Future Access Pricing in the Water Sector a Discussion Paper

Water today, water tomorrow

Future access pricing in the water sector A discussion paper

www.ofwat.gov.uk Future access pricing in the water sector

2 Water today, water tomorrow

About this document

This document introduces some of the terminology, concepts and issues we will need to consider in developing a new charging rules framework for access pricing for the water sector in England and Wales. It describes:

• what access pricing is and why it matters; • some of the key issues we will need to consider around access pricing; • which costs could be considered in setting access prices; and • the lessons that we can learn from other sectors.

The UK Government’s Water Bill, published in June 2013, will extend the role of competition in the sector in England. This will mean new companies will have access to the systems and services provided by monopoly water and sewerage and water only companies. The Water Bill also requires us to prepare rules that monopoly companies will need to follow in setting the prices they will charge for providing access.

Contents

1. Why does access pricing matter? 4 2. What are the main issues? 8 3. Which costs should we consider? 12 4. What lessons can we learn from other sectors? 15 5. Next steps 26 6. Further information 27

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1. Why does access pricing matter?

Most people in England and And in June 2013, the UK Together these reforms will Wales receive their water Government published draft encourage: services from one of 19 licensed legislation (the Water Bill) to regional monopoly companies achieve this vision. Once the • greater competition in providing and their sewerage services from changes in the Bill become law, it certain services; one of 10 companies. Some will – among other things – allow: • the delivery of improved customers also receive services services, and lower prices to from licensed local companies • all non-household customers in end consumers; (new appointments). Only certain England to be able to choose • greater innovation; and non-household customers can their retail supplier (‘retail • increased transparency of costs choose their supplier. reforms’); and leading to more informed • new companies – called ‘new decision making around Each monopoly company entrants’ – to become licensed environmental trade-offs, in turn currently provides a ‘source to to supply particular wholesale leading to improved tap’ business in its area to services (‘upstream reforms’). environmental outcomes. household and non-household They would not have to provide customers (it is ‘vertically any retail services to end In particular, the UK Government integrated’). It controls: customers as they do under the has estimated there could be current water supply licensing overall benefits of £2 billion to • customer-facing (‘retail’) (WSL) framework. They would customers, the economy and the services such as reading water also be able to provide environment from its reform of meters and sending bills to sewerage services. wholesale services. customers; and • less customer-facing (‘wholesale’) services such as collecting and treating water and wastewater.

The Water Bill Water supply licensing The Water White Paper (‘Water for Life’), which was published In 2005, the water supply licensing (WSL) framework was December 2011, described the introduced to encourage competition in water retailing UK Government’s vision for future water management in England in activities and upstream water resource activities. which: Under WSL, new companies can supply any non-household • the water sector is resilient; customer that uses more than five million litres of water a year • all water companies are more (50 million litres a year in Wales). efficient and customer focused; and Companies can only supply retail services or combined retail • water is valued as the precious resource it is. and wholesale services. So they are unable to specialise in offering particular services. This limits the scope for them to innovate and deliver lower prices or improved services.

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The costs principle Access to what? Historically, the costs principle has been interpreted as If new entrants are to provide requiring monopoly companies to charge access prices based wholesale services, then they will on ‘ARROW’ costs. These are costs that, as a result of being need to interact with the existing replaced as the supplier, the monopoly company: monopoly water and sewerage companies. This may involve the monopoly companies charging • avoids; new entrants a price for using • reduces; or (‘accessing’) their infrastructure. • recovers in other ways.

Access to a monopoly company’s water supply and sewerage infrastructure may include principle has been widely • principles for determining the access to: criticised as being anti- amount of any charge that may competitive and for giving little be imposed. • networks; incentive to monopoly water • storage facilities; and companies to become more Alongside charging rules, we will • treatment works. efficient. set rules in the form of codes of practice (‘market codes’), with For example, a new entrant could The Water Bill seeks to remove which all parties will have to apply for a ‘wholesale the costs principle from comply. These codes will describe authorisation’, which would legislation, and in its place give what is expected of all market enable it to introduce water into Ofwat the ability to issue new participants, which will enable the the supply system of an existing charging rules. market to operate efficiently in monopoly company. So, the customers’ interests. We set this monopoly company will charge a out in further detail in our price for moving the new entrant’s New charging rules discussion document on ‘Water water through its pipe network. market governance The Water Bill proposes that we arrangements’, which we A new entrant may also wish to should set charging rules for published in October 2013. purchase a range of other access pricing that cover: services from the monopoly company. • the types of charges that may be imposed; • the amount (or the maximum What price? amount), or methods for determining the amount (or In the past, prices that monopoly maximum amount), of any type companies could charge for of charge; access to their infrastructure have • principles for determining what been calculated by using the types of charges may or may ‘costs principle’. But the costs not be imposed; and

