in place would apply to all wholesalers affected.

The analysis of the options published alongside the consultation paper essentially looks at the timescales over which collateral and working capital would be required based on the approach and timescales for billing, payment, settlement and interim supply, most of which are prescribed in the various market codes.

"Existing 2.5% net retail margin should be sufficient to provide reasonable return for an efficient retailer”

The paper also says that the credit analysis undertaken by Ofwat “could suggest that the existing 2.5% net retail margin should be sufficient to provide reasonable return for an efficient retailer.”

Ofwat also emphasised that “it should not be assumed that any credit arrangements for the business retail market would necessarily be implemented similarly for any residential retail market framework” in the event of competition being extended to residential customers.

Following on from the consultation, Ofwat will then seek to take the proposed changes through the Interim Code Panel in August. If appropriate, changes would also be reflected in the methodology for the 2019 Price Review (PR19) which Ofwat intends to publish in 2017. 

Deadline for submission of responses is close of business on 7 July 2016 – click here to download the consultation document.