Full text of DOI:10.1111/j.1475-5890.2001.tb00039.x

Fiscal Studies (2001) vol. 22, no. 2, pp. 189–215
The Development of Competition in
the English and Welsh Water and
Sewerage Industry
JOHN W. SAWKINS*
Abstract
This paper examines the introduction of competition into the English and Welsh water and
sewerage industry following privatisation of the 10 regional water authorities in 1989. It outlines
the development of comparative, capital and product market competition, arguing that the greatest
opportunities now lie with the last through the introduction of common carriage agreements, the
extension of Inset appointments and the introduction of transferable abstraction licences. Despite
competitive innovations, the industry remains highly regulated, complex and difficult to enter. One
of Ofwat’s outstanding challenges for the next decade is to examine the means by which the
regulatory burden might be lightened and barriers to entry lowered, to encourage potential entrants
to compete with incumbents.
JEL classification: L9.
I. INTRODUCTION
The 1989 restructuring of the English and Welsh water and sewerage industry,
and privatisation of the 10 regional water authorities (RWAs), was, arguably,
one of the most technically challenging and politically ambitious projects
undertaken by Mrs Thatcher’s Conservative government. With the exception of
British Telecommunications (BT), British Gas and the British Airports Authority
(
BAA), all privatisations up to that point had involved companies subject to
significant product market competition across most of their activities. In the case
*
Division of Economics, Heriot-Watt University.
The author acknowledges and thanks the Competition Policy Department of Ofwat for their assistance. The
views represented in this paper are those of the author. The usual disclaimer applies.
©
Institute for Fiscal Studies, 2001

Fiscal Studies
of BT, its monopoly power was gradually being eroded by new entrants
employing new technology. For British Gas, although the monopoly enjoyed by
its distribution network company, TransCo, was secure, it faced competition
from suppliers of alternative fuels such as electricity. For BAA, its local
monopoly power was subject to competition from other modes of transport.
However, the water and sewerage companies (WaSCs) — private sector
successors to the RWAs — faced none of these competitive pressures. Instead,
they enjoyed an unrivalled degree of monopoly power underpinned by the low
substitutability of the services they offered and their ownership and control of
1
water and sewerage networks.
Historically, the two branches of the industry — water and sewerage —
developed separately in England and Wales. Both were natural monopolies in
their own right by virtue of their distinct distribution and collection networks.
Unlike the electricity, gas and telecommunications utilities, no ‘national grid’ for
either service emerged due to the prohibitively high cost of transporting heavy,
non-compressible and potentially hazardous liquids over long distances.
Nevertheless, by the middle of the twentieth century, a process of integration and
consolidation had begun to gather momentum. This brought together many
hundreds of independent water and sewerage bodies which had earlier secured
the monopoly right to supply particular localities with one or both of these
services. The process culminated in the reorganisation of the industry under the
terms of the Water Act 1973 and led to the formation of 10 publicly owned
multifunctional RWAs in 1974.
The organising principle of ‘integrated river basin management’ endowed
these new bodies with operational, environmental and regulatory functions,
including responsibility for water supply, sewerage, sewage disposal, water
resource planning, pollution control, fisheries, flood protection, water recreation
and environmental conservation. However, the Act also preserved the position of
2
9 private statutory companies that were permitted to continue to supply water,
as agents of the RWAs, in their own areas. These water-only companies (WoCs)
supplied around a quarter of the population.
In 1986, Stephen Littlechild submitted a report to the Department of the
Environment (Littlechild, 1986) in which he discussed the way that a privatised
water and sewerage industry might be regulated. Given its status as ‘the natural
monopoly par excellence’ (Littlechild, 1986, p. 5), he asserted that any transfer
of public monopoly to the private sector would require a new, permanent
regulatory settlement. The 1989 Water Act embraced this idea by creating a new
economic regulator, the Office of Water Services (Ofwat), and by transferring
2
the environmental regulatory functions of the RWAs to other bodies. The 10
RWAs were privatised and licensed to operate as WaSCs, whilst the 29 WoCs
1
Water mains and sewers.
2
Including the newly established National Rivers Authority.
1
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English and Welsh Water and Sewerage Industry
—
already privately owned — were also licensed and continued to operate in
their respective areas. All 39 operators came under the economic regulatory
auspices of Ofwat, headed by the Director General of Water Services, Ian Byatt.
According to Littlechild, the need for permanent regulation did not rule out
the possibility of competition within this industry:
Competition is not an alternative to regulation of the water authorities, but it is an
important complement which can facilitate the regulator’s task and provide added
protection to customers.
Littlechild, 1986, p. 1
Three forms of competition, he believed, were possible: comparative (yardstick)
competition, product market competition and capital market competition. The
government, however, was not optimistic about the industry’s competitive
potential, and limited one of the statutory duties of the Director General of Water
3
Services to the facilitation rather than the promotion of competition. This duty
was weaker than that laid upon the Director Generals of Telecommunications
4
and Gas. Furthermore, the facilitation of competition was to be a secondary
concern, ranking alongside the protection of customer interests and the
promotion of economy and efficiency. The Director General’s primary duties
were to ensure that the functions of water and sewerage undertakers were
properly carried out and adequately financed. As the new regulatory regime
matured, however, the government and Ofwat sought to explore actively the
means by which industry operators might be exposed to competitive pressure.
This paper examines the introduction of competition into the English and
Welsh water and sewerage industry. It outlines its development and the role of
the Director General of Water Services as facilitator. It moves on to analyse the
policy’s effects, and concludes by considering the scope and prospects for
competition in the future.
II. THE DEVELOPMENT OF COMPETITION
One of the most significant challenges facing the newly appointed Director
General of Water Services in 1989 was the lack of a comprehensive information
infrastructure. Instead, Ofwat inherited responsibility for the economic
regulation of an industry that possessed no centralised reporting mechanisms and
no agreed set of technical definitions relating to even the most basic input and
output measures. There was, within the industry, a culture of secrecy and a
reluctance to share information borne of the protracted negotiations with
government over the terms of the privatisation settlement (Sawkins, 1995).
3
Water Industry Act 1991 section 2(3)(e). This Act superseded the Water Act 1989.
Telecommunications Act 1984 (c 12) section 3(2)(b); Gas Act 1986 (c 44) section 4(2)(d).
4
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Competition was well down the political policy agenda, and instead attention
was focused on the delivery of the largest programme of capital investment ever
5
undertaken by the industry. To compound matters, there was uncertainty that the
regulatory regime would prove to be stable or effective, as opposition parties
made much of their policy promises to return the industry to public sector
ownership and control.
Ofwat quickly put in place reporting arrangements to enable it to monitor
company activities. It consulted with the industry on the question of performance
measurement, harmonising company definitions for output parameters such as
‘
water delivered’. It required companies to submit a comprehensive annual
report of activities — the ‘July Return’ — and established a formal mechanism
for reporting back — ‘Dear Managing Director’ letters. During his first year in
post, it would have been possible for the Director General to focus his attention
and the resources of his Office exclusively on these and other activities
associated with his primary duties. However, in early policy statements, he
signalled his willingness to explore, actively, the means by which this
information might be used to facilitate competition within the industry.