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Bulk supplies What should the charging Closely linked to access pricing is the pricing of bulk supplies. rules deliver? A bulk supply is a supply of water from one monopoly company to another. Bulk supplies are sometimes referred to As an economic regulator we have a range of duties. Our as ‘water trades’ as they are a way for companies to trade primary duties are to: water. • protect the interests of The Water Bill also seeks to provide Ofwat with the ability to consumers, wherever set charging rules for bulk supplies. So it may be desirable for appropriate by promoting us to consider the charging approach for bulk supplies competition; alongside access pricing, as there are many similar issues to • ensure that the companies properly carry out their be resolved across these two areas. This includes: functions; and • ensure that the companies can • sending efficient price signals; finance their functions. • encouraging environmentally sustainable outcomes; and • ensuring efficient companies can finance their functions. The Water Bill also proposes to give us a new primary duty to ensure resilience of water and sewerage services.

Our secondary duties include:

• promoting economy and efficiency; • ensuring that no undue preference or discrimination is

The UK Government has estimated there could be overall benefits of £2 billion to customers, the economy and the environment from its reform of wholesale services

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shown by companies in the around environmental trade-offs fixing of charges; (our sustainable development • contributing to the achievement duty). of sustainable development; and We will also need to ensure that • having regard to the principles the various stakeholders involved of best regulatory practice. in water and sewerage service delivery have appropriate controls We also need to have regard to and accountability on the quality the framework – and specific of water delivered to customers guidance – from the UK and and discharged into the Welsh Governments. environment. This is likely to be enforced through a combination So we will need to deliver an of market codes, licence access pricing framework that conditions, and/or other helps enable: subsidiary documents.

• greater efficiency in the provision of services, leading to How will we develop new lower bills for customers (our access pricing rules? customer duty, and our efficiency duty); We plan to consult on our • more choice and flexibility in the preferred approach in due course. provision of services, leading to But we want to begin the debate greater sector-wide resilience with our stakeholders now on how (our yet to be enabled resilience to develop the best approach to duty); and access pricing, and would • greater transparency around welcome your views. costs, leading to more informed decisions being able to be made

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2. What are the main issues?

There are a number of issues we detailed information about their cause a change in their local will need to consider in costs would also place a burden costs (‘cost drivers’). But: developing our approach to on them – and ultimately access pricing. We explore some customers, who will pay these • this is provided it was more of them in more detail below. costs through their bills. efficient for companies to capture data on drivers rather One potential compromise would than their specific costs; and Preventing monopoly be for us to require companies to • producing and maintaining such abuse develop cost models based on models could still involve their average costs of providing companies using a significant The water sector in England and access, but with factors that amount of time and resources. Wales is dominated by vertically integrated companies. This may give these companies the incentive (and the ability) to The cost information that monopolies provide discriminate against new entrants in favour of their own operations. Over the past few years, we have required monopoly This is a fundamental concern companies to provide us with data about the different activities that we will need to address (‘business units) that they carry out. through access pricing and by using other tools such as market This means they report the accounts (costs, revenues, assets codes. and liabilities) for their different business units to us separately. We call this accounting separation. Selecting the right level of cost information Accounting separation has helped us improve significantly the way we regulate the companies. If we are to ensure monopoly companies recover no more than We want to take steps in the next price control period to their costs of providing access, improve the way we regulate companies’ monopoly network we will need to make sure they when we next set prices in 2019, through the phased base their access prices on their introduction of two new tools: costs. And to do this, cost data will be required that are suitably fit for purpose for each of the • network plus – designed to reveal information about costs relevant charges. and revenues related to companies’ network and treatment activities; and The more detailed the cost • network management – designed to reveal information information used, the more about companies’ network management policies, practices effective the price signals that and cost drivers. access pricing could send. But asking companies to collect These new tools will reveal information about companies’ costs, and could help enable effective access prices to be set.

