Ofwat has said that it is unlikely to be appropriate to either remove price protection or to move to a “reasonable and non-discriminatory” approach for small and medium enterprises at this stage in the development of the retail market sector.

Commenting in a paper setting out its initial thoughts in a new consultation for price protections beyond March 2020 for the Retail Exit Code, the water industry regulator said:

“We do not have enough confidence that either of these will give sufficient protection to SMEs at this stage of market development, particularly given the limited awareness of market opening and switching we have seen.”

Ofwat is seeking comments on the proposed framework and methodology for retail price protection after March 2020.

At the time of market opening in England in April 2017, Ofwat said that customers who had not engaged in the market were likely to need some protection from potential price increases that might arise because competition had not yet developed to an effective level.

While customers of incumbent water companies are protected by regulatory price controls set in 2016 (PR16)many incumbent companies have chosen to exit the retail market and transfer their customer base to new retailers. With PR16 due to expire at the end of March 2020,

The Retail Exit Code (REC), which sets out requirements on the price and non-price terms and conditions offered to this group of customers, specifies that they should have the same price protection they would have received had they continued to be served by the incumbent.

Ofwat now needs to review the REC to identify what form of protection should apply beyond March 2020.

The consultation paper sets out 4 options:

• removal of price protections;
• specifying only that prices must be reasonable and non-discriminatory;
• maintaining a control based on PR16, possibly with some adjustments;
• or setting up a price control based on a new underlying model.

The regulator’s initial view is that it is more likely to be appropriate to continue to apply the PR16 controls - possibly with some adjustments - which would be more proportionate than constructing a new bottom-up cost model on which to estimate price protection.

For larger business customers, the regulator said it has observed a greater degree of awareness and engagement in the market than for SME customers - for transferred larger customers, the current protections are based on PR16.

However, it is “not clear whether or not awareness and engagement among large customers is sufficient to move away from a cost-based control” to a “fair and reasonable” approach”, the paper says.

For other eligible larger business customers, the current protections are that prices must be reasonable and non-discriminatory, and Ofwat is “not aware of any reasons to change this.”

Some retailers tell Ofwat low retail margins have made it difficult to enter market and acquire customers

With regard to current price protections, some retailers have told Ofwat that low retail margins, particularly for SME customers, have made it difficult for them to enter the market and acquire customers.

The consultation paper says:

“They said that the margins are small in absolute terms and inconsistent with the level of risk and cost of operating in the market. Specifically, stakeholders have said that the default tariffs are missing certain cost categories, such as customer acquisition costs and MOSL costs and have raised concerns about cost allocation. However, other retailers have said that they can adapt to function with the existing level of margins.”

Ofwat to look at whether billing in advance, not in arrears, is “in the spirit of the REC”

Commenting on its monitoring of market developments, Ofwat said it had noted that some retailers had begun to bill customers in advance (or partially in advance), whereas they used to be billed in arrears. The regulator is now “separately considering whether the measures are in the spirit of the REC” but Ofwat does not propose to include this in the scope of the REC review.

Ofwat continued:

“We do not consider that it is appropriate to review the REC more widely at this stage. The market is still in the early stages of development and….we believe it is appropriate to allow the market to develop further before assessing the Code’s effectiveness….

“It may be appropriate to conduct a comprehensive review in the longer term, when the market is more mature.”

SME engagement in the market

Commenting on SME engagement since market opening, Ofwat said it had observed “encouraging signs of customer awareness and engagement “ , with around half of micro businesses and the vast majority of larger businesses aware of the retail market opening. 

In addition, Ofwat has estimated that around ten per cent of all of eligible customers will have engaged in some way in the new business retail market during its first year.

However, the regulator flagged up differences in awareness and engagement levels between businesses of different sizes, with SME customers less active and aware of their opportunities in the market than larger companies. Compared with larger organisations, micro-businesses and SMEs are currently less aware of their ability to change water and wastewater supplier and less likely to actively consider switching supplier.

Removing price protection ruled out to ensure that “customers are not exploited in the short term”

Given the relatively low level of awareness of retail market opening for SMEs outlined above, in Ofwat’s view it may be likely that many SMEs would be unresponsive to price changes by the existing supplier.

“We therefore consider that it is likely to be appropriate to maintain some form of price protection while the market continues to mature. This will help to provide confidence that the open retail market will not unduly disadvantage groups of customers and will help us fulfil our strategy of building trust in water.”….“We therefore propose to rule out removing price protection to ensure that customers are not exploited in the short term, in line with our consumer protection objective.”

The paper also says:

“We might expect that larger organisations will tend to have greater ability to engage in the market and therefore are at a lower risk of being exploited while the market matures.”

Cost based control provides stronger protection to customers and should also facilitate competition

Ofwat takes the view that a cost based control provides stronger protection to customers and should also facilitate competition. According to the regulator, companies with costs at or below the estimated level of costs, should be willing to enter the market and compete.

The paper says a cost based price control could be implemented in a simple and proportionate way and that the existing PR16 determinations could be rolled forward with adjustments if necessary.

Despite the fact that a new price control may better reflect current costs, enabling a more accurate understanding and trade-off between consumer protection and competition, Ofwat has rejected this approach on the basis that it could impose a “significant burden on retailers” to provide sufficient cost data to carry out this exercise.

Deadline to submit responses to the consultation by 8 May 2018. Ofwat intends to issue a fuller consultation on the exact nature of the price protection in summer 2018, after the publication of its Market Monitoring Report, which is also due to be published in summer 2018.

The regulator said it will make a final decision in good time before the price protections expire in March 2020.

Click here to download the consultation paper

Click here to download the consultation paper