In the first Ofwat Annual Report (1989), Ian Byatt set out the general
objective of his Office with respect to competition:
Consumers cannot look to market mechanisms to protect them from unnecessarily high
charges or poor service. My objective will be to achieve, through regulation, the same
outcome as would normally arise from a competitive market.
1
989 Ofwat Annual Report, p. 11
He enlarged on this, referring implicitly to each of the three forms of competition
outlined by Littlechild (1986). On comparative and capital market competition,
he noted their potential and drew attention to new statutory powers that
permitted take-overs and mergers of water undertakings provided they did not
unduly prejudice his ability to make valid comparisons. On product market
competition, he outlined the possibility of making ‘Inset appointments’, where
rival companies would be given the right to supply services on a greenfield site
within an area already allocated to an existing appointee. It was not expected that
progress would be equally rapid on all three fronts, however, and the Report
made clear that the focus of Ofwat’s competitive activities would fall, initially,
on comparative competition.
1
. Comparative Competition
The origins of comparative competition may be traced to the bench-marking
activities of public and private sector organisations seeking to calibrate their
performance against that of their rivals. The idea was formalised, however, by
5Estimated as £25 billion over 10 years in the 1989 Ofwat Annual Report.
1
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English and Welsh Water and Sewerage Industry
Shleifer in his seminal paper, ‘A theory of yardstick competition’ (Shleifer,
1
985), in which he modelled a situation where the price a regulated firm received
for its services depended on the costs of identical firms in the same industry. In
equilibrium, each firm found it optimal to choose a socially efficient level of cost
reduction. This result was shown to generalise to cover the situation in which the
industry was comprised of heterogeneous firms with observable differences.
In his report on the economic regulation of privatised water authorities,
Littlechild (1986) drew on this idea, stressing the potential for its application to
an industry comprised of a series of regional monopolists (Littlechild, 1986,
section 10.16). The idea was given statutory recognition in section 29 of the
Water Act 1989, which required the Monopolies and Mergers Commission, in
coming to a view on the desirability or otherwise of water industry take-overs or
mergers, to take into account the effect such an action would have on the
Director General’s ability to make comparisons between companies.
Ofwat’s pragmatic approach to comparative competition was articulated with
characteristic clarity by the Director General in the first Annual Report:
I shall compare the performance of the 39 appointed companies and use the examples of
the best to set standards for the others to introduce an element of comparative competition.
Such comparisons will cover differences in operating cost, capital cost, levels of service
and ‘customer care’. There will be allowances for differences, such as geographical
conditions, which are outside the control of efficient managements. These comparisons will
help me achieve a better deal for all water customers in England and Wales.
1
989 Ofwat Annual Report, p. 11
The main obstacle to implementing this policy was the informational asymmetry
between regulator and regulatees. The water companies effectively had a
monopoly of operational information, which protected their position.
Consequently, Ofwat gave priority to setting up reporting systems, establishing a
common basis for measuring activities and arranging for the independent
certification of all information supplied by the companies. These activities
sought to reverse the gradual restriction in information availability that had
occurred during the late 1980s.
Under the terms of their new operating licences, companies were required to
supply information annually on a specified series of Levels of Service Indicators.
This information was published on a largely unattributable basis for the first time
in October 1990 (Ofwat, 1990), but broken down by company in the following
year. Meanwhile, the scope of the July Return of information by companies to
Ofwat was widened substantially in 1991 (and in later years) to include more
details of operating costs, capital investment and efficiency. In June 1992, Ofwat
published summary data in anonymous format on the amount of water delivered
to customers and the unit costs of doing so (Ofwat, 1992a). The first attributable
information of this sort entered the public domain in November 1992 (Ofwat,
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1
992b). From that point on, progress was rapid as the scope and quality of
comparative information that was made publicly available increased; new
6
measures were reported and others were refined or replaced. In December 1995,
the Director General placed the whole July Return for each company, with the
exception of a small amount of commercially confidential information, in the
Ofwat library for public inspection. This information is now made available on
CD-ROM as a matter of routine and stands as evidence of the way in which
Ofwat has sought to break the water companies’ informational monopoly.
Allied to Ofwat’s efforts to extend the scope and quality of reported
information has been its analytical work, aimed, primarily, at comparing
company performance. Early attempts were hindered by uncertainty over
parameter definitions and data quality. Nevertheless, Ofwat was not deterred
from using raw unit-cost information at the outset. This was initially employed
not as a basis for explicit relative efficiency judgements but as a means of
7
eliciting justifications from particular companies for their high unit costs and
thereby goading them into improving their performance.
The establishment of an Ofwat technical sub-group to advise on modelling
methodology resulted in further refinements to the July Return. In July 1992,
information relating to company operating conditions was gathered and
subsequently used in a research paper (Ofwat, 1993a) that sought to identify the
most significant factors in explaining variations in the cost of operations.
Subsequent reports written by Professor Mark Stewart of the University of
Warwick (Ofwat, 1993b, 1994a, 1994b and 1994c) employed conventional
econometric techniques to model 1992–93 operating costs for water, sewerage
and sewage treatment. Ofwat used the results to place individual companies
within broad operating-cost ‘efficiency bands’.
The results of these and other comparative efficiency studies fed into the
8
Periodic Review of water company price caps in 1994. However, their role was
as corroborative evidence to be used in conjunction with basic unit-cost data.
The limitations of techniques such as stochastic frontier function estimation
employed in the commissioned research reports were recognised by Ofwat.
Consequently, the results of this analysis were used once again, primarily, to
prompt companies to explain why their performance measures were out of line
with industry comparators:
The ability to compare the costs of water and sewerage companies, however, is particularly
valuable in assessing the scope for high-cost companies to reduce their costs ... At the
Periodic Review, the onus of proof will be on high-cost companies to explain their costs.
6
Unit costs of sewage collected were reported on an attributable basis for the first time in Ofwat (1993c).
7
Ofwat Press Notice 32/92, 1 December 1992, ‘Ofwat publishes report on water costs and water losses’.
8
Details of the way in which these studies fed into the 1994 Periodic Review are discussed in Monopolies and
Mergers Commission (1996, pp. 51–2).
1
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English and Welsh Water and Sewerage Industry
Water delivered and sewage collected are the two most appropriate summary measures of
the services provided by the water and sewerage companies. Efficiency comparisons will
therefore begin with the unit costs of water delivered and sewage collected.
