Introduction
On 22 May 2008, the Court of Appeal handed down its judgment in Dŵr Cymru's appeal against part of the CAT's judgment in the long running Albion Water case (Dŵr Cymru Cyfyngedig v Albion Water Limited [2008] EWCA Civ 536 and [2006] CAT 23 and [2006] CAT 36). The main subject of that appeal was the correct interpretation of the law on the abuse of margin squeeze.

This article outlines the background to the case and seeks to summarise some of the law and arguments presented on margin squeeze as well as the court's judgment on them. In essence, the court has held that the test for establishing an abusive margin squeeze does not demand that a new entrant provider engages in some kind of transformative activity or displaces the incumbent provider. Nor does it require the incumbent to avoid costs as a result of the new entrant's activities. However, such features may be relevant in deciding whether or not a margin squeeze is objectively justified.

Background
In 1999, Ofwat granted Albion Water Limited (Albion) an inset appointment in relation to the Shotton paper mill site in Deeside (under the Water Industry Act 1991). That site is connected to and served by a water supply system owned by Dŵr Cymru (Dŵr) and the inset appointment gave Albion the authority to operate the water supply system on site, to make a wholesale purchase of water and to retail that water to the paper mill using the supply system owned and operated by Dŵr.

Initially, Albion entered agreement with Dŵr for the supply of water to the Shotton site at a price of 26p/m3, the same price already paid by the paper mill. Seeking to establish its margin, Albion then sought alternative arrangements. These included a proposal to purchase water wholesale from United Utilities and to carry that water across Dŵr's system in order to supply it to Shotton (a 'common carriage' arrangement). Albion would have had to pay United Utilities 3p/m3 and so, at 23.2p/m3, the 'access price' that Dŵr quoted to Albion would not have left it with an effective margin.

Albion complained to the Director General of Water Services (Ofwat), who has concurrent authority with the OFT to apply the Competition Act 1998 to the water industry in England and Wales. It alleged that such an access price constituted an abuse of Dŵr's dominant position because it was both excessive and a margin squeeze. Without considering the question of dominance, Ofwat did not accept Albion's arguments. In basic terms, Ofwat looked at the retail price Dŵr was charging the paper mill and deduced the costs it would save by providing services to Albion rather than the mill (this approach is commonly referred to a 'retail-minus' approach or sometimes the 'Efficient Component Pricing Rule' or ECPR). Ofwat noted the fact that Dŵr was simply serving one customer (Albion) rather than another (Shotton) and so considered it to not be saving any real retail costs. It therefore found that the proposed access price was neither excessive nor created a margin squeeze. Albion appealed to the CAT.

In 2006, the CAT found against Ofwat in relation to its analysis of the margin squeeze elements of Albion's complaint (its final judgment on excessive pricing is awaited). The CAT subsequently also found Dŵr to be in a dominant position. Dŵr appealed both the CAT's judgment on margin squeeze and its finding on dominance to the Court of Appeal. Ofwat intervened in that appeal, as did the OFT and Ofcom.

In addition to finding that the CAT was entitled to make a judgment on the question of Dŵr's dominance (although the appealed Ofwat decision had not decided that question) the Court of Appeal also upheld the CAT's rejection of Ofwat's approach to testing for margin squeeze. The following sections of this article provide some more detail as to why.

Margin Squeeze – the law and the arguments
Margin squeeze is an established form of abuse both domestically and in Europe. It relates to the situations where there are two related markets and focuses on the price charged by a dominant upstream provider to a competitor provider in a downstream market.

The European Commission's Telecommunications Notice ((1998) OJ C265/2) provides one of the clearest statements on the abuse existing in its own right. Whilst that notice calls the abuse a 'price squeeze', it states, at paragraph 117, that the abuse could be demonstrated by "showing that the dominant company's own downstream operations could not trade profitably on the basis of the upstream price charged to its competitors by the upstream operating arm of the dominant company." The notice further recognises that the abuse could also be established by showing that a 'reasonably efficient' downstream operator would not be able to obtain a normal profit on the basis of the price charged by the dominant upstream operator.

The recent Deutsche Telekom case (Case T-271/03 [2008] ECR 00) also considers the alternative comparators that may be used to establish a margin squeeze – an 'equally efficient competitor' test which looks at the actual or nominal costs of the downstream part of the dominant undertaking's business or a 'reasonably efficient competitor' test which considers the costs of an actual or potential competitor in the downstream market. In that case, the Court of First Instance noted that there has not yet been an explicit ruling on the relative merits of the different approaches but considered the principle of legal certainty to support the use of the equally efficient competitor test.

