A new report commissioned by United Utilities, Severn Trent and Thames Water is highlighting the potential for creation of a system operator in the UK water sector.

System Operators (SO) are institutions whose primary purpose is the achievement of coordination efficiencies when a network is being used: they can provide a means of addressing risks of coordination failures arising, or of increasing the extent to which potential coordination efficiencies are realised.

The report identifies two ‘gaps’ in the water sector where there are significant coordination challenges and two key phases in which an SO could provide coordination benefits:

• The efficiency of coordination between water company network development decisions (and the development of interconnectors for water trading between companies) – the SO could facilitate the development of new interconnector projects, including securing necessary regulatory approvals and assurances to underpin financing
• The efficiency with which water resources can be developed, accessed and traded – the SO could facilitate access to the interconnector and broader water trading.

A range of institutions already operate as System Operators in other sectors, including:

• electricity - National Grid Electricity Transmission plc  
• air traffic management control providers - Eurocontrol across Europe and NATS in the UK
• payment system providers - UK inter-bank payment systems Bacs which provides for the processing of direct debits and credits and CHAPS which consumers typically use for house purchases,  but is otherwise primarily used by non-consumers.

The report’s aim is to promote discussion of how SOs might evolve in the water sector and in particular highlights the potential role that ‘bottom-up’ company-led development of SO-type institutions might have. The report says:

“The role that ‘bottom-up’ company-led development of SO-type institutions could play – with SOs established as joint ventures between water companies looking to develop interconnection – merits particular attention.”

“The approach aligns well with the focus that SOs tend to have on the detailed practicalities of how systems operate and are used, as companies typically are better placed than regulators to identify how those operational activities might best be structured and undertaken.”

According to the report, the most challenging and novel part of the bottom-up SO model is the potential for an SO to facilitate water trading on an ongoing basis – however, this is also seen as an area where there may be” significant opportunities for desirable institutional innovation.”

Bottom-up company-led development of SOs has potential to be a highly productive form of institutional innovation 

Bottom-up company-led development of SOs, therefore, has potential to be a highly productive form of institutional innovation in the water sector, the report says.

SOs could be established through Joint Ventures between affected businesses (e.g. by two or more water companies). Ahead of construction, an SO could play a key development role in the identification of a preferred interconnector option. Once built, an SO could then be responsible for managing access to and operation of the interconnector. The SO’s direct powers would arise through the contracts with interconnector developers and users.

In the option identification and assurance stages, ahead of construction, a not-for profit vehicle might be appropriate for an SO, while a for-profit business could then be established to operate the interconnector once built and to facilitate efficient usage.

The report draws attention to the fact that a notable feature of the other sector examples is the extent to which SOs in GB/the UK are private, for-profit businesses. This contrasts with the US Independent System Operator model in the electricity sector, where ISOs operate on a not-for-profit basis and can have public interest type objectives.

In terms of regulation, in the absence of any legislative change, the SO would not be subject to economic regulation by Ofwat although it would be subject to general competition law.

Interconnector capacity in England and Wales that allows substantial volumes of water to be transferred between some water company areas has already been in place for many years e.g. the Elan Valley Aqueduct in Wales which provides water to Birmingham.

However, no new interconnectors have so far been developed as a means of addressing projected shortfalls identified in recent years.

The report concludes that bottom-up company-led development of SOs looks like a promising way of seeking to tackle coordination problems. It could help address a number of practical coordination issues concerning the assessment and progressing of interconnector developments, and could also facilitate the development of more efficient trading arrangements.

The role that System Operators might play in the water sector has been considered for several years, but remains very much an open question.

In December 2015 Ofwat considered whether requiring separate System Operator functions within water companies – either through accounting or through functional separation – might be desirable.  However, as it had done for PR14, Ofwat decided not to pursue either of these options for the upcoming 2019 Price Review.

Click here to download What role for System Operators in the water sector?