Leaking profits in the new water market: are you ready?
Partner at Bond Dickinson LLP http://WWW.BONDDICKINSON.COM
Post date: Thursday, 30th March 2017
The opening of the retail water market in April 2017 will change the water sector on a fundamental level with most businesses in England being able to choose their preferred suppliers.
There is no doubt that the opening of the market presents both opportunities and risks for water suppliers. The already low margins in the industry will naturally be squeezed through competition, but the race for new business could also drive behaviours that further damage suppliers' profitability.
Balancing the tension between these risks and making the most of the opportunities will be key to which suppliers benefit most from the opening of the market, and which suppliers see their profits suffer.
Potential pitfalls of contracting in the new market
Moving away from the current statutory charging schemes, suppliers will, from April, supply non-domestic customers based on either an express supply agreement, or a ‘deemed contract’.
The Water Services Regulation Authority, or OFWAT, will soon release the final form of the Retail Exit Code which will stipulate the regulatory requirements that suppliers' deemed contracts must meet. Although deemed contracts are well established in the gas and electricity markets, the Retail Exit Code takes a slightly different approach to deemed contracts in the water industry.
The Code specifies different price requirements for deemed contracts which are to apply to inherited customers including SME customers and non-SME customers. This poses a compliance risk because the Retail Exit Code defines an SME solely by reference to the number of employees (which must be fewer than 250 to qualify). This is often not within a supplier's knowledge so it cannot be certain whether a customer is genuinely an SME. This approach differs from the definition in the gas and electricity markets which is determined by more readily available data.
Deemed contracts also pose various other risks to suppliers because it is often difficult to ascertain the true occupier of premises (and therefore the actual counter-party to the deemed contract) and where there are multiple occupants or there is a shared supply between multiple premises, a supplier may have issues in enforcing the deemed contract and securing payment.
Even when suppliers are entering into express supply agreements, care will need to be taken. Employees will need to be trained in the fundamentals of contracts, the potential pitfalls and the key differences of dealing with different types of legal entities. It may not always be obvious who is contractually liable and unscrupulous customers will seek to use any doubt to avoid making payment.
If targeting new customers in public sector organisations, large corporations or 'buying groups', suppliers should be cautious of entering into agreements where the customer’s own framework agreement is imposed on the supplier. The attraction of winning significant 'volume' needs to be weighed against onerous service obligations and payment terms.
Customer insolvencies, phoenix companies and corporate abuse
As an unsecured creditor, a supplier will usually receive little or no payment in respect of historic charges if a customer becomes insolvent. Therefore insolvency issues within the customer base are likely to have a severe impact on the bottom line.
In addition, there are specific limitations on the actions that a supplier can take once a customer has entered a formal insolvency procedure because the supply of water to customers is protected as an "essential supply" under the Insolvency Act 1986. If an insolvency practitioner is appointed and requests that a supply is ongoing, a supplier cannot make the payment of pre-insolvency charges a pre-condition. Suppliers can however make it a condition of the ongoing supply that the insolvency practitioner personally guarantees the payment of future charges.
In the event of administrations and company voluntary arrangements (as well as individual voluntary arrangements where the supply is for a business purpose), there are additional limits on the ability of suppliers to terminate the contract or the supply. To best protect a supplier's position requires careful consideration of these limitations and early engagement with insolvency practitioners on a case by case basis.
The use of deemed contracts and the ability to change suppliers within a short timeframe will also mean that water suppliers will be subject to an increased risk of 'phoenix companies' within their portfolios, A phoenix company is a commercial entity which has emerged from the collapse of another through insolvency.
Experience in the energy market shows that customers from certain sectors present a higher risk of the corporate regime being abused to evade payment via phoenix companies. Suppliers should therefore take a number of steps to minimise their exposure to such customers:
- Use a robust vetting process that combines the use of credit information and a review of supply histories to identify those using serial insolvencies of limited liability entities to avoid payment.
- Ensure the supply terms and conditions (as well as the business’ systems and processes) provide adequate protection in the case of a change of ownership or occupation of a premises.
- Using the disconnection process, or the threat of disconnection, to prompt unwanted customers to change suppliers.
- Take targeted legal action against customers and utilise insolvency practitioners to investigate the conduct of insolvent companies and their directors.
The transfer and use of personal data between the present statutory undertakers and suppliers in the new market is likely to create further areas of risk. Suppliers will need to ensure that the personal data they inherit is accurate, processed lawfully and stored securely in accordance with the current data protection regime under the Data Protection Act 1998 (and under the General Data Protection Regulation that will be in force from May 2018).
Inherited customers will need to be informed of the supplier becoming the new data controller. There may be instances of shared supply points (part-commercial, part-domestic) in relation to which a supplier may hold data on the physical or mental health of the occupants to comply with their obligations to vulnerable customers. Such information constitutes ‘sensitive personal data’ and attracts a greater level of regulation than other personal data when being processed or held. Before processing such information, a supplier is required to obtain explicit consent from the data subject.
Some suppliers may undertake a cross-border transfer of data if, for example, they are setting up back-office support or utilising an off-shore customer service centre. Subject to certain limited exemptions, it is prohibited to transfer data to a country or territory outside the EEA unless that country or territory ensures an adequate level of protection for the rights and freedoms of data subjects.
Direct marketing campaigns and the sharing of information with third parties (such as utility brokers) may be prohibited without consent from customers. In the rush to secure new customers and corporate introductions, the risk of data being mishandled (and shared without consent) increases considerably. Suppliers should therefore consider carefully the ways in which they incentivise sales staff and agents, to drive the right behaviours.
Navigating this area can be complex. A contravention of the data protection regime can result in enforcement action by the Information Commissioner’s Office. This could ultimately result in prosecution against the company and against its officers in certain circumstances. Data subjects are also able to bring civil proceedings.
Dealing with brokers
In the energy market, many of the largest customers engage brokers and this pattern is likely to be repeated in the water market, suppliers will therefore naturally be keen to foster relationships with brokers in the hope of winning new business.
However, thought will need to be given to how risks concerning broker conduct are managed. In the energy market, a number of suppliers have paid multi-million pound fines as a result of mis-selling by their agents. To avoid repeating these mistakes water suppliers should have robust oversight processes in place to govern the actions of their agents.
In addition under the Commercial Agents Regulation 1993 suppliers could find themselves liable for substantial compensation claims when terminating a contractual relationship with a broker and consequently suppliers should factor this risk into any contracting arrangements with brokers.
Conclusion and top tips
Water suppliers need to balance the opportunities that new competition brings with the risks and take advantage of the lessons that can be learnt from the energy market. In light of the imminent changes, suppliers will need to look at the following areas:
1. Train staff to understand the fundamentals of contracts and different legal entities, and to assess and mitigate credit risks.
2. Where appropriate with high credit risk customers, the use of directors’ or parent company guarantees and security deposits should be considered to minimise exposure.
3. Understand the risks inherent in deemed contracts and take steps to identify the deemed contract segment of your portfolio to ensure that customers are charged in accordance with the regulatory obligations.
4. Implement robust due-diligence processes to avoid doing business with potential phoenix companies and use the threat of disconnection in appropriate cases.
5. Develop a proactive process that manages customer insolvencies via early engagement with insolvency practitioners to protect your position, especially in relation to ongoing supplies.
6. Impress the importance of your data protection policy within your business from day one.
7. Take care in your dealings with brokers and look to limit any exposure under the Commercial Agents Regulations 1993.