Competition in upstream sewage and sludge markets (PROC/01/0166) Final Report Ofwat Prepared by London Economics 1 Contents Page Glossary v 1 Introduction 6 1.1 Overall aims 6 1.2 Background 6 1.3 Approach 8 1.4 Structure of this report 8 2 Market definition 9 2.1 Sector overview 9 2.2 Overall approach to market definition 12 2.3 Precedents 14 2.4 Market definition – upstream sewage and sludge 16 3 ‘Traditional’ sewage treatment 25 3.1 Background 25 3.2 Potential for and barriers to competition 28 4 Sewage treatment for individual households and small communities 32 4.1 Description of the market(s) 34 4.2 Scope for competition 37 4.3 Enabling further competition 39 5 Sludge treatment and disposal 41 5.1 Background 41 5.2 Description of the market 45 5.3 View of competition 51 5.4 Potential competition 55 5.5 Potential measures to increase competition 58 5.6 Conclusions 58 6 Sludge transport 60 6.1 Description of the market 60 6.2 Other factors 61 6.3 Conclusion 61 7 Pre‐treatment and recycling of wastewater 62 7.1 Description of the market 62 7.2 Competition in the market 62 London Economics February 2010 ii Contents Page 7.3 Barriers to entry 63 7.4 Scope for more competition 63 7.5 Domestic and commercial wastewater recycling 64 8 Overview of scope and options for increasing competition 66 References 71 Annex 1 Summary of responses to Ofwat consultation July 2007 72 Annex 2 ‘Alternative’ sewage treatment processes 74 Annex 3 Indicators of commercial activity 79 Annex 4 Services Sydney Case 85 London Economics February 2010 iii Contents Page Table 1: Market definition summary 24 Table 2: Large works – details 27 Table 3: Alternative systems for domestic sewage treatment 33 Table 4: The different steps of sludge treatment 47 Table 5: Companies active in elements of the upstream sewage and sludge sector in England & Wales 80 Table 6: ‘Sewage treatment’ companies in FAME, other than the ten main undertakers 81 Table 7: Number of Public tenders in 2009 84 Figure 1: Overview of upstream sewage and sludge activities 10 Figure 2: Proportion of works by works’ size – using number and loads received 26 Figure 3: Proportions of volumes treated 2008/09 (%) 28 Figure 4: Alternative treatment solutions for domestic sewage 35 Figure 5: The market for sludge 42 Figure 6: The market for sludge treatment and disposal 43 Figure 7: The market for raw sewage sludge 44 Figure 8: The sludge treatment sequence 48 Figure 9: Sludge disposal and recycling routes for sewage sludge 49 Figure 10: Sludge disposal processes 49 Figure 11: Anaerobic digestion and CHP 50 Figure 12: A potential market for sludge treatment? 57 Figure 13: Examples of cesspool and septic tank 75 Figure 14: Example of a drainage field 75 Figure 15: Examples of package treatment plants 76 Figure 16: Example 1 ‐ Airflow AF14 77 Figure 17: Example 2 ‐ Clereflo MBR 78 London Economics February 2010 iv Glossary Glossary Terminology Sewerage undertaker: The 10 regulated water and sewage companies that undertake sewage treatment in England and Wales. Sewerage: The pipeline infrastructure for transporting sewage from source to treatment. Sewage: The physical material (biological). Abbreviations STW: Sewage treatment works EA: Environment Agency OFWAT: Water Services Regulation Authority (Ofwat) WaSCs: Water and sewerage companies London Economics February 2010 v Section 1 1BIntroduction 1 Introduction This final report has been produced by London Economics and is submitted to Ofwat under contract PROC/01/0166. The research was undertaken over a relatively short period between late November 2009 and January 2010. 1.1 Overall aims The main aim of the research is to provide Ofwat with an independent assessment of: 1) the level of competition that already exists in the upstream sewage and sludge sector; 2) an assessment of the scope for increasing competition in the sewage and sludge markets; and, 3) some options for further developing upstream competition in sewage and sludge markets. By ‘upstream sewage and sludge’ Ofwat mean the treatment and disposal of sewage and sludge and by ‘competition’, Ofwat are referring to ‘in‐the‐market’ competition only. In consequence, the research does not consider benchmarking or franchising approaches to competition or sewerage network activities such as collection and transport of sewage (except insofar as they are relevant to the assessment of in‐the‐ market competition for sewage and sludge treatment and disposal services). The work has not involved the collection of primary data and has been restricted to surveying existing information. Given the short timescales our analysis is not as complete or as comprehensive as a much fuller competition analysis could be, involving the use of tailored industry surveys and so on, but we believe that it should provide Ofwat with a reasonable and sensible basis for taking the policy process forward. 