1
993 Ofwat Annual Report, pp. 61–2
In the wake of the first Periodic Review, further analytical work was
commissioned. The portfolio of comparative performance measurement
techniques used by Ofwat was extended to include variations on standard
econometric approaches, linear programming studies employing methods such as
data envelopment analysis, and standard inter- and intra-industry bench-marking
9
techniques. An important aspect of the more recent total comparative efficiency
measurement research programme was the work examining the future scope for
efficiency improvements within the industry. Work by the Babtie Group and
Europe Economics (Ofwat, 1998b), for example, suggested that there was scope
for annual efficiency savings of 1–2 per cent in capital expenditure and 2.5–3.5
per cent in operating expenditure over the next five years. Allied to this has been
Ofwat’s desire to derive robust estimates of long-run marginal costs as a means
of informing pricing policy (Ofwat, 1999b). Early estimates showed considerable
inter-industry variation, and companies were initially reluctant to publish either
their methodology or their raw data. Once again, Ofwat overcame these
objections, and it put this important comparative information into the public
domain for the first time in its 1999–2000 report on tariff structure and charges
(
Ofwat, 1999d). All this new comparative information fed into the 1999 Periodic
Price Review.
Over the past 10 years, therefore, the two main technical means by which
Ofwat has stimulated pseudo-competitive behaviour between firms in the
industry have been the publication of comparative information and the
dissemination of the results of analytical work. However, this approach has been
criticised on the grounds that Levels of Service Indicators, for example, may
prove less informative once all companies achieve a certain level of
performance. Furthermore, their focus is exclusively quantitative, as is the focus
of most of the analytical work to date. The way in which qualitative aspects of
company operations may be incorporated into Ofwat’s performance
measurement programme is, therefore, one of the main technical challenges for
the future.
Meanwhile, Ofwat remains convinced that comparative competition has been
an effective means of goading companies into wringing inefficiencies out of
their operations:
9
A discussion of the results of the July 1998 Ofwat survey of bench-marking techniques is contained in Ofwat
(1998d). See also Ofwat (1998e).
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We use comparative competition as our main vehicle for improving company performance.
It encourages companies to provide a better service at lower cost. Comparative competition
stimulates the behaviour that market competition might produce.
1
998 Ofwat Annual Report, p. 22
Undoubtedly, the publication of comparative information has revealed disparities
between companies and the opportunities for arbitrage of various forms. Capital
market competition through take-overs and mergers is one way in which these
opportunities have been taken up.
2
. Take-Overs and Mergers
The Water Act 1989 did not prohibit the take-over of a water company by
another enterprise. There were, however, two qualifications to this general rule.
First was the case where the take-over involved a merger with another UK
water company. If the proposed merger involved a company with assets valued at
under £30 million, the proposal would be considered under the normal
provisions of the Fair Trading Act 1973. If the value of the assets to be taken
over and the value of those already owned by the bidder both exceeded
£
30 million, reference to the Monopolies and Mergers Commission (MMC) was
mandatory. In coming to a decision, a significant new provision was that the
MMC was required to have regard to the principle that the Director General’s
1
0
ability to make comparisons between water companies should not be impaired.
Other mergers involving target water companies whose assets were worth at least
£
70 million might be referred to the MMC at the discretion of the Secretary of
State for Trade and Industry under the Fair Trading Act 1973.
Second, special or ‘golden’ shares were issued for each of the 10 WaSCs.
These were held by the Secretaries of State for the Environment and Wales, and
they limited shareholders in these companies to a maximum 15 per cent stake for
a period of five years. This was aimed at giving the industry a period of stability
to permit the WaSCs to meet their environmental objectives. On 31 December
1
994, nine of the 10 special shares were redeemed at par. The restriction
remained in place for Welsh Water for reasons of national identity.
As with comparative competition, Ofwat was keen to exploit the potential of
capital market competition delivered through take-over and merger activity.
Gradually, it became clear to industry analysts that the initial regulatory
settlement had been extremely generous to the companies, an impression
confirmed when most companies, under pressure from Ofwat, were able to hold
1
0Section 29 Water Act 1989, amended by section 34(3)(a) Water Industry Act 1991, in turn amended by
section 39 Competition and Service (Utilities) Act 1992.
1
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English and Welsh Water and Sewerage Industry
TABLE 1
Water Mergers
New company
Date of single
licence
31 March 1992
Companies
Reference Price reductions
to MMC
involved
North East Water
Newcastle &
Gateshead
No
1% from April 1991
Sunderland &
South Shields
Severn Trent
1 September 1993 Severn Trent Water No
East Worcester
15% over three years
(EW area only)
Essex & Suffolk
Three Valleys
31 March 1994
Essex Water
No
None
Suffolk Water
31 March 1994
Colne Valley
Lee Valley
Yes
9% for combined
company over six
years
Rickmansworth
South East Water 1 April 1994
Eastbourne
Mid Sussex
West Kent
No
No
2.7% for combined
company over one
year
Bournemouth &
West Hants
1 July 1994
Bournemouth &
District
0.8% for combined
company over four
years
West Hampshire
Water
Sutton & East
Surrey Water
1 April 1996
1 April 1996
East Surrey Water
Sutton & District
No
3.5% over three years
5% best endeavours
Northumbrian
Northumbrian
Water
Yes
15% over six years
(merged water
revenue only)
North East Water
Dee Valley
1 April 1998
Chester
No
3.5% by 1 April
2001
Waterworks
Wrexham Water
South East
Anglian
1 January 1999
1 April 2000
1 April 2000
1 April 2000
1 October 2000
Mid Southern
South East
No
No
No
No
No
0.5%
Anglian
—
Hartlepool
Yorkshire
Yorkshire
15% (YW area only)
York Waterworks
Northumbrian
Three Valleys
Northumbrian
—
—
Essex & Suffolk
Three Valleys
North Surrey
Source: Various Ofwat News Releases.
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1
1
price increases well below those permitted by their price caps. The improved
quality and quantity of comparative information allowed predators to identify
potential take-over targets and assess whether profitable opportunities existed.
Once take-overs had been approved, it was generally the case that
negotiations would begin between Ofwat and the new owners to arrange a single
licence or appointment for the newly merged company. Therefore the date of
take-over generally preceded the date on which a single licence was granted by
12
months or years. Table 1 lists the successful mergers between water enterprises
to date.
The first wave of take-over and merger activity was undertaken by French
multinationals that had acquired large shareholdings in many statutory water
companies in the late 1980s. For example, Lyonnaise UK plc, a subsidiary of
Lyonnaise des Eaux, consolidated the operations of Newcastle and Gateshead
Water and Sunderland and South Shields Water with the creation of North East
Water in November 1990. Although the merger did not qualify for an automatic
reference to the MMC, agreement was reached with Ofwat to reduce charges by
1
per cent across the area. In the case of the Three Valleys Water Company
created from the Lee Valley, Colne Valley and Rickmansworth water companies,
an MMC inquiry did take place. The MMC report (MMC, 1990) concluded that,
whilst the merger would operate against the public interest by reducing the
number of comparators available to the Director General, the adverse effects
could be mitigated if the benefits of merger were passed on to customers in the
form of lower charges. The Secretary of State for Trade and Industry allowed the
merger to proceed provided General Utilities plc — a wholly owned subsidiary
of Compagnie Générale des Eaux and the majority shareholder in the Lee Valley
Water Company — reduced charges by 9 per cent across the Three Valleys area.
These two examples illustrate the Ofwat policy towards small company
mergers, articulated in its 1989 Annual Report:
Mergers between existing water enterprises in the UK and the integration of their
management would reduce the number of comparators and prejudice my ability to make
valid comparisons. I recognise, however, that there may be public benefits which could
outweigh such a detriment. In such circumstances I would generally wish to see a single
new appointment for merged or jointly managed companies with a new price limit (K) for
that company.
1
989 Ofwat Annual Report, p. 11
1
1
Companies ‘voluntarily’ agreed to limit their price increases to levels below those permitted under the price
cap settlement in September 1991 (Ofwat Press Notice 25/91, 1 October 1991, ‘Water companies cut price
increases’). Price limits were formally reduced by ‘Interim Determination’ in October 1992 when Ofwat issued
notices to 19 of the 32 companies of an adjustment under condition B of their licences (Ofwat Press Notice
2
7/92, 16 October 1992, ‘Most water companies settle for lower charges next year’).
For example, the companies comprising Three Valleys merged in October 1990 but were not granted a single
12
licence until 31 March 1994.
1
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English and Welsh Water and Sewerage Industry
TABLE 2
Merger References to the Monopolies and Mergers (Competition) Commission
Parties involved
Date
Date
MMC findings
adverse
Approval by
Secretary of
State for Trade
and Industry
referred
MMC
report
published
27.4.90
General Utilities plc /
The Colne Valley Water
Company and Rickmansworth
Water Company
7.9.89
Yes
Yes
General Utilities plc /
4.1.90
4.7.90
Yes
No
No
Yes
Yes
No
No
No
The Mid Kent Water Company
Southern Water plc /
4.1.90
4.7.90
Mid-Sussex Water Company
Lyonnaise des Eaux SA /
31.3.95
21.5.96
21.5.96
23.5.96
26.7.95
25.10.96
25.10.96
21.1.97
Yes
Yes
Yes
Yes
Northumbrian Water Group plc
Severn Trent plc /
South West Water plc
Wessex Water plc /
South West Water plc
Mid Kent Holdings plc /
General Utilities plc /
SAUR Water Services plc
It was not always the case, however, that an accommodation could be reached. In
the case of Mid Kent Water, two separate references to the MMC in 1990 and
1
996 (see Table 2) resulted in possible take-overs by General Utilities plc and
SAUR being blocked. In both cases, the MMC was not persuaded that any price
reduction would be sufficient to remedy the expected detriment of the merger to
Ofwat’s system of comparative competition. This finding underpinned the action
of the Secretary of State for Trade and Industry in blocking both bids.
A second wave of take-over activity was precipitated by the expiry of the
government’s ‘golden share’ in the WaSCs in December 1994. Two of the
smallest WaSCs — Northumbrian and South West — were quickly targeted,
leading in each case to an MMC reference (see Table 2). Final decisions by the
Secretary of State for Trade and Industry once again turned on whether Ofwat’s
ability to make comparisons would be prejudiced unduly. In the case of
Northumbrian, the potential partner, Lyonnaise UK, already owned North East
Water, which operated exclusively within Northumbrian’s area. Despite the loss
of a water comparator, however, the merger was allowed to proceed on the
grounds that a 15 per cent price reduction for water services would be delivered
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over six years. Crucial to this decision was the fact that Lyonnaise UK did not
own or control any of the other combined WaSCs, and the number of sewerage
comparators would therefore be unaffected. In contrast, proposals by Wessex
Water and Severn Trent to merge with South West Water were blocked. If
allowed to proceed, either merger would have reduced the number of separately
owned companies delivering sewerage (and water) services from 10 to nine. In
the MMC report on the proposed Severn Trent–South West Water merger, the
importance of ownership diversity for effective comparative competition was
discussed:
The DGWS [Director General of Water Services] also told us that a diversity of ownership
of water companies was likely to secure the greatest variety of management styles and
techniques. The industry was more diverse than it had been under public ownership and
companies had continued to differentiate themselves one from another in the sector.
Experience had shown that differences in performance were fundamentally affected by
differences in management style and priorities, which were themselves driven by
differences in ownership. The more independent companies that were able to take part in
this process, the more effective comparative competition would be. Separate Appointments
in the hands of a common owner were a poor substitute for separate ownership; for
example, the DGWS told us that each of the French Groups (General Utilities, SAUR and
Lyonnaise) had their own management style which permeated the whole group. This
overall management style tended to impose uniformity on the performance of the individual
companies in the group, reducing their value as comparators.
Monopolies and Mergers Commission, 1996, p. 14
In addition to mergers between water enterprises, other utility operators
sought potential partners in this sector. In the instances involving electricity
suppliers, Ofwat and the Office of Electricity Regulation (OFFER) issued joint
consultation papers and advised the Secretary of State for Trade and Industry of
the implications of sanctioning the creation of ‘multiutilities’. It was generally
the case that the mergers were allowed to proceed subject to minor amendments
to operating licences. Water–electricity partnerships were the most popular:
North West Water joined with Norweb to form United Utilities, Welsh Water
acquired SWALEC and Southern Water was taken over by Scottish Power.
The examples discussed above are representative of the competitive activity
in the water industry capital market since 1989. This activity continues;
however, Ofwat has signalled its reluctance to contemplate any merger of
WaSCs and indeed any further reduction in the number of water-only companies
remaining. The 1995 Ofwat Annual Report set out in tabular form a ‘spectrum of
detriments’ from mergers (see Table 3).
It remains possible that the surviving WoCs will finally be absorbed by the
WaSCs in whose area they operate, particularly if by doing so they act as a new
2
00

English and Welsh Water and Sewerage Industry
TABLE 3
Spectrum of Detriments from Water Mergers
Most harmful
Least harmful
Merger of two contiguous water and sewerage companies
Merger of two non-contiguous water and sewerage companies
Merger of two independently controlled large companies in the same region
Merger of two large companies in different regions
Merger of a large company with a small company
Merger of two neighbouring small companies
Source: 1995 Ofwat Annual Report, p. 32.
exemplary comparator in terms of efficiency. However, the emergence of
product market competition may prove to be the catalyst that will reverse the
trend that has seen the number of independent water enterprises operating under
independent licences reduce from 39 in 1989 to just 27 a decade later.
3
. Product Market Competition
(
a) Inset Appointments
One of the most radical innovations of the 1989 Water Act was its opening-up of
the possibility of product market competition within the industry. The main
vehicle for this was to be the ‘Inset appointment’ — an agreement whereby one
company would be given the right to supply services within another’s statutory
area. The Act limited Inset opportunities to sites not receiving a service from an
existing undertaker (‘greenfield sites’) which were located more than 30 metres
distant from the incumbent undertaker’s main or sewer. However, although the
Act ended the right of companies to act as regional monopolists in principle, in
practice product market competition of this form was very slow to develop.