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De-averaging used in setting price limits. overall allowed return from the Initially, it represented the value of relevant wholesale services. In order to set efficient access companies at privatisation. Over prices, it is likely that localised time, companies’ RCVs have To ensure that individual costs will need to be considered, been increased by their capital wholesale charges are consistent rather than simply using a investments and inflation, and with the revenue requirement, the company’s average costs. decreased in line with the RCV-based return could be depreciation of their assets. ‘allocated’ to regulated charges Some stakeholders have raised However, RCVs do not relate to for different services, which in concerns that this may result in any specific asset. aggregate summate to a significant de-averaging of company’s total revenue customers’ bills. However, this is In setting allowed revenue for requirement. not necessarily the case. most licensed companies’ Companies’ end household wholesale services, Ofwat allows One challenge associated with charges will still be regulated. a return based on companies’ this approach is that the RCV is RCVs. Companies require such a not attributable to the costs Independent expert George return in order to finance incurred in providing specific Yarrow has stated that: investment in wholesale services wholesale services – that is, the and supporting infrastructure. RCV is a construct that The value of replacing assets with represents the capital associated “…so long as those of similar capabilities is with a wholesale water or transportation of the reflected by modern equivalent wastewater business in asset values (MEAVs), which can aggregate. Therefore, to apply relevant commodity be identified for each asset. this approach, a means of remains a regulated allocating RCV-based return to monopoly, there is no Companies’ MEAVs are different wholesale services reason to think that the significantly higher than their would be required. introduction of competition RCVs. The total industry’s RCV is about 12% of the total net MEAV One way of doing this could be to into other activities because of the way in which the allocate the RCV-based return to undertaken in a sector will industry was privatised. different services proportionate to give rise to any immediate the MEAV identified to those and direct pressures for If access prices were to be set services. We call this an a major change in the with the return based on RCV, ‘unfocused’ allocation. The risk there is the potential for charges associated with this approach is geographic pattern of to be set below the efficient level that it could restrict the provision pricing”. due to the heavy RCV discount. of efficient price signals and However, setting access prices hence the development of without directly considering effective competition. This is RCV discount companies’ RCVs, may – in the because the return to wholesale future – create a risk of services in the contestable parts A company’s regulatory capital companies either over- or under- of the wholesale value chain value (RCV) is the capital base recovering contributions to their would reflect the large RCV

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discount, so that incumbents Helping the environment we may need to write market would be able to price lower than codes with environmental efficient entrants purely as a Setting access prices for considerations in mind. result of the legacy of monopoly services will help privatisation. enable water trading to be We may also wish to consider undertaken on a consistent basis explicitly reflecting environmental An alternative could be to adopt a with aligned bulk supply prices – costs can be a subjective ‘focused’ allocation. This would and help reveal the value of this exercise, albeit one which the involve making a decision about resource, which varies widely sector must undertake on a how the RCV-based return should across England and Wales due to regular basis (for example to be allocated to different services. localised supply and demand prepare water resource For example, most of the RCV- conditions. management plans, river basin based return could be ‘allocated’ management plans, and business to contestable services in setting Access pricing could help send plans). There is also a limits on the prices for different more efficient price signals fundamental question of who services (for example via ex ante around transporting water, which should bear which costs, which sub-limits or charging rules), can be an energy-intensive the Government is considering in which would generate higher activity. It could also more clearly 2015 in the context of river basin charges less biased by legacy reveal the cost of leakage on management plans. privatisation outcomes for the different parts of the companies’ contestable areas and offsetting networks. lower charges for the monopoly Interactions with the 2014 areas, and hence increase the This, in turn, could help inform price review scope for effective competition. decisions on how and where best to reduce the volume of water In 2014-15, we will decide the Alternatively, the RCV approach taken out of the environment price and service package (the could be maintained for setting (‘abstracted’) by companies in ‘price controls’) that each of the price limits for services provided areas where this does cause monopoly water and sewerage by the core monopoly parts of a damage. This would help protect and water only companies in company’s business, and the environment and result in England and Wales must deliver alternative methods for setting more efficient investment. in each of the five years between prices could be used in the more 2015 and 2020. contestable areas. This would The UK Government plans to extend the approach we have carry out a fundamental reform of In ‘Setting price controls for already taken for contestable the way the abstraction of water 2015-20 – final methodology and retail services. is paid for and managed in the expectations for companies’ coming years. So, in developing business plans’ (our ‘methodology Care would need to be taken to an access pricing framework, we statement’), which we published avoid inefficient asset stranding in may need to stay flexible to in July 2013, we confirmed that the process, which would drive up accommodate future abstraction we will use a range of innovative the costs of financing investment reforms. However, before regulatory rewards and penalties above efficient levels. abstraction reforms take place, (‘incentives’) to encourage

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companies to deliver efficient and sustainable services to customers and the environment. These include:

• a total expenditure (totex) approach to cost assessment and revenue recovery; • incentives to encourage companies to trade water where it makes economic sense; • an abstraction incentive mechanism (AIM) to encourage companies to reduce over- abstraction; and • proposals for companies to reveal more information about their upstream value chains during the price control period.

In developing an access pricing framework, we will need to ensure that there is suitable alignment to our price control Setting access prices for monopoly incentives. This is so that there services will help reveal the value of are no unintended distortions in the incentives that companies this resource, which varies widely face. across England and Wales

Interactions with the Open Water programme

Ofwat, the UK and Welsh Among other things, the Open water and sewerage services Governments, companies, and Water programme will: in Scotland. other regulators have formed a High Level Group. The group is • develop market codes; There are many key interaction directing the work necessary to • identify the necessary data, points between any decisions we prepare for the implementation of processes and systems; and make with regard to charging, markets proposed by the UK • establish arrangements to and what the Open Water Government’s Water Bill (the encourage interaction with the programme will need to deliver. ‘Open Water programme’). competitive market for retail

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3. Which costs to consider?

In developing an access pricing framework, we will need to consider the type of costs that are Cost recovery at the 2009 price review used to set access prices. There are many different types of costs In 2009, when we set the limits on the prices that monopoly involved in providing a service, companies could charge during 2010-15, companies were: and they can be considered in different ways depending on: • allowed to earn a return on their asset bases, which reflected their historic and forecast investment; • the time period to which they relate; • funded their depreciation charges on these assets based on • the products and services (the current cost accounting; and scope) they cover; and • funded their operating costs based partially on: • their economic nature (see ̶ their expenditure in a particular year (‘base year’), minus below). an efficiency challenge; and ̶ forecasts about how specific costs would move to meet Choices in these areas will expected future demand. determine the incentives that exist for new entrants and existing companies – and how they will behave as a result. price signals about efficient future of historic, current, and forward- Ultimately, this will affect how well investment. This is because they looking costs. markets operate, and the benefits are intended to reflect the costs that are delivered to customers, that companies will incur to meet the environment and the wider demand. But setting prices on a Scope of costs economy. forward-looking basis can create issues of companies either Infrastructure networks can be Below, we discuss each of the recovering too much or too little complex. Allowing access to a three areas – and the choices of the revenue they need to new entrant may result in an that can be made within them. finance their functions overall, as existing company incurring prices would be one step additional localised operating removed from the costs costs. Potentially, it may also Time period of costs companies currently incur in require them to reinforce their financing their functions. network in other areas. Prices can be set by considering monopoly companies’ historic, In setting the prices that The extent to which a price current, or forward-looking costs. monopoly water and sewerage reflects direct and indirect costs is companies could charge their often referred to as the ‘depth’ of Arguably, forward-looking costs customers in the past (‘price the charge. are the most effective at sending reviews’), we used a combination

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Charges could also be solely or Economic nature of costs partially based on the amount of capacity that a monopoly There are a number of different types of economic classifications of company provides a new entrant, costs. These include the following. rather than solely on an absolute volume of a service or commodity. Fixed and variable costs. Costs can vary with different In some cases, it can make more measures of demand. But some costs do not vary at all and are sense to allow monopoly fixed. When considering which costs are fixed and which are companies to set their prices variable the relevant time period is key. In the short term, some based solely on capacity rather costs (particularly capital costs) are fixed. The shorter the time than the short run costs incurred period considered, the more costs are likely to be fixed. In the very – for example, if the provision of long term, all costs are considered to be variable, although in the the capacity is the main cost water sector some network assets have lives of 100 years or more. driver for the company.

But excluding all short run costs Incremental cost. This is the cost of producing a specified can lead to inefficient operating additional amount (‘increment’) of product, service or output over a practices, as companies are specified time period. Another way of expressing this is that the shielded from the effects of their incremental costs of a service are the difference between the total short-term decisions. costs in a situation where the service is provided and the costs in another situation where the service is not provided. Incremental costs are often assessed where particular investment decisions are being considered (for example, to serve new customers).

Short run marginal cost (SRMC). This is the additional cost of providing an additional unit of service or product in the short term, assuming there is no change to companies’ fixed assets. SRMCs are often used where maximising the use of existing capacity is identified as a key objective. Setting prices at SRMCs ensures that anyone wanting to buy a particular product or service is able to do so at a price that will cover the short-term costs of providing that service. But SRMC pricing means that prices will not cover a company’s fixed costs. As well as potentially creating financing issues for existing assets, this can lead to limited incentives for companies to invest in new assets.

Long run marginal cost (LRMC). This is the additional cost of providing an extra unit of service or product in the long term. But LRMC pricing creates a disconnect between the costs a company currently faces (driven by its existing network) and the prices it sets (reflecting potentially different future network decisions). This can create issues of companies either recovering too much or too little of the revenue they need to finance their functions overall.

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Long run incremental cost (LRIC). This is the additional cost of meeting a defined sustained increment of demand for services or products in the long run. For example, it would include the capital and operating costs of a new asset required to meet demand over the long term.

Fully allocated cost (FAC). This is an accounting approach under which all of a company’s costs are distributed between its various products and services. This ensures that companies do not recover too much or too little of the revenue they need to finance their existing functions overall.

Stand-alone cost (SAC). This is the cost of meeting a defined demand for a particular service on its own. These are the costs incurred by a new entrant in a given market with no existing customers for the service concerned. It is therefore often important to consider the SAC when considering whether it is possible for an alternative company to enter a market and provide a given service.

Distributed long run incremental cost (DLRIC). This is a cost measure related to the LRIC of a given product or service that forms part of a broader service (or product). The DLRIC of an individual service is equal to the LRIC of the service plus a share of the costs that are common between different services in the broader package (for example a regulated company as a whole). The sum of the DLRICs of all the individual sub-services is equal to the LRIC of the overall package of services.

Distributed stand-alone cost (DSAC). The DSAC of an individual service provided as part of a broader package of services can be calculated by distributing the SAC of the broader package between all the individual services within the package arising from providing the package of services together. So each individual service takes a share of the common costs. The sum of the individual service DSACs is equal to the SAC of the broader service.

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4. What lessons can we learn from other sectors?

Other regulated sectors have their own access pricing frameworks. Some aspects of other sectors are not directly comparable to the water sector. But there are still a lot of useful lessons available to us in developing an access pricing framework that allows new entrants effective access to monopoly assets or services. Studying access pricing in other industries reveals that:

• approaches to access pricing can be complex; • a range of pricing and governance approaches can be used depending on the specific issues at hand; and • approaches can evolve and develop over time.

In this chapter, we consider the access pricing frameworks in the:

• water industry in Scotland; • post in Great Britain; • rail in Great Britain; • telecoms in Great Britain; • gas in Great Britain; • electricity in Great Britain; • airports in England; and • water industry in Australia.

We also set out some of the lessons we learn from them in developing a future access pricing framework for the water sector in England and Wales.

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The water industry in Scotland

In Scotland, all non-household customers can choose their supplier for water and sewerage retail services. Competing retailers buy wholesale services from Scottish Water to sell on to their end customers. Scottish Water also has a retail business (‘Business Stream’) that competes with other retailers to supply customers.

This is a form of access pricing, as third parties are buying a monopoly’s services. Potential lessons

Scottish Water (the only We could require monopoly wholesale company) publishes a companies to publish their series of wholesale charges and wholesale charges the associated methodology for calculating them. This is then The Water Bill does not propose alongside a detailed available to entrants and potential for the monopoly companies in charging methodology. entrants. England and Wales to be legally separated, which places an even Wholesale water and The risk of Scottish Water greater importance on developing sewerage access charges an effective access pricing abusing its dominant position is can include availability and mitigated by: framework. capacity components. • the Water Industry Commission Scottish Water’s wholesale for Scotland (WICS) – the charges comprise a number of economic regulator – setting the different components. Some company’s allowed revenue; charges are split in terms of a and charge for operating and a charge • Scottish Water being legally for availability. Some charges are separated from its non- levied on a capacity basis, while household retailing activities. others are single unit charges.

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Post in Great Britain

In the postal sector, third parties can insert mail downstream (closer to the point of final delivery – that is either avoiding pillar boxes, or avoiding pillar boxes and the outward functions of mail centres) in Royal Mail’s value chain. As in water in England and Wales, Royal Mail is a for-profit vertically integrated provider of services in both wholesale and retail markets.

Ofcom – the economic regulator – does not directly regulate the access prices that third parties are charged by Royal Mail. Instead, it uses a test (an ‘ex ante margin squeeze’ test) to ensure that the difference between the access price and the equivalent retail price will cover the incremental cost of the company providing the service.

Royal Mail and the third parties have some degree of flexibility in negotiating the terms and Potential lessons conditions of access agreements within a code subject to There is regulatory regulatory oversight. A process is precedent not to set used to resolve disputes where detailed rules, instead they cannot agree. between its access prices and the defining an appropriate set equivalent retail prices. of checks and balances Ofcom considers that long run incremental cost (LRIC) Royal Mail has yet to produce where industry participants structures provide correct signals robust LRIC models. In the are able to take the lead in for entry in the market, and that interim, a proxy for LRIC has negotiating detailed terms. Royal Mail should set its prices to been assumed to be 50% of fully maintain a minimum LRIC margin allocated costs (FAC). A LRIC-based approach can be seen to provide effective signals for market entry.

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Rail in Great Britain

Network Rail owns and operates directly incurred. This is is also designed to compensate most of the rail network assets in interpreted as being the short run Network Rail for increases in Great Britain. Train operators are marginal cost (SRMC) of using volume-related payments. separate companies that pay the network (that is, costs that • A charge that recovers the costs Network Rail to use the network. vary with traffic). of providing electricity for Network Rail is not allowed to traction purposes. compete in the train service Variable access charges are • A coal spillage charge is levied markets and is a company limited levied that include the following. only on freight operators by guarantee with debt backed by carrying coal, which recovers Government. • A variable usage charge to the costs associated with coal reflect the cost of damage (wear spillage on the network. The Office of Rail Regulation and tear) that trains operating (ORR) – the economic and health on the network do to the EU legislation also permits ‘mark and safety regulator – determines underlying infrastructure. ups’ (recovering those costs overall limits on the revenue from • A capacity charge whereby train exceeding SRMCs) to be levied access charges through its operators are compensated by on track access charges, as long periodic review process, and also Network Rail for reductions in as they comply with various approves the charges in their revenue when they principles and provisions. individual access agreements (for experience service delays example for new train franchises caused by Network Rail or Fixed costs are recovered in within the periodic review period). otherwise beyond their control. regulated fixed access charges As traffic on the network from passenger and freight train In accordance with EU legislation, increases, the likelihood of operators; some franchised variable track access charges are these delays occurring passenger train operators are calculated on the basis of costs increases. The capacity charge subsidised by Government. The fixed charges help to cover Network Rail’s net revenue requirement.

In addition Network Rail itself receives grant funding directly from Government.

Potential lessons

There is regulatory precedent to set prices based on SRMCs with specific mark-ups.

Prices have been set for a variety of different key cost drivers where there are different types of users requiring access to, and sharing, the same fixed network.

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Telecoms in Great Britain

Oftel – originally the economic regulator of the sector before Potential lessons Ofcom – initially set BT’s access prices based on fully allocated Approaches to access cost (FAC) charges on a historic pricing can develop over a cost accounting (HCA) basis. However, in 1997 this was sustained period of time. changed to LRIC-based prices set on a current cost accounting A range of different (CCA) basis. A core rationale for economic approaches can this was to set efficient price be used to address different signals to encourage new challenges. entrants to enter the market.

BT’s LRIC model uses its CCA accounting values. BT is responsible for publishing its LRIC models, taking into account any updates.

In 2005, Ofcom switched from CCA to HCA for the pricing of access to network assets that existed before Oftel had switched increases and decreases for now two markets where there is to CCA-based charging in 1997. different asset types depending some degree of geographic cost This was due to an appreciating on a variety of factors, including de-averaging. asset base, and subsequent forecast input prices and concerns that BT would over- technological change. Unlike the In testing for cost orientation for recover revenue (initially it was glide-path approach Ofcom uses individual charges, Ofcom uses anticipated that competition would in other price controls, this DLRIC floors and DSAC ceilings hold prices in check). For these methodology change resulted in as benchmarks. However, these assets, Ofcom established a some step changes in access are not intended to be used totally regulatory asset value (RAV) that prices. deterministically; rather they represented the remaining HCA serve as a first test when value of these assets. The assets The charging methodology was investigating whether or not a that were put in place after 1997 based on top-down LRIC models, given charge is anti-competitive continue to be valued on a CCA which were adjusted according to or excessive. basis. the findings and challenge of a bottom-up engineering model. All In changing the approach, there costs were geographically were significant revenue averaged; however, there are