1.2 Background In 2007 and 2008, Ofwat undertook a review of competition in the water and sewerage sector in England and Wales. Whilst the review focussed mainly on competition in water services, consideration was also given to competition in sewerage services. Following consultation in July 2007, Ofwat proposed in December 2007 that the Government should introduce retail competition in sewerage services under the Water Supply Licensing regime and that Ofwat would further explore the scope for combined sewerage competition.1 More than half of respondents to the 1 Ofwat reached similar conclusions in the second report on their review, published in May 2008. 'Combined competition' is a term from the legislation and means a licence which allows an entrant to compete in retail and common carriage competition. London Economics February 2010 6 Section 1 1BIntroduction consultation did not agree that combined sewerage competition should be explored further citing costs and lack of benefits to consumers.2 In 2008 and 2009, Professor Martin Cave undertook a review of competition and innovation in the Water sector in England and Wales. The review made a number of recommendations. Those related to the sewerage sector included: the introduction of retail competition for sewerage services alongside water services; a step by step approach to introducing more competition, starting with the introduction of a ‘market‐like framework’ that includes: o an economic purchasing obligation (for both water and sewerage services); o Unbundling the current combined supply licence to allow more specialisation; o The creation of an upstream sewerage and sludge licence alongside the upstream water supply licence created by unbundling the combined supply licence. o Raising the transparency of water and sewerage supply costs at different stages in the value chain; o Introducing an ex ante access pricing framework based on forward‐ looking long run avoidable costs at the water resource zone level.3 for the longer term (post 2015) consideration should be given to the introduction of an independent contracting entity to buy water and wastewater services from suppliers and sell them on to retailers; the review suggested that the advantage of measures to encourage in the market competition would vary across the country and across the value chain, but suggested that at present the risk‐return ratio is too uncertain to proceed further. The aim of our research is to consider what initial steps Ofwat might take in order to increase the scope for in the market competition in the long term, indicating which markets are most likely to be amenable to this type of competition. We have not made any direct assessment of the costs and benefits of upstream in the market competition in our research. Instead we have focussed on assessing the level of existing competition and on options for increasing the level of in the market competition. In order to assist Ofwat, we have made the assumption, for the purposes of this analysis, that competitive arrangements for retail sewerage services will be introduced, as will the extension of revised common carriage arrangements for sewerage as proposed in the Cave Review. 2 Ofwat’s summary of these responses is included in Annex 1. 3 The review does not refer to sewerage costs specifically here, but it may be more appropriate for sewerage costs to be estimated at the sewerage network level. London Economics February 2010 7 Section 1 1BIntroduction 1.3 Approach Following an initial review of the main activities and processes that make up the upstream sewage and sludge sector we reviewed the literature relevant to competition in this area, searching in particular for precedents for market definitions and competition analysis; and we also used the FAME database and other methods, such as web searches, to obtain an indication of the range of companies active in these markets. We also reviewed stakeholder responses to the various consultation papers that have been issued in respect of competition in the water sector in England and Wales and had telephone conversations to clarify specific questions with one of the water and sewerage undertakers and with the Environment Agency. Using the evidence we gathered, we defined markets in the sector and then assessed the level of competition in each of those markets and considered the options for improving competition in those markets. Our approach to market definition and competition assessment was based on the standard approaches used in competition cases. For each market we consider whether the suppliers of goods or services in that market are likely to have any market power with respect to purchasers, or whether purchasers are likely to have any market power with respect to suppliers. Nevertheless, because many of the activities are vertically related, effective competition in some of the markets may not mean that the final consumer of sewerage services directly benefits from that competition.