Written by Simon Harms and Stephen C. Tupper

Introduction

On 22 September 2011 the Office of Fair Trading (the “OFT”) published a market study on the state of competition in the organic waste sector in England and Wales (the “Market Study”) which was instigated at the request of the Water Services Regulation Authority (“Ofwat”) in the context of its ongoing comprehensive review of how it regulates the water industry.

Scope and findings

The Market Study covers the treatment of all types of organic waste which the OFT categorises into two broad types: sewage sludge (“SS”) which falls within Ofwat’s regulatory ambit; and other organic waste (“OOW”) such as slurries, manure and food and drink waste, the treatment of which is not directly regulated by Ofwat. The OFT examined the markets for the treatment of organic waste from three distinct angles:

• competition between statutory water and sewerage companies (“WaSCs”) for the treatment of SS;
• competition between WaSCs and other waste management companies for the treatment of SS; and
• competition between WaSCs and other waste management companies for the treatment of OOW.

In summary, the OFT found that competition between different WaSCs as well as between WaSCs and waste management companies for the treatment of SS is virtually non-existent. In addition, there exists only limited competition between WaSCs and waste management companies for the treatment of OOW.

The OFT identified the following main barriers to the development of meaningful competition in the organic waste treatment sector:

Economic regulation

First and foremost, the current system of economic regulation in the water industry creates a number of actual or perceived disincentives for WaSCs to use their regulated assets to compete for unregulated activities such as treating SS for other WaSCs or OOW. At the same time it provides WaSCs with advantages over waste management companies when treating their “own” SS and also favours WaSCs in the treatment of OOW.

The main features of the current system criticised by the OFT are:

• Potential CAPEX bias. The system of price-setting for water companies allows a return on capital expenditure but not on operating expenditure. In addition, savings in operating expenditure may be retained as additional profit for a period of up to 7.5 years. Expenditure by WaSCs on outsourced SS treatment is generally classified as operating expenditure while expenditure on in-house treatment is classified as capital expenditure. As a result, the system incentivises WaSCs financially to favour capital expenditure solutions (i.e. to build treatment facilities) even in situations where it may be more economic to outsource treatment.
• Transfer pricing/cost allocation. A WaSC which undertakes SS treatment on behalf of other WaSCs is obliged to include the full cost of capital attributable to the SS treatment when allocating costs or setting a transfer price (to ensure that this unregulated activity is not subsidised by the WaSC’s regulated activities). In contrast, a WaSC which does not outsource the treatment of SS only needs to cover its operating costs as the sunk costs have already been incurred. As a result, the cost of outsourcing SS treatment is artificially inflated when compared to the cost of in-house treatment.
• Cost of capital. The price control framework provides for a return on regulated capital value (“RCV”). The risk associated with regulated investments is perceived to be low. However, a WaSC investing in infrastructure to treat another WaSC’s SS or OOW carries out an unregulated activity and cannot add that capital expenditure to its RCV. As a result, the cost of capital for such an investment is higher. Combined, these factors ensure that the supply-side of the disposal market, at least in part, does not respond as one might expect in a normally functioning market. Accordingly, the OFT concludes that regulation has artificially skewed the proper functioning of the relevant markets.

Environmental protection regulations and standards

The current system of statutory environmental protection and industry standards creates a number of barriers to effective competition. For instance:

• Disincentives for co-treatment of SS and OOW. Firstly, companies engaged in co-treatment are required to comply with two different sets of regulations, thereby raising regulatory costs. In addition, industry quality standards result in increased costs for companies co-treating SS and OOW because the inclusion of SS rules out certain economically advantageous recovery and disposal routes such as spreading on agricultural land.
• Higher regulatory costs for non-WaSCs. WaSCs benefit from certain exceptions to the Environmental Permitting Regulations 2010 which waste management companies treating SS must comply with. As a result, higher regulatory costs are placed on non-WaSCs when carrying out the same activity.

Planning regime

According to a number of stakeholders, the current planning regime favours infrastructure developments by WaSCs. Firstly, the public tends to regard sewage sludge treatment works as part of “essential” water infrastructure whereas waste treatment facilities operated by non-WaSCs are regarded as pure “moneymaking” exercises (i.e. useful as long as they are in somebody else’s back yard). In addition, the planning regime favours the installation of new sludge treatment infrastructure in locations which already house existing waste water and/or sludge treatment works. As WaSCs own virtually all such installations, they have a distinct advantage when it comes to planning applications.