The main practical obstacle to Insets at the start arose as follows. For Inset
applicants to be successful, they were under an obligation to demonstrate to the
Director General that they had enough water available to supply customers.
However, they were not permitted to apply for bulk supplies from other
companies until they had been appointed undertakers for the relevant areas. This
and other practical obstacles led to new legislative provisions contained in the
Water Industry Act 1991 (sections 7 and 8) as amended by the Competition and
Service (Utilities) Act 1992 (section 40).
The outcome of these changes in the law was to enlarge the scope for product
market competition, making Inset appointments possible in respect of all
greenfield sites and all sites where existing customers were supplied with 250
1
3
megalitres or more of water a year. Crucially, Inset applicants were given the
1
3The Secretary of State was given the right to reduce the 250-megalitre threshold with the permission of
Parliament.
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Fiscal Studies
right to apply to existing undertakers for bulk supplies of water and for mains
sewerage connections in advance of appointments being made. In cases where a
potential appointee was unable to obtain the necessary supplies of water or
access to sewage treatment facilities from an existing appointee, the Director
General was given the right to determine the price and the other terms of supply.
Inset appointments could also be granted if an incumbent consented to change its
boundary to allow part of its area to be transferred to another undertaker.
However, Insets could not be used as a device for taking over the whole of
another undertaker’s area.
Despite these changes, the Inset appointment process remained lengthy and
involved. Delicate negotiations between applicants, customers, incumbents and
Ofwat were often frustrated by a reluctance on the part of rival companies to
share commercially sensitive information. The 1995 Ofwat publication
Competition in the Water Industry: Inset Appointments and their Regulation
sought to clarify the criteria and process for applying for Inset appointments,
estimating that applications would take approximately 23 weeks to process. This
proved to be extremely optimistic.
By June 1994, just two Inset applications had been received. It was not until
May 1997 that the Director General granted the first Inset appointment, almost
eight years after the principle had been established in statute. Under the new
agreement, Buxted Chickens Ltd became a customer of Anglian rather than
Essex and Suffolk Water. Company licences were altered and a new 3.5km
dedicated pipeline constructed to link the site with an Anglian water main. The
first Inset sewerage agreement was also entered into by Anglian, which took over
provision of sewerage services on the former RAF Finningley site in March
1
998. Later that year, Ofwat published proposals to allow Hartlepool Water to
14
supply a greenfield site in Northumbrian’s area. This first Inset application for
an undeveloped site was finally granted in February 1999.
Revised Inset appointment guidelines were issued by Ofwat in February 1999
(
Ofwat, 1999a), including a new timetable, which predicted a 16- to 30-week
period for the whole Inset process. The new guidelines emphasised the need for
greater transparency in the exchange of price, cost and tariff information and
encouraged potential applicants to discuss their intended actions with Ofwat at
an early stage. Amongst the changes aimed at reducing regulatory transactions
costs was the Director General’s decision not to set a price cap for new Inset
appointees but merely to ensure that the customer was left no worse off than if it
had remained with the previous supplier. Overall, the aim of the new guidelines
was to encourage transparent negotiations and thereby lower entry barriers for
prospective competitors.
1
4Ofwat Press Notice 43/98, 26 October 1998, ‘Ofwat publishes proposals to allow water company to supply
new development in another’s area’.
2
02

English and Welsh Water and Sewerage Industry
In March 1999, Albion Water (Shotton) Ltd was granted a licence and
became the first new entrant to the industry since privatisation, replacing Dwr
Cymru (Welsh Water) as Shotton Paper’s supplier of water services. Under the
terms of the agreement, Albion, a subsidiary of Enviro-Logic Ltd, acted as an
intermediary, buying water from the incumbent Welsh Water and delivering it to
Shotton. This arbitrage arrangement is typical of the agreements agreed or being
15
negotiated at present.
Most recently, on 17 August 2000, regulations came into force that lowered
the Inset appointment threshold to 100 megalitres per year for companies in
England. Ofwat estimates that this will permit more than a thousand additional
users to apply for Inset appointments.
(
b) Other Forms of Product Market Competition
Several other forms of product market competition are permitted under current
legislation: first, cross-border supplies. The Competition and Service (Utilities)
Act 1992 gave customers the right to demand a supply of water to be used for
domestic purposes from any undertaker irrespective of where they live. The
customer is obliged, however, to meet the costs of making any necessary
connections. Clearly, the option is unattractive at present for the vast majority of
domestic users, although customers living near the border of two competing
1
6
suppliers might be in a position to benefit from a change in supplier. At
present, there are no instances of domestic cross-border supplies. In May 2000,
however, Thames Water announced its commitment to provide a cross-border
supply of water to Brands Hatch motor racing circuit. Projected customer
savings are judged to be of the order of 20 per cent. Second, it is open to
customers to buy water and sewerage services from private operators that
develop new sources and that do not come under the economic regulatory
auspices of Ofwat. These companies are permitted to negotiate prices without
constraint, but always subject to meeting minimum quality standards. Third,
companies are permitted to subject many of their functions to market
competition via competitive tendering procedures. In theory, for example, some
operational functions could be subcontracted to other suppliers. The basic
requirement is that licensed operators must retain sufficient control of operations
to ensure they deliver a proper service to their customers whilst meeting
environmental obligations.
To this list must now be added common carriage — the shared use of the
supply pipes and other infrastructure of an existing statutory undertaker by a
third party in order to enable the third party to provide services within the
1
1
5
6
By 31 March 2000, six Inset appointments had been made and eight other applications registered with Ofwat.
The boundaries between the WaSCs generally follow divisions between watersheds such as ridges, hills or
mountains. Pumping water across watershed boundaries is very costly.
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Fiscal Studies
incumbent’s area. This is, arguably, one of the most controversial and potentially
far-reaching consequences of the Competition Act 1998.
The Act, which came into force on 1 March 2000, prohibits companies
entering into agreements that are anti-competitive, i.e. that prevent, restrict or
distort competition in the UK. It also prohibits abuse of a dominant market
position, a provision which may provide an effective legal framework for the
development of common carriage. For example, if, by denying access to
infrastructure assets, such as mains or sewers, an incumbent company excludes a
potential competitor unreasonably, the competitor may make a complaint of anti-
competitive behaviour to the Director General of Water Services or the Director
General of Fair Trading. A company’s access prices may be considered
unreasonable if it treats new entrants differently from the way it treats itself or if
it discriminates unduly between different entrants. It may refuse to offer terms,
or offer anti-competitive terms. If a breach of the Act has taken place, the
Director General of Water Services can direct a company to change its conduct
and, if appropriate, impose financial penalties of up to 10 per cent of the
offender’s UK turnover per year. All decisions under the Act are subject to
appeal to the Competition Commission.
