This article was first published in June 2008 by the Lawtext Publishing Ltd in the Journal of Water Law, Vol 18, Issue 6, 2007. 

Interpretation of the 'costs principle', set out in section 66E of the Water Industry Act 1991 (WIA91), has proved to be both controversial and strategically important. The focus of the long running Shotton Paper Mill case, Ofwat have described it as "one of the most significant barriers to the development of effective retail competition." Ofwat has recently applied the principle, which governs the charges that a new entrant water supplier must pay to an incumbent water company for 'access' to its network, for the first time in its determination of the wholesale access price offered by Anglian Water Services Ltd (Anglian) to Aquavitae UK Ltd (Aquavitae). This paper summarises the statutory and factual background to that determination before outlining the analysis that Ofwat applied. It concludes with a re-cap of the CAT's summary judgement in the Shotton case and asks the question – where can aspirations for a competitive retail market go from here?

Background
Statutory
Since December 2005 and the introduction of the water supply licensing in England and Wales, water undertakers in England and Wales (broadly speaking, those companies authorised to own and operate the water infrastructure and supply customers within a specifically defined geographic area), have been obliged to offer terms for access to their network to licensed water suppliers. Depending on the type of supplier (i.e. retail or combined), there are three types of access that may be sought:

First, 'wholesale access' under section 66A of the WIA91. This section obliges a water undertaker to provide a water supplier with a supply of water in order that the supplier may retail that supply to one of its customers. In this case the customer's premises would be within the undertaker's geographic area and the supply would be of wholesale water only, it would not allow the supplier to physically 'access' the undertaker's network in any way. Secondly, 'primary carriage' access under section 66B of the WIA91, which provides for a water undertaker to allow a supplier to introduce its own water to the undertaker's network and use that network to transport the water to the supplier's customer. Thirdly, 'secondary carriage access' under section 66C of the WIA91 provides for a water undertaker to allow a supplier to arrange for a second water undertaker to supply the supplier with water and then to use the first undertaker's network to supply that water to its customers. The second two of these three bases involve what is generally referred to as 'common carriage'.

If the water supplier and the water undertaker fail to agree terms and conditions (including those relating to charging) for any of these three types of access, the water supplier may ask Ofwat to determine what the terms and conditions should be. These determinations are governed by section 66D of the WIA91, subsection 3 of which specifically provides that the charges payable by a supplier under any of these three types of access arrangements must be fixed in accordance with the costs principle outlined in section 66E of that Act.

The correct interpretation of section 66E of the WIA91 is much debated. The section relates to the charges that a water undertaker may recover from a licensed supplier under any of the three types of access arrangements described above. It provides that:
"(1) the charges payable by a licensed water supplier to a water undertaker … shall enable the undertaker to recover from the supplier: (a) any expenses reasonably incurred in performing any duty under sections 66A to 66C above in accordance with that agreement or determination; and (b) the appropriate amount in respect of qualifying expenses and a reasonable return on that amount, to the extent that those sums exceed any financial benefit which the undertaker receives as a result of the supplier supplying water to the premises of the relevant customers.

(2) In subsection (1) above, 'qualifying expenses' means expenses (whether of a capital nature or otherwise) that the water undertaker has reasonably incurred or will reasonably incur in carrying out its functions.

(3) For the purposes of subsection (1)(b) above, the appropriate amount is the amount which the water undertaker (a) reasonably expected to recover from relevant customers; but (b) is unable to recover from those customers as a result of their premises being supplied with water by the licensed water supplier.

(4) Nothing in subsection (3) above shall enable a water undertaker to recover any amount: (a) to the extent that the expenses can be reduced or avoided; or (b) to the extent that any amount is recoverable in some other way (other than from other customers of the undertaker)."

Ofwat has summarised this section as meaning that the access price in any particular case will be equal to any expenses reasonably incurred by the undertaker, plus the retail charge levied by the undertaker, less what it describes as the ARROW costs (i.e. those specified in subsection 4 above, being costs that are avoided, reduced or recoverable in some other way).

Whilst Ofwat used this interpretation of section 66E in defence of its position in the Shotton Paper Mill case, the section was not in force at the time it took its contested decision. This Aquavitae determination is therefore the first time that Ofwat has made a determination under section 66D and actively applied the costs principle. (Full details of the determination are available in Ofwat's notice of determination under section 66D(2)(b), dated 28 March 2008 and available on its website at www.ofwat.gov.uk.)

Factual
Aquavitae is one of the new entrant water suppliers licensed under the waste supply licensing regime with a combined licence. It is therefore able to supply customers who consume (or are likely to) more than 50 megalitres of water annually with their water and is authorised to be granted access over an incumbent water undertakers' network to support that supply. Aquavitae signed a wholesale master agreement with Anglian (the water and sewerage undertaker appointed in relation to the East of England and Hartlepool) in April 2006. This agreement regulates the terms of access to Anglian's system and provides the framework for future, customer specific access agreements to be made between the two companies.

In June of 2006, Aquavitae applied for access prices to supply three customers under that wholesale master agreement with Anglian. The prices that Anglian offered in March of 2007 represented less than a 0.6% discount from the retail prices that Anglian itself charged those customers. Aquavitae requested an access price for a fourth customer in June of 2007 and in August of that year, was quoted a similarly low discount by Anglian.