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Gas in Great Britain

The gas industry has a number of blocks (depreciation, opex and LRMC estimates are based on features in common with the return relating to a regulatory the physical distance between the water sector, such as the asset value), while the SO’s entry/exit point multiplied by an transportation of a physical allowed earnings are set in expansion factor which is an commodity through a pipe reference to costs and incentive estimate of building additional network. However, the gas schemes. NTS capacity of a given length of industry is vertically separated, pipe. with retail, distribution, The TO’s allowed revenues transmission, and the provision of mainly comprise a capacity Commodity charges comprise the actual commodity all component and a commodity charges per unit of gas operating as separate entities. component, while the SO’s transported at exit and entry The transmission network and allowed revenues comprised points. retail markets are national, and primarily just a commodity the distribution networks operated component. National Grid Gas implements the by separate regional companies. charging methodology in TO entry capacity is allocated accordance with its licence using auctions, reserve prices for obligations. National Grid and Transmission which are set using the NTS other parties such as the relevant transportation model, and the shippers can propose Charges for access to the entry capacity charges reflect modifications to the methodology. National Transportation System auction outcomes. Discounts for These modifications are (NTS) are based on a system of short-term and interruptible implemented if the relevant entry-exit charges. The methods capacity products help ensure industry panel approves them and and principles on which that spare capacity is used, to if Ofgem gives its consent. Ofgem transmission transportation complement the auctions. can make a modification proposal charges are derived are set out in only in certain circumstances. the Uniform Network Code (UNC) The NTS transportation model – Transportation Principal calculates the LRMC of Document (TPD). transporting gas from each entry Distribution point to a ‘reference node’ and Charges cover the transmission from the reference node to each There are eight gas distribution operator’s (TO) allowed revenue ‘off-take’ point. In general, the networks (GDNs), which each and the system operator’s (SO) further the entry or exit point is cover a separate geographical allowed revenue. The TO’s from the reference node the region of Great Britain. Four of allowed earnings are calculated higher the LRMC estimate. The the GDNs are owned by National using standard regulatory building unit costs that underpin the Grid Gas, the incumbent network

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operator. There are also a the costs are driven by capacity number of smaller networks investment. owned and operated by Independent Gas Transporters Distribution charges can be (IGTs). changed once a year on 1 April (unless Ofgem says otherwise). The GDNs levy charges on Indicative charges are published network users to collect the five months in advance revenues they are entitled to as (1 November) and actual charges determined by the price control are published two months in framework. All GDNs are required advance (1 February). Gas to maintain a ‘use of system’ transmission charges can be (UoS) charging methodology, changed twice a year on 1 April which must explain to customers and 1 October. Potential lessons the principle of and methods used to calculate charges. The gas Different approaches can transporter licence also requires be used for different parts of that these methodologies achieve the value chain. certain objectives – for example, that charges: In gas, transmission pricing • are cost reflective; includes a distance • facilitate competition; and component, while costs are • reflect developments in gas geographically averaged for distribution. distribution.

Within a given region, UoS Entry and exit charges can charges do not depend on be used in network pricing. customer location within a GDN but on customer size, which acts as a proxy for the distribution assets a customer uses. Charges contain both a capacity and a commodity element. The charges are heavily weighted towards the capacity component, as most of

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Electricity in Great Britain

Similar to the gas industry, the Distribution in as a step change as opposed electricity industry in Great Britain to using a glide path. is vertically separated, with retail, There are 14 licensed distribution distribution, transmission, and the network operators (DNOs), each The Distribution Charging and provision of the actual commodity of which is responsible for a Methodologies Forum (DCMF) is all operating as separate entities, distribution services area. The the industry group that discusses and levying charges for the DNOs are owned by six different charging issues. Proposed various products and services groups. There are also four changes to the common charging that they provide. independent network operators, approach are progressed through which own and run smaller the Distribution Connection and networks embedded in the DNO Use of System Agreement Transmission networks. (DCUSA) under open governance arrangements. There are three distinct Initially the DNOs all had their transmission areas each with their own charging methodologies. own transmission operators However, there was a move to (TOs). National-level system adopt common nation-wide operator (SO) activities are methodologies: carried out by National Grid Electricity Transmission (NGET). • the Common Connections Charging Methodology (CCCM) The primary requirement of the for connecting new customers; transmission licence is that the • the Common Distribution various charging mechanisms Charging Methodology (CDCM) should achieve the ‘relevant for customers at the lower objectives’ of: voltages; and • the EHV Distribution Charging • facilitating competition; Methodology (EDCM) • reflecting costs incurred; and predominantly for customers at • taking account of developments the extra high voltage. in the transmission and connection businesses. This move was enabled through a licence condition. Companies Ofgem does not set or approve engaged with their customers in the level of individual charges, but advance to make them aware of does approve the form of the any incidence effects, but the charging methodologies. effects themselves were brought

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Potential lessons

Standardised methodologies can be reached over time, even where there are very different starting points.