Corporate culture

The OFT strongly criticises what it perceives to be a “[…] sectoral culture that focuses on core (regulated) businesses to the potential detriment of consideration of market incentives.” In essence, the OFT considers that WaSCs avoid risk instead of managing it and tend towards over-reliance on regulatory guidance instead of responding to market signals. Among the examples cited by the OFT is the assertion by a number of WaSCs that outsourcing SS treatment would increase risk as WaSCs are under a statutory duty of care to treat and dispose of sewage sludge generated by their regulated activities. The OFT acknowledges that this may be the case but considers that “[i]n normal commercial environments similar risks to those faced by the WaSCs are effectively addressed by appropriate contractual terms and/or insurance policies, rather than by resorting to regulatory control.”

Interestingly, the OFT also hints that WaSCs may have a strategic interest in not providing treatment services to other WaSCs because carrying out too many unregulated activities with regulated assets might lead a conclusion that those assets could be excluded from the regulated ring.

The OFT’s recommendations and implications

The Market Study does not make radical proposals in respect of the markets it analyses. In summary, the OFT:

• is not seeking to refer the market to the Competition Commission;
• considers that structural remedies such as divestments of SS treatment infrastructure would be disproportionate; and
• does not consider that SS treatment infrastructure should be taken out of the regulated ring.

The OFT has clearly identified the current system of economic regulation of the water industry as the most significant barrier to the development of competition in the organic waste treatment sector. While the OFT states that “[…] complete e-regulation (on its own or combined with divestment) could appear, in the first instance, attractive […]” it ultimately does not recommend taking SS treatment outside the regulated ring. One reason for not doing so appears to be the realisation that complete de-regulation would mean the loss of regulatory leverage over what it considers in effect local or regional monopolies for SS treatment. Complete de-regulation might increase competition at the margins but would hand increased market power to dominant or monopoly providers of SS treatment services.

The OFT’s main recommendation is for Ofwat “[…] to adopt a system that, within a regulatory framework, better incentivises WaSCs to consider alternative market solutions and a better use of market-based instruments to manage risk.”

The OFT goes on to state that:

“[…] we advise Ofwat to consider the introduction of a specific regulatory system for SS only if changes to the regulatory framework resulting from its root and branch review are not deemed to address the specific concerns identified in this market study and after ensuring that the rationale for having a differentiated system is subject to close scrutiny.”

The Market Study’s recommendations in respect of the environmental regulations and the planning regime are vaguer still. In respect of the former, the OFT essentially recommends further alignment and convergence of the legal framework for environmental protection and of relevant quality standards for treatment of SS and OOW. As regards the planning regime, the OFT points to the ongoing work in relation to the National Waste Management Plan for England and the formulation of a national waste policy. It also recommends increasing engagement between local communities, local authorities and the waste management industry.

Lastly, and unsurprisingly, the Market Study does not contain any specific recommendations relating to the perceived corporate culture in the water industry. However, the OFT considers that:

“[…] the dialogue facilitated and encouraged by this market study, together with the potential impact from the adoption of our recommendations (most notably in relation to the reform of the economic regulation regime) will prove valuable in addressing the challenges associated with embedding a more market-focused culture in the water and sewerage sector.”

Conclusion

The Market Study provides an interesting and straight-talking analysis of how the current system of economic regulation in particular distorts competition in the organic waste treatment markets. However, having found an almost total lack of competition in the markets it analysed, the OFT has effectively ducked the responsibility for making any detailed recommendations for increasing competition.

The OFT’s recommendations (or lack thereof) must be read with the somewhat unusual background to the Market Study in mind (i.e. its “commissioning” by Ofwat). The detail of policy formulation and implementation has – presumably intentionally – been left to Ofwat (and other government departments insofar as environmental regulations and the planning regimes are concerned). If, and to what extent, they take account of the OFT’s findings is effectively left to such bodies. Alternatively, it may be that it is easier to identify the problems with this sector than it is to prescribe workable solutions. In such a situation, we may be witnessing an adroit piece of buck-passing? Whichever way you look at it, however, the issue is now firmly back in Ofwat’s lap. Whether Ofwat decides to follow its pro-competition instincts here and seek a radical restructuring or its more conservative side, which will mean that little will change, is the next big unanswered question.