Guidelines on how the Act will operate were published jointly by Ofwat and
the Office of Fair Trading (Office of Fair Trading, 2000). These emphasise the
importance of ensuring that the competitive process is unhindered and note that
the Director General of Water Services may investigate breaches of the Act on
his own initiative. Guidance on how companies should deal with drinking water
quality aspects of common carriage were issued separately by the Drinking
Water Inspectorate (Drinking Water Inspectorate, 2000). Significantly, the
Inspectorate was of the view that public health and environmental concerns were
not a barrier to common carriage operations. Ofwat’s approach to the
administration of the Act was summarised in a series of Dear Managing Director
17
letters.
In coming to a view as to whether a company has behaved anti-competitively,
Ofwat is constrained to act in a way that is consistent with all its statutory duties.
It must be satisfied, for example, that common carriage arrangements do not lead
to an unsatisfactory level of service or jeopardise an incumbent’s ability to
finance and carry out its functions. In determining charges, Ofwat must avoid
‘
undue preference’ between customers, and in particular must protect the interest
of rural customers. This is a complex balancing act. For, as product market
competition develops through common carriage arrangements, cross-subsidies
will unwind further and charges become more cost-reflective. Any competitive
initiatives involving further regional de-averaging of prices must remain
consistent with the Director General’s duty to protect the interests of all classes
of customers. The scope and potential for the development of further product
17Ofwat, 1999c, 2000e, 2000g and 2000h.
2
04

English and Welsh Water and Sewerage Industry
market competition will continue, therefore, to be constrained by this wider
regulatory framework. It may be many months or even years before the first
common carriage agreements are finalised and this new form of product market
competition realised.
III. THE EFFECTS OF COMPETITION: AN ASSESSMENT
There is little doubt that these advances in competition would not have come
about but for the commitment of the first Director General of Ofwat, Ian Byatt,
to the policy. Throughout his time in office, he confirmed in public statements
his belief in its efficacy as a means of delivering benefits to water company
customers. The following recent statement is typical:
Comparative competition has served the customer well. They can now expect — and
receive — better service than ever before. Comparative competition has reduced
companies’ costs and, as a result, prices will be lower for customers. Inset appointments
have had a trickle-down effect with benefits extending to the next tiers of customers. ...
Parliament requires water–water mergers to be referred to the Competition Commission.
The bottom line is that we should not have such mergers without counterbalancing and
overwhelming benefits to customers.
Ofwat Press Notice PN32/9918
It remains difficult, however, to quantify the effect of Ofwat’s pro-competitive
stance in the absence of an appropriate comparator group of companies operating
within a similar institutional setting. Nevertheless, there is some empirical
evidence available that might be brought to bear on the question of the efficacy
of competition.
1
. The Effect of Comparative Competition
From the beginning, comparative competition was, undoubtedly, one of the most
effective regulatory devices at Ofwat’s disposal. The early publication and
dissemination of comparative statistics served to inform key industry
stakeholders of the relative positions of individual companies along several
dimensions of performance. Armed with this information, the stakeholders —
regulators, water company customers, shareholders and the government — began
to seek explanations from individual organisations regarding the gross disparities
in operational performance. This, in turn, prompted the companies to reallocate
resources towards those dimensions of performance that were measured and
reported. Consequently, the range and variance of these measures reduced as the
1
8
3
0 June 1999, ‘Customers can reap benefits of competition now says Ian Byatt’ (extract from a speech to the
European Policy Forum’s Pro-Competition Round Table on 29 June 1999).
205

TABLE 4
Total Industry Performance
Per cent
Indicator
DG2
Description
1990–
1991–
92
1992–
93
1993–
94
1994–
95
1995–
96
1996–
97
1997–
98
1998–
99
1999–
9
1
2000
Properties at risk of low
pressure
1.85
1.69
1.27
1.02
0.81
0.78
0.43
0.25
0.17
0.13
0.06
DG3
Properties subject to
unplanned supply
interruptions of 12 hours
or more
0.42
0.20
0.38
0.35
0.26
0.58
0.21
0.15
0.05
DG4
DG5
DG5
Population subject to
41
13
12
0
3
39
30
3
3
0
hosepipe bans
Properties subject to
sewer flooding incidents
Properties at risk of
flooding from sewers
once every 10 years
Billing contacts not
responded to within five
working days
0.05
0.09
0.04
0.09
0.03
0.09
0.02
0.07
0.02
0.07
0.03
0.07
0.02
0.07
0.03
0.08
0.13
31.18
31.09
0.11
30.49
25.64
DG6
DG7
20.15
18.14
16.27
24.12
11.05
5.48
10.00
5.79
3.67
8.16
5.07
4.74
1.99
2.53
1.28
1.52
0.64
Written complaints not
responded to within 10
working days
DG8
DG9
Bills not based on meter
2.32
0.88
0.34
9.70
0.33
9.29
readings
Received telephone calls
not answered within 30
seconds
26.97
18.76
Source: Ofwat, 2000a, Table 1, p. 6.

English and Welsh Water and Sewerage Industry
new regulatory regime matured. Table 4 illustrates this process at the industry
level for the key performance indicators specified in company licences. The
same pattern is observable in the disaggregated company-level data, where the
gap between the best- and the worst-performing companies along the various
1
9
dimensions has steadily narrowed throughout the last decade.
At the same time, the Director General was aware that improvements in
measured aspects of performance sometimes brought about a deterioration in the
unmeasured aspects. Ofwat responded to this problem by phasing in new
performance indicators or refining those already in use. To date, however, it has
proved reluctant to drop any but the most peripheral indicators within its
package.
Other instances of the way in which Ofwat has goaded companies into
improving their performance may be offered. In each case, comparative
information has been used by the regulators and other interest groups such as
politicians, customers or the press to exert pressure on poorly performing
companies to modify their behaviour. Comparative statistics relating to leakage,
disconnections and unit costs have enabled Ofwat — in the first instance — to
identify underperforming companies. Armed with information supplied by other
companies, it has then been possible to set challenging but realistic targets for
2
0
improvement and to track progress towards meeting those targets consistently.
Overall, although the prominence given to comparative competition by Ofwat
has diminished slightly in recent years, there is no question of it abandoning this
regulatory tool. Having served as a means by which the gross inefficiencies have
been wrung out of the industry, it continues to provide valuable insights into
company operations.
2
. The Effect of Capital Market Competition
In general terms, capital market competition might be expected to reduce X-
inefficiency within a company, drive down costs and thereby reduce the
possibility of take-over by a hostile predator. Isolating and measuring the effects
of this form of competition is, however, problematic. For the English and Welsh
water industry, it is further complicated by the legislative and regulatory
antipathy towards water–water mergers in cases where important comparators
are involved.
The threat of merger or take-over has, however, prompted companies to offer
price reductions to customers. This implies reduced revenue and operating profit
unless efficiency gains are made. Price reductions are, therefore, a crude proxy
for the effect capital market competition has on particular firms within the
industry, if it is assumed that they would not have been offered in the absence of
take-over or merger activity. A leading example of this in England and Wales
1
2
9
0
See, for example, Ofwat (2000a, Table 5, p. 15).
See, for example, Ofwat (1998c).
207

Fiscal Studies
was South West Water’s announcement of a £15 customer rebate and 20.4 per
cent increase in interim dividends during its 1996 defence of hostile take-over
bids from Severn Trent and Wessex Water. In the end, the bids were blocked by
the Secretary of State for Trade and Industry. The threat of take-over, however,
was enough to induce South West to put its management under considerable
pressure to make good the reduction in profit that resulted from the customer
rebate. Table 1 sets out other price reductions agreed between the water
companies and Ofwat in cases where mergers have been sanctioned.
As the number of independent companies within the industry has declined
and the regulator has indicated reservations over the consolidation of WaSCs
(
Table 3), the potential for domestic capital market competition to elicit further
efficiency improvements has been diminished. Only product market competition
now appears to have the potential to give competition new momentum.
3
. The Effect of Product Market Competition
The possibility of Inset appointments began a process that made the commercial
and domestic water markets in England and Wales more contestable. This has
had two main effects.
First, companies have introduced large-user tariffs, for potable water, waste
water and trade effluent. The numbers doing so have increased slowly as the
procedures for Insets have become less cumbersome in the wake of the
Competition and Service (Utilities) Act 1992. In 1993–94, North West and East
Surrey pioneered separate tariffs for a class of large industrial customers.
Anglian, Severn Trent and Essex & Suffolk followed in 1994–95. In these and
other cases, revisions to the tariff structure were made before the first Inset
appointment had been confirmed. Clearly, the threat of competition had an effect
on the companies and led them to modify their behaviour. As at May 2000, all
but two companies operating under separate licences had large-user tariffs for
water. Seven of the 10 WaSCs offered large-user waste water tariffs and four
offered lower tariffs to large trade effluent customers.
All of these tariffs are structured so as to avoid giving customers the
incentive to waste water. Most operate with a high fixed charge and a low
volumetric rate, whilst the minority have a lower volumetric rate for all
consumption over a certain threshold. Ofwat’s key operating principle is that
prices must not be driven below the long-run marginal costs of supply, which
include incremental capital costs (see Ofwat (1997)). Prices, in other words,
must reflect costs imposed at the margin.
The second effect of product market competition has come about as a direct
result of the introduction of large-user tariffs. By 1999, Ofwat judged that the
market for large users was sufficiently contestable to enable it to remove them
from the regulated tariff basket. The licences of all companies except Sutton and
East Surrey Water were amended to remove customers using not less than 250
2
08

English and Welsh Water and Sewerage Industry
megalitres per year from the tariff basket with effect from 1 April 2000. The
same licence modification applies to Sutton & East Surrey from April 2001.
Ofwat explained the decision in the following way:
Taking large users out of the tariff basket means that companies cannot automatically
recoup from other customers lost revenue arising from reduced charges to their large users.
These large users are part of a competitive market that does not require the same degree of
regulation as other groups of customers. Notwithstanding this, companies must ensure that
charges to these large users should not be unduly preferential or unduly discriminatory.
They must also ensure that they are not acting anti-competitively.
Ofwat, 2000b, p. 60
Removal from the tariff basket does not mean, therefore, that these prices will
completely escape Ofwat’s regulatory control.
4
. Regulatory Involvement
One of the ironies of Ofwat’s duty to facilitate competition has been the growth
in the scale and scope of its involvement with the industry and therefore its size
(
Table 5). The amount of information gathered for monitoring purposes has
grown unremittingly as the suite of performance indicators has expanded,
placing a particularly heavy burden on the smaller companies. In addition,
further substantial informational demands are made as part of the Periodic
2
1
Review process every five years.
It may be argued that an early expansion of regulatory activity was necessary
to take control of an industry that was exploiting the generous post-privatisation
regulatory settlement. Much early groundwork was also necessary to put in place
robust and reliable reporting systems that would deliver timely information of a
high quality. Nevertheless, there is little evidence to suggest a scaling-down of
regulatory activities in the near future, which would be the logical concomitant
of increased competition. Initiatives such as the removal of large-user tariffs
from the tariff basket, although symbolically important, have not, apparently,
turned the tide of regulatory expansion.
TABLE 5
Ofwat Staff
1
990
1991
1992
132
1996
194
1997
190
1998
206
1999
220
Number of staff
51
112
Source: Various Ofwat Annual Reports.
2
1
In its evaluation of the 1994 Periodic Review, Ofwat reported that the companies had noted an incongruity
between the volume of data they were asked to submit and the information supplied by Ofwat to support its
decisions.
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Fiscal Studies
IV. THE SCOPE OF AND PROSPECTS FOR COMPETITION
Over the last 10 years, most regulatory effort has been invested in the
development of the comparative and capital market forms of competition. Such
initiatives are now largely played out, and, with the passing of the Competition
Act 1998, the focus of attention has shifted towards product market competition.
As yet, however, barriers to entry remain high in the industry, and the
opportunities for this form of competition are still rather few and far between.
The government and Ofwat, believing that only product market competition
now has the potential to give competition new momentum, have sought to
nurture this tender plant carefully. As in the gas and electricity industries,
competition has been rolled out in stages, starting with the largest customers.
The recent lowering of the Inset threshold indicates a willingness to follow this
pattern, gradually extending the benefits of choice to smaller users. To date,
there has been no mass switching of supplier by customers. But the potential for
switching has undoubtedly focused corporate minds, prompting water companies
to introduce new tariffs tailored to suit large users. Nevertheless, it remains
uncertain whether customers will switch or threaten to switch supplier in
sufficient numbers to generate critical mass to ensure that the momentum of
product market competition will be preserved.
Undoubtedly, the survival chances of product market competition were
boosted by the Competition Act 1998 (CA98). This and the associated debate
over common carriage have led to an important change in attitude within the
industry towards competition in general:
Even as little as two years ago, most water companies adopted a neutral or defensive
attitude to competition. In particular, the concept of competition through shared use of
networks, which had been so significant in electricity and gas, was not actively considered
in water. ... The consensus seemed to be that there would never be a significant level of
market competition in the water industry. Now there has been a marked change in attitude.
More companies positively seek out competitive opportunities. ... The introduction of
CA98 has been significant in changing attitudes. It has strengthened considerably the legal
powers available to the Director to prevent abuse of a dominant position and other anti-
competitive behaviour. It has been a catalyst for the development of common carriage by
putting incumbents at risk of abusing a dominant position if they refuse to share the use of
their networks with potential new entrants, or offer unreasonable terms.
Ofwat, 2000j, pp. 5–6
In the near future, the main competitive opportunities lie in two areas: first in
the development of common carriage arrangements. In June 2000, Severn Trent
was the first company to put its full access code into the public domain. Since
then, others have followed suit, and legislation is currently being discussed
regarding a sector-specific framework to encourage the development of common
2
10

English and Welsh Water and Sewerage Industry
carriage. Second, competitive opportunities lie in the establishment of a system
of abstraction licence trading. Again, this initiative is at a relatively early stage
of development; however, there is a commitment on the part of the Department
of the Environment, Transport and the Regions to its implementation
(
Department of the Environment, Transport and the Regions, 2000a and 2000b;
Ofwat, 2000i).
