Ofwat, the water industry regulator for England and Wales, has called for a market-led system on abstraction licence reform to ensure that the price of water reflects its scarcity.

The comments form part of the water industry regulator’s response to the consultation by the Department for Environment  and Rural Affairs (Defra) on reforming the water abstraction management system, which closed on 28 March..

Defra’s consultation proposals identified two main options for reform -  “Current System Plus” and “Water Shares”.

Under Current System Plus, Defra would continue to use the tools currently applied to some licences to reduce or stop abstraction to leave enough water for the environment or other abstractors when flows are low.

The Water Shares option would be a bigger change from the current system. Abstractors would have a share in the available water resource, rather than an absolute amount, encouraging abstractors to take a shared responsibility for water resources in catchments. This option would allow for pre-approval of shorter-term trading between abstractors and of a wider range of trades.

Ofwat said it supported both options which would both promote a more efficient system which can respond better and more flexibly than the current arrangements to future uncertainties.

However, based on current evidence it prefers the ‘Water shares’ option as the most likely to provide the greatest protection for customers and the environment in the face of future challenges in England. It also offered a “more efficient, flexible and dynamic set of arrangements” that can deliver the most efficient allocation of water.

New system must ensure that price of water refelects its scarcity

 Ofwat wants the new system to ensure that the price of water reflects its scarcity, taking the view that a market-led system (such as the Water Shares option) would be preferable to ensure that this can be done in a dynamic and responsive way, commenting:

“Under the Water Shares option, abstraction charges will be set by the demand for water in the market, and will reflect the real-time variation in the cost of water. In a less dynamic system, such as Current System Plus, the price for abstracting water would need to be set. This introduces a risk that the price may be set too high (which may block efficient uses of water), or too low (which may result in inefficient or excessive use of water).”

The response says that  a more flexible trading system would also be better at responding and adapting to short and long term pressures, such as drought or increases in demand and that the ‘Water Shares’ option is likely to more effectively achieve this.

The response states:

“Experience in other sectors has also shown that market-led systems yield the greatest economic values through allocating scarce resources most effectively and allowing prices to be determined by the users.”

Ofwat also said it was important that any reforms to the abstraction management system were developed from robust evidence and  there was a need for more testing and evidence gathering – a view separately reflected in the water companies’ collective response to the consultation.

More work needed on cost-benefit analysis of both options

More work was now needed to understand both options, including further work on the cost benefit analysis of both options to understand which option yields the greatest benefits. In particular, Ofwat said more work is needed in the following areas to increase understanding and evidence base to make a fully informed decision:

• All the benefits of both options need to be quantified in the impact assessment as far as possible, including the potential environmental ‘externalities’ and wider benefits. We think that there is more that could be done to improve the cost benefit analysis in these areas.

• We think the testing or piloting of approaches at a regional level would be a sensible way forward, given the uncertainties and the significant differences in pressures and local circumstances across regions within England and Wales.

• Any changes should be tested with local customers and citizens for acceptability and affordability to ensure that changes maintain the legitimacy of customers and local communities.

The regulator cited examples of trading systems in other countries which had been shown to deliver significant environmental benefits through the ability to reallocate water to better manage water scarcity - including  Water trading in the Murray-Darling Basin in Australia and the Colorado–Big Thomson project in the United States is which transfers water east across the Rocky mountains to supply 30 towns and cities.

Further work would also be needed to develop the detail of how the Water Shares option would operate in practice (e.g. the number of reliability classes, limits for the scaling allocations, allocation periods, the systems required) and the transition arrangements will need to be carefully handled.

Greater clarity needed in reform timetable

Ofwat also called for a collaborative approach to be taken on considering measures for moving to a new system, irrespective of the option chosen, with further work needed to model the impacts of transition of both options on all users

The regulator wants to see greater clarity around the timetable and the interactions with other activities  - including on measures that are taken in the transition to the upstream market arrangements in the Water Bill that could help support the move to a new abstraction system.

 Ofwat said it was also important to consider the role of the 2019 price review (PR19) and company investment plans and that it would need clarity around the transition timetable when  planning  begins for PR19.

Emphasising the need for further work on testing the proposals, the regulator warned of the need to avoid any unintended consequences from other arrangements or the upstream reforms in the water bill being implemented first. In particular, the work should consider possible changes in the behaviour of abstractors in the lead up to key deadlines in the transition programme.

The response states:

“ An integrated plan which includes such modelled impacts of transition is needed to avoid unintended consequences. We need to be mindful of current water trading mechanisms and possible disincentives driven by uncertainty around long term abstraction licences, for example we need to ensure that water companies are not discouraged by the abstraction reform proposals and choose to reduce water trades in the lead up to transition. “

Ofwat has been working with Defra and the Environment Agency on adequate protections which  could be put in place to protect the environment and water users as it develops upstream trading arrangements in the Water Bill and abstraction reform , including considering the risk of ‘awakening’ sleeper licences. The regulator is also considering the use of codes and clear requirements for new (licensed) entrants to an upstream market to demonstrate that they are using sources of water sustainably, through collaboration and consultation with the Environment Agency.

 The response says that pilot schemes would help with validating the understanding of the options and the impact of the implementation of the new abstraction system and that where feasible, pilots should be conducted as soon as possible in both England and Wales. This would  enable Defra to reflect the different regulatory arrangements and areas of the water company supply chain that will be open to competition.

Ofwat has also lent its support to a proposal by Southern Water to facilitate a trading platform in a catchment over several months this year to monitor the impact of trades on water availability.

Click here to read the Ofwat response in full.