Industry forums can play a role in developing charging methodologies.

23 Future access pricing in the water sector

Airports in England

Airport Charging Regulations (ACR) are set out in legislation.

The ACR apply to airports with more than five million passengers in the two years before the current year. A regulated airport operator must supply to all airport users in relation to the regulated airport it manages:

• details of its intended future airport charges; • details of the associated quality of service it intends to provide; and • information on the components serving as a basis for determining the system or level of all charges proposed.

The Civil Aviation Authority (CAA) does not mandate or approve the structure of charges at airports. But it can investigate if an airport is failing to abide by the ACR. If it finds that an airport has breached the regulations, it can give that Potential lessons airport an order requiring it to take the appropriate steps specified in There is precedent for the order. This can include allowing companies to ensuring that the airport complies develop their own charging with the ACR, and remedying any Charges can take account of schemes within a broader loss or damages sustained. various factors, such as: governance framework. Airports generally levy a range of • aircraft weight; charges on airlines. Those • destination of passengers; and Different charges may covered by the ACR are: • time of day or season of the require different governance year. frameworks. • runway charges (for departing and landing aircraft); Charges are often designed to • per passenger charges (that reflect the external environmental generally cover terminal costs associated with aviation for facilities and may include a example with discounts for aircraft separate security charge); and with lower noise and air quality • aircraft parking charges. impacts.

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The water industry in Australia

In Australia, water trading has In contrast, exit fees are levied developed over a number of when a water entitlement is sold years, with access rights now out of the infrastructure operator’s being unbundled from delivery network or district. rights. The Australian National Water Charging approaches have also Commission considered that exit developed over time. Recently, fees could form an impediment to Potential lessons protocols have been put in place trading. They are now illegal in to replace the ‘exit fee’ charging the Murray–Darling Basin. Exit and termination fees system with ‘termination fees’. have been used in water charging. Termination fees and exit fees are payments to infrastructure Different types of charging operators associated with a reduction in the demand for and can prevent water trading. use of water delivery infrastructure. They are designed to manage the risk of ‘stranded assets’ that may emerge when irrigators terminate access to the delivery system and the operator is left with committed fixed costs, which threaten the financial viability of the delivery systems for remaining irrigators. Termination and exit fees differ in terms of the action that triggers their payment.

Termination fees are payable by an irrigator upon surrendering a delivery entitlement to the infrastructure operator (reducing use of or disconnecting from the network), with the corresponding removal of the rights and obligations associated with that delivery entitlement.

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5. Next steps

We will need to consider carefully produced draft charging be considering for setting a range of technical issues in guidance. But in the meantime, effective prices? developing an effective future we welcome views from • What is the best way to gain the access pricing framework for the stakeholders on any of the issues data and information required to water sector. Studying access we have raised in this document. develop effective access pricing in other sectors reveals In particular, we welcome prices? that: responses to the following questions. Please send your views to Tom • approaches to access pricing Rogers at can be complex; • Are there any key issues we [email protected]. • a range of pricing and have not identified in this governance approaches can be document? used depending on the specific • Should we be considering issues at hand; and fundamentally different charging • approaches can evolve and approaches for different parts of develop over time. the value chain? • Do any of the charging Because of the complexity of the approaches used in other issues involved, we will require sectors particularly lend significant engagement with the themselves to the water sector? water sector and other • What are the different assets stakeholders in designing the and/or services that may require appropriate framework. specific access prices to be set? • How prescriptive should we be We will consult on potential in determining access charging approaches to access pricing rules? once the UK Government has • What types of cost should we

26 Water today, water tomorrow

6. Further information

Ofwat publications

‘Ofwat’s review of competition in the water and sewerage industries – part II’, May 2008

‘Valuing water – how upstream markets could deliver for consumers and the environment’, July 2010

‘A hypothetical model for upstream water markets in England and Wales – a technical paper’, January 2011