Beyond that, it is possible to speculate on more radical initiatives implying
industrial restructuring. Specialist companies may emerge: network companies,
supply companies and resource companies. Each of these could be individually
licensed, with licences being sold on the basis of franchising arrangements.
Time-limited Inset appointments could be offered in this way at an early stage,
thereby increasing competitive pressure within the industry. In these and other
ways, the regulatory burden may be lightened as competition takes root.
Just before his retirement as Director General of Water Services, Ian Byatt
reiterated his confidence in the competitive process. He noted also that Ofwat’s
role must continue to evolve in response to changes in the competitive
environment: ‘Ofwat is moving from being a regulator to also being a
competition authority, matching the changes in the industry’ (Byatt, 2000, p. 6).
That competition is now seen as an ally of regulation and a fact of life for water
companies in England and Wales is due, in large part, to his personal
commitment to the cause.
Restructuring the Industry
Although the regulatory functions of the RWAs were not inherited by their
successors, the WaSCs were privatised largely intact as vertically integrated
regional monopolies in 1989. This privatisation settlement was not as radical as
that suggested by authors such as Vickers and Yarrow (1988):
As a matter of general principle public policy should seek to isolate the natural monopoly
elements and to prevent the firms entrusted with these activities from extending their
monopoly powers into other areas. By limiting the degree of vertical integration, extensive
use of franchising and contracting out would therefore serve to expand the domain of
economic activity in which effective competition can be introduced.
Vickers and Yarrow, 1988, p. 404
Restructuring of the industry in the short run was effectively precluded by the
issuing of 25-year licences and the requirement for 10 years’ notice to be given if
these were not to be renewed. The first opportunity for such notice to be given is
2
004.
In order to isolate natural monopoly elements of the industry and to introduce
competition into other areas, a case may be made for breaking up the 10 WaSCs,
first along functional lines. Littlechild (1986) noted that there were, in fact, two
separate distribution systems — water and sewerage — which had developed
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Fiscal Studies
independently. What little empirical evidence exists on the relative performance
of single-function and integrated suppliers suggests that the economies of scope
derived from integration are not of decisive importance from the point of view of
22
industrial structure. The comparative performance of many of the WoCs in the
English and Welsh industry over the last decade would appear to support this
23
observation.
Within these broad functional divisions, a further unbundling may take place.
For water, the abstraction and treatment functions may be separated from
distribution. For sewage, collection may be separated from treatment and
disposal. In general, the costs of the abstraction and treatment of water and of the
treatment and disposal of sewage are relatively low in relation to the transport
costs for treated water and untreated sewage. The point was made in the Ofwat
Annual Report of 1994 in relation to the bulk pricing of water:
Ofwat does not believe that unit charges should be lower for business customers merely
because they use a large amount of water. There are not believed to be significant
economies of scale involved in the abstraction, storage and treatment of water. There may,
however, be economies of distribution which relate to the delivery of large quantities of
water to a single customer or a group of customers.
1
994 Ofwat Annual Report, p. 40
Clearly, by dividing up previously integrated functions, there is a danger of
dislocation and vastly increased transactions costs due to a lack of co-ordination.
Consequently, there is a case for continuing to organise the industry under the
integrated river basin management principle, allowing the water resource profile
to influence industrial structure. Generally, however, sewage operations may be
organised on a smaller, more local, scale than water, as economies of scale are
exhausted at a lower level for sewage transportation, treatment and disposal than
for water abstraction, treatment and distribution.
To maximise the degree of competition within each area of the industry, the
following steps may be taken. First, the water and sewerage networks may be
separated from other functions, divided up along regional lines and the operating
franchises auctioned. Given the more localised sewerage networks, the
expectation would be for several sewerage franchisors to operate independently
within one regional water franchisor’s area. Second, water and sewage treatment
functions may be unbundled and management concessions for individual works
or groups of works auctioned in a similar way. This solution would have much in
2
2
However, Hunt and Lynk (1995) (see also Lynk (1993)) found that economies of scope were sacrificed by
separating the regulatory function from the RWAs at privatisation. The related empirical literature on the effect
of ownership on the relative efficiency of water utilities is, however, inconclusive (see, for example,
Bhattacharyya, Parker and Raffiee (1994) and Bruggink (1982)).
23
An overall performance assessment is given in Ofwat (1998a, Figure 1, p. 4). The two best-performing
companies for 1997–98 were WoCs.
2
12

English and Welsh Water and Sewerage Industry
common with the French concessionary system in which local municipalities
remain ultimately responsible for services and the ultimate ownership of the
fixed assets (Sawkins and McMaster, 1997). Third, functions such as pipeline
construction, mains connections, maintenance and billing might also be
separately contracted out. Given the strict environmental standards imposed on
all aspects of the industry’s operation, any deterioration in service quality would
be identified quickly, allowing remedial action to be taken (McMaster and
Sawkins, 1993), the ultimate sanction being the replacement of a defaulting
franchisor.
All these developments would facilitate comparative competition by
increasing the number of independent operators. There would remain a need for
economic and environmental regulatory authorities, however, to continue to
ensure the industry operated within statutory limits.
V. CONCLUSION
Despite unpromising beginnings, the scope and extent of competition in the
English and Welsh water industry have widened steadily during the last decade.
Overall, progress has been slow, symptomatic of Ofwat’s legislative duty to
facilitate rather than promote competition. Nevertheless, the Director General
has developed the policy in the face of opposition from water companies, and
has succeeded in securing identifiable and measurable benefits for customers,
particularly through his operation of comparative competition.
Working within its present statutory limits, the greatest competitive
opportunities remain for Ofwat in the field of product market competition. This
includes exploring the ways in which common carriage might be facilitated,
arguing for a reduction in the Inset threshold yet further and encouraging
potential entrants to develop and exploit new resources. An appropriate litmus
test for the success or otherwise of this form of competition will be whether
there is a move away from arbitrage (brokerage) arrangements to innovation in
supply.
At present, the industry remains highly regulated, complex and difficult to
enter. Regulatory monitoring is extensive and burdensome, particularly for the
smallest water companies. One of Ofwat’s outstanding challenges for the next
decade, therefore, is to examine the means by which this regulatory burden
might be lightened without compromising its effectiveness, and thereby
encourage potential entrants to compete with incumbents. Contestability may
well be an unattainable goal for the English and Welsh water and sewerage
industry. Greater competition is not.
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BIBLIOGRAPHY
Bhattacharyya, A., Parker, E. and Raffiee, K. (1994), ‘An examination of the effect of ownership
on the relative efficiency of public and private utilities’, Land Economics, vol. 70, pp. 197–
2
09.
Bruggink, T. H. (1982), ‘Public versus regulated private enterprise in the municipal water industry:
a comparison of operating costs’, Quarterly Review of Economics and Business, vol. 22, pp.
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