With non-household retail competition in England in only a few months’ time, water companies are looking carefully at how they are structured. Retail separation has the potential to give companies greater strategic flexibility.
So what is actually meant by retail separation? Separation can range from basic accounting separation through to full ownership separation, with many steps in between (such as establishing separate business units within an overall structure, with varying degrees of autonomy).
New opportunities in the market could range from forming new partnerships, targeting particular customer segments, through to full divestment. Furthermore, the greater the degree of separation between a water company’s contestable and non-contestable functions, the easier it will be to avoid falling foul of competition law.
Competition law requires that dominant companies do not abuse their privileged positions. Such abuses could include price and/or non-price discrimination. With the former, if wholesale prices are set too high and/or retail prices are set too low, such that it is not possible for another company to pay the wholesale price and compete effectively, then competition authorities may deem this to be a ‘margin squeeze’.
One notable example of margin squeeze is where the European Commission ruled that Deutsche Telekom was in breach of the law.1 In this case, the precedent was set that a company is not exempt from competition law merely because the regulatory body had approved its charges; a point that Ofwat has made repeatedly.2
When undertaking margin squeeze analysis, two approaches are commonly used: the ‘equally efficient competitor’ test and the ‘reasonably efficient competitor’ test. The former considers whether the incumbent would be able to provide the retail service to the customer in question were the incumbent not receiving wholesale revenues. The latter considers a notional competitor (i.e. a hypothetical ‘efficient’ company according to the regulator’s measures), which is a more stringent cost benchmark.
Ofwat has indicated that it favours the former approach. This is broadly in line with established precedent.3 As well as the end prices offered, equal consideration needs to be applied to how the underlying costs are treated. Essential for ensuring a level playing field are fair allocation of costs between the services provided by the companies, and making sure that interactions between the retail functions and the parent companies (such as the provision of working capital) are at arm’s length.
Non-price discrimination can refer to the incumbent’s wholesale function offering a competing retailer a different level of service to that provided to the incumbent’s retail function. This can be one of the most difficult potential abuses for management to guard against. Staff right across the company may be used to particular ways of working – for example, simply sharing information with people operating in the same business. The extent of retail separation may help to mitigate this (sitting functions in different locations could help), as could cultural training.
Ofwat has already sought commitments from Bristol Water, which proposed structural separation of its wholesale business from its retail business for the provision of the already contestable developer services.4 This was intended to help ensure equivalence in both price and non-price terms for equivalent transactions.
In summary, with the non-household retail market opening in only a few months’ time, water companies in England will be considering how, or whether, they will want to compete in the market, and, if they do, how they should structure their businesses for success. Separation is not a binary concept; different degrees exist. But as long as ownership integration remains, companies will need to think carefully how to stick within competition law.
