Unit 3 Micro: Economics of the UK Water Industry

The English water and sewerage industry was privatised in 1989 and since then household and business consumers have received water services from a regional monopoly business. Companies such as Thames Water or Severn Trent are vertically integrated, water companies, which provide a ‘source to tap’ service: obtaining water from source through abstraction, treating it to an appropriate standard, and providing it to customers’ taps via company-owned infrastructure. Only very large business customers are able to choose their supplier.

In Wales, Glas Cymru is a single purpose water and sewerage company with no shareholders run solely for the benefit of customers. Scotland and Northern Ireland have retained the state-owned model.

Post privatisation, an industry regulator OFWAT was created. Like other regulators OFWAT has a number of roles including the aims of promoting the public interest and increasing cost effectiveness of the water and sewerage suppliers. The water industry has been subject to price controls over the last twenty three years with each price-control regime lasting for a period of five years. The current price control lasts until 2015.

OFWAT argues that their policies have delivered substantial benefits to both consumers and the environment. They point to improved environmental compliance, with 98.6% of bathing waters meeting required standards and 99.95% compliance in meeting EU standards for clean drinking water. Water suppliers have reached a level of productive efficiency such that a litre of water is delivered and taken away for less than half a penny. OFWAT points out that water and sewerage companies have invested about £90 billion (in today’s prices) over the past two decades.

Rising cost of water bills

Despite this there are many critics of the performance of the industry and the regulator. Annual customer bills have soared from an average £64 to £376 since 2001 and an estimated 2.4 million households have trouble paying their water bills. In addition, for many years private water companies have been accused of not doing enough to cut the rate of leakage. Here is an example. Severn Trent supplies water and sewerage to households and industry across much of the Midlands and mid-Wales and it loses about 20 per cent of its treated output to leakages from its pipes. That is mid-range within an industry average of 15 per cent to25 per cent lost. Rising bills, high leakage rates and frequent hosepipe bans have combined to create a high level of customer dissatisfaction with many water companies.

Ageing infrastructure

In their defence, regional water monopolies argue that they are struggling to deal with 100-year-old water distribution networks which are being gradually being replaced at 0.5 per cent a year. Cutting leakages is an expensive business, replacing all the pipes in England and Wales would cost an estimated £100 billion - and still leakage levels would only be halved. OFWAT has the power to impose fines on water companies that fail to meet leakage reduction targets. In 2006, Ofwat imposed an effective fine of £150m on Thames Water and in 2007 Severn Trent was fined £36m for underreporting leakage rates.

The current system of pricing for the Water industry allows for above-inflation annual rises in water bills to help provide extra finance for investment in infrastructure. As far as water leaks are concerned, Ofwat sets leakage reduction rates, but leaks are only fixed when the cost of lost water outweighs the cost of repair – this policy is known as Sustainable Economic Level of Leakage (SELL)

Foreign ownership

The UK water industry has seen a number of foreign takeovers over the years, indeed in 2012 there are only three water suppliers listed on the UK stock exchange. In 2001, Thames Water, with 8.5 million water customers, 100 water treatment plants, 290 pumping stations and 235 reservoirs was acquired by Germany’s RWE, one of Europe’s largest power utilities. It was then bought by Kemble Water, controlled by Australian infrastructure fund Macquarie. More recently, Cheung Kong Infrastructure bought Northumbrian Water for £4.74bn; Capstone, the Canadian infrastructure fund bought a controlling stake in Bristol Water for £133m; the Abu Dhabi Investment Authority has acquired a 9.9 per cent stake in Thames Water’s holding company Kemble and the China Investment Corporation, the country’s sovereign wealth fund has taken an 8.68 per cent stake in Kemble for an undisclosed sum.

Barriers to entry and competition in the market

The vast majority of consumers have no choice over which business supplies water to their home. In this sense there is virtually no competition at retail level and it is difficult to see how this might be changed with a huge level of new investment into the water sector. The biggest barrier to entry is the need for any new water supplier to gain access to treated water and sewerage treatment plants.

Some people believe that market reforms in the water industry could draw on lessons from structural changes in electricity and gas sectors. New water “retailers” would buy water wholesale from existing companies at prices regulated by Ofwat and seeking to win business from incumbents by offering preferable prices and/or services to their customers. This system was introduced into Scotland in 2005.

Others believe that fewer water companies in the industry might boost the performance of the sector. Steve Mogford, chief executive of United Utilities, and Richard Flint, chief executive of Yorkshire Water have been reported as arguing that having just six to eight water companies in England would give greater opportunities for economies of scale, leading to lower average bills for consumers and also allowing water to be moved around more easily, helping to guarantee supplies to customers.

Growing environmental and economic pressures on water

Undoubtedly, the water supply industry across the UK faces many challenges going forward including a changing and unpredictable climate and the effects of population growth, particularly in the south-east of England where water is already scarce. Suppliers also face rising cost pressures from tighter environmental standards including implementing the EU Water Framework Directive which covers water quality and protecting the eco-systems in water systems from over-extraction.

Water pricing – should meters become universal?

At a more fundamental level many are now asking the question - is water for household and business use under-priced? The cost of household supplies is less than £1 per day and some economists and industry experts argue that introducing mandatory water metering is required to cut non-essential water consumption and reduce the risk of water restrictions becoming more frequent in the years ahead. The Institution of Civil Engineers (ICE) has made a call for universal metering and removal of regulations discouraging water sharing between neighbouring companies. The Environment Agency wants most households in the South East to have water meters by 2015 and all homes in Britain by 2030. Water meters cost up to £250 to install, which is paid for by the customer through water bills. It costs around £10 per year to check the meters although smart metres can be checked remotely.

As well as universal metering, ICE said discretionary tariffs should be introduced to protect the poor. These would be known as social tariffs and would cut prices for Britain’s poorest households. Some water companies are experimenting with seasonal tariffs where water is priced more highly during peak summer months.

In addition to measures designed to control or reduce consumption per capita, investment is also needed in increasing levels of water catchment. This might involve building new reservoirs and constructing medium and small scale storage, such as household and community-scale rain water harvesting and Sustainable Drainage Systems in urban and rural areas. Even individual households can make a difference for example collecting raw rainwater in butts for use in gardening and car washing.

Notes:
• Most households in England and Wales receive bills where the price is fixed depending on a home’s ‘‘rateable value’‘
• Around 40% of households have water metres installed where water is charged according to the amount consumed
• The average water bill in England and Wales is £376, which costs 11 per cent of households more than 5 per cent of their disposable income

Water use / consumption
• 70 litres are used in the production of one apple, and 15,500 litres for one kilogram of beef
• UK daily water consumption per person is about 150 litres
• 63% of daily water consumption at home originates from the bathroom and the toilet
• Flushing the toilet uses approximately a third of daily water consumption
• Sprinklers can use as much as 1,000 litres of water per hour - more than a family of four can use in a whole day
• A dripping tap wastes at least 5,500 litres of water per year
• Global demand for water is forecast to outstrip supply by 40% by 2030 due to factors such as population growth and climate change.
• Around 40% of homes in England and Wales are metered - for over half of the population there is no direct connection between the amount of water that they use and the size of their water bill