The Court of Appeal's judgment provides a more detailed and very useful summary of the other authorities and precedents on margin squeeze (including the OFT's draft guidelines "Assessment of Conduct" (OFT 414A, April 2004). On the basis of such authority and precedent, the parties and the court agreed that the 'test' for margin squeeze contains the following five elements:

  1. That there is a vertically integrated dominant undertaking which operates in two distinct but related markets (i.e. 'upstream' and 'downstream').
  2. That the dominant undertaking is dominant in the upstream market and active in the downstream market. 
  3. That an input from the upstream market is necessary in order to compete in the downstream market. 
  4. That the margin set by the dominant undertaking between its upstream price and its own downstream price, makes it unfeasible for an efficient downstream competitor to be able to operate profitably in the downstream market; and 
  5. That there is no objective justification for the prices charged by the vertically integrated undertaking at the upstream or downstream level.

Dŵr and Ofwat argued that there are two further elements: First that the activities of the competitor in the downstream market must either displace the dominant undertaking in that market or transform the input from the upstream market in some new way. Second, that the activities of the competitor undertaking must allow the dominant undertaking to avoid some of its costs.

The appellant and Ofwat argued that such features were common to the facts of the precedent cases and, without them, the dominant undertaking would be subsidising the competitor undertaking, which would increase the overall costs of proving the product to the consumers.

Margin squeeze – the judgment
The Court of Appeal rejected Dŵr and Ofwat's arguments. Aside from its concerns about the logic of confusing the contents of the test with the particular circumstances in which it is applied, the Court was of the view that an essential feature of the test would be referred to explicitly in either the authorities or the precedents and it could find no such reference.

The Court of Appeal's judgment in Albion therefore confirms that the correct test for establishing the abuse of margin squeeze is the five-stage test described above.

As for the question as to whether an 'equally efficient' or 'reasonably efficient' competitor should be used when considering step four, paragraph 80 of the judgment says that Deutsche Telekom judgment is a "…clear endorsement of the 'equally efficient competitor' test in preference to the' reasonably efficient competitor test." Therefore the 'equally efficient' comparator method must now be seen as the safer route for margin squeeze analysis (albeit the 'reasonably efficient' comparator method remains recognised in authority such as the Commission's Telecommunications Notice).

Nevertheless, the Court of Appeal's judgment recognises that the actual (or potential) displacement of the incumbent provider, transformation of the upstream input and the extent to which the incumbent will avoid costs are all potentially relevant for the objective justification of any apparent margin squeeze. The existence and application of such factors will be a question of fact, to be assessed and decided in each case.

Finally, it should also be noted that the court was explicitly critical of the length of the CAT's judgment (the main judgment running to 241 law report pages) and the duration and complexity of proceedings in this case. Whilst practitioners who are asked to advise on borderline cases may find such deep judgments useful, lengthy and complex proceedings have obvious disadvantages. Perhaps we shall now see some form of contraction in the way that CAT cases progress.

Potential implications
By clarifying the law on margin squeeze and rejecting the arguments put forward by Dŵr and Ofwat, this judgment may encourage other would-be competitors to challenge the wholesale or access prices they are quoted by vertically integrated, dominant incumbents. It certainly provides essential reading for anyone advising such new entrants.

In defending margin squeeze challenges, incumbents will have to look at the costs incurred (more broadly, the 'efficiency') of their own downstream operations. Such information is not always readily available and the courts may assume a nominal part of the incumbent's business and make their own assessment of that business' costs. It could therefore help an incumbent provider to get on the front foot by using a robust methodology to calculate their internal transfer prices and external access price offers.
For the water industry specifically, this case comes at a time of potential change. Ofwat has recently come out in favour of a renewed push for competition and the current Defra sponsored Cave Review is also considering what can be done to help innovation in the industry. Although it was not directly the subject of this case, the costs principle (contained in section 66E of the Water Industry Act 1991) drives access-pricing policy in the industry and Ofwat's interpretation of that principle is in line with its previous, retail minus, interpretation of margin squeeze. Ofwat argue that, amongst other legislative interventions, section 66E must be amended to allow competition to flourish. This case's assessment of what constitutes an abusive margin squeeze should be at the heart of whatever amendments to or future interpretations of that section are made. It is therefore very likely to have an impact on how water companies will charge for access to their infrastructure in the future.

Fiona Parker is a solicitor specialising in energy law at leading UK law firm Shepherd and Wedderburn LLP.

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