14 December 2011

Cutting edge regulation at Ofwat

Ofwat has regulated investor-owned water companies in England and Wales since privatization in 1989. These regulations have often been on the frontier of performance incentives, which means that Ofwat is often the first regulator (worldwide) to attempt to put new incentives into place.

One such scheme -- "common carriage rates" for one water company to use another company's network for serving a customer -- was a good idea that has failed in practice: only one customer out of 2,200 eligible customers signed up.

I spent two days in London recently, learning about Ofwat's latest ideas on regulation.

On Monday evening, I participated in a panel discussion on big strategic questions regarding sustainable water. Many of my answers to questions involved more pricing (less regulation) and more markets (less management), which may not be news to readers of this blog, but was more often news to the audience.

On Tuesday, I participated in workshops on water trading and breaking the vertical monopoly, i.e., separating the monopoly wholesale monopoly on sourcing, treating and distributing water from the (potentially) competitive business of administering customer services and billing (post to come).

Most water trading proposals involve long term sales from water companies in surplus areas to other companies in shortage areas. Participants wanted to find the "right price" for a this bi-lateral monopoly structure, but that price is hard to know. Some suggested that the regulator should set the price; others worried that prices and deals might come unstuck in year 22, say, which would upset financial markets.* Even worse, there was no clear indication of how profits from trades (on both sides) would be treated against regulated returns. It's clear that profits could not be used to lower prices, but also clear that prices SHOULD move in response to rising/falling revenues. These discussions were even premature -- given the importance of quantifying water rights that were both over-issued (familiar problem!) as well as badly specified. I suggested that participants look to existing water markets in Australia for success (and California for failure), while attempting to bring in as many ideas as possible from competitive markets. We'll see how this project develops.

Despite all of these problems, Ofwat can move towards wholesale markets for water (abstraction permits and flows) by starting trade among homogenous groups:
  1. quantify rights, 
  2. set a simple transaction structure, and
  3. ensure access to conveyance.
Problems of bi-lateral monopoly, price discovery and trading volume can be addressed via my all-in-auctions idea. Start with short-term trades before moving to long-term trades. Also note that robust market institutions will be useful in coping with changes in environmental flows, adapting to climate change, and maximizing flexibility among different water users. They should NOT be used to increase water consumption, since such "optimization" will remove buffers from systems that will need them in case of big disruptions (everything from infrastructure failure to drought).

For deeper thoughts on these issues, I recommend Jon Stern's papers on reforming and improving water company performance. Begin with this short overview of the industry [PDF], then read Jon's proposal for including scarcity charges in water prices [PDF]. (Are you folks in the "water crisis" areas listening?). You can also browse most of his papers here. HIGHLY recommended.

Bottom Line: Ofwat's process of inviting discussion from industry, interested parties (consultants, consumer groups, other ministries) and outsiders (me!) is a brave and useful way to explore and design innovations in water regulation that will keep water companies in business while benefitting consumers.

* Water companies are far too coddled by regulators, which is why financial markets love them (guaranteed returns!). It would be better to put more emphasis on company performance -- including taking more risks -- than on stable cash flows.

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