Nine days after Anglian quoted the access price for the fourth customer, Aquavitae referred the matter to Ofwat for determination under section 66D(2)(b). Interestingly, Aquavitae also lodged a complaint with the OFT about Anglian's proposed access price as it was also arguably an abuse of dominance under the Competition Act 1998 (CA98). (Whilst it is outside the scope of this paper to consider the application of Chapter II of the Competition Act 1998 to these facts, a summary of the potentially applicable arguments and case law on excessive pricing and margin squeeze abuses of dominance is provided in the article on the CAT's summary judgment in the Shotton Paper Mill Case is provided in an article in Journal of Water Law, Vol 17, Issue 4, 2006.) Following analysis under the OFT's guidance on the application of the CA98 to the water and sewerage sectors (OFT 422), Ofwat's determination notes that it was considered more appropriate to deal with the dispute under section 66D of the WIA91 rather than the CA98 (at paragraph 4.6). Ofwat provided a number of reasons for this assessment, including the fact that section 66D provides a bespoke route of assessment; the relative speed with which a determination under section 66D could be reached and the fact that Ofwat would be able to determine a definitive access price that Aquavitae could then take forward.

The determination
Anglian had interpreted Ofwat's guidance on calculating cost principle compliant access prices ('Water Act 2003, Water Supply Licensing - Access Codes Guidance", the latest version of which dated July 2007, is available on Ofwat's website at www.ofwat.gov.uk) as creating a seven-step methodology. That methodology may be basically summarised as being:

  1. Anglian allocated its customer service, bad debt and customer credit cost data (partly as shown in its June return) to the 14 retail activities identified by Ofwat (see page 67 of its Access Codes Guidance. These retail activities include customer billing and meter reading, payment handling, account management activities and 'other' retail costs ).
  2. It then allocated those costs between fixed (which it did not consider able to be ARROW costs) and variable (which it did). 
  3. Anglian then divided each of the fixed and variable cost groupings between eligible and ineligible customers. This allowed Anglian to derive total variable costs for eligible customers in relation to each of the 14 retail activities.
  4. Anglian then divided each of the 14 retail activities into unit costs (e.g. the number of meter readings or bills issued) to derive an average variable unit cost.
  5. It then calculated the annual ARROW costs for each of the four customers using the average variable unit costs derived at step 4.
  6. Anglian also used those average variable unit costs to derive the costs (or 'expenses') that it would incur supplying Aquavitae rather than the customers; and
  7. It deducted the expenses derived at step 6 from the ARROW costs identified at step 5 and deducted the result of that calculation from the retail charge it levied on each of the customers. It quoted the resulting figure as the access price in each case.

Ofwat took no general objection to this interpretation of its guidance, it did however challenge a number of Anglian's specific assumptions or items of data. The insight into Ofwat's approach that these challenges provide will be very useful for any water undertaker asked to quote access prices under the costs principle in the future and a selection of some of the more notable are:

  • Ofwat did not accept that all the costs associated with Anglian's IT system were fixed costs. In particular, Ofwat noted that when Anglian procured its current IT system in 2006, it could have acquired one that automatically catered for transferring customers, which would have created avoidable costs if customer numbers had reduced. Ofwat's policy position is therefore stated to be that "…IT costs should not be attributable to customers who switch." (Paragraph 6.13 of its determination, dated 28 March 2008.)
  • Similarly, Ofwat did not allow Anglian to recover the cost of issuing separate bills to Aquavitae in respect of each of the four customers simply because its billing system was not calibrated to issue composite bills (paragraph 6.22 of its determination, dated 28 March 2008). Nor was Anglian allowed to recover the costs of disaggregating the single payment received from Aquavitae (paragraph 6.36 of its determination, dated 28 March 2008). 
  • Pointing to the fact that Anglian no longer has a contractual relationship with the customers, Ofwat did not allow it to recover costs related to the assumption that it would be forced to pursue the customers for payment should Aquavitae default (paragraph 6.48 of its determination, dated 28 March 2008).
  • Nor was Anglian allowed to recover its costs for continuing to provide information and sales and marketing information to the four customers (paragraph 6.54 of its determination, dated 28 March 2008).

The overall impression given by Ofwat's determination is that it found it difficult to identify which of the elements of the 14 retail services were to be provided by Aquavitae and which were to continue to be provided by Anglian (note in particular, Ofwat's comments at paragraphs 5.5 to 5.7 in Ofwat's determination). In some cases, for example meter reading, Anglian submitted that it would still have to continue to perform the retail tasks despite Aquavitae's stated intention to do so. Continuing with the meter reading example, Aquavitae intended to read three of the four customer's meters but Anglian suggested that it would still need to read those meters itself on a quarterly basis. Anglian had therefore suggested that the expenses it would incur in providing services to Aquavitae (calculated at step 6) would only be one third of the ARROW costs identified for meter reading for each customer at step 5. Despite its statement that "[w]e …do not agree that Anglian Water can expect to charge for the duplication of activities" (paragraph 5.7 of its determination, published on 28 March 2008), Ofwat accepted that Anglian may need to perform some meter readings itself. However it was of the view that annual meter readings would be sufficient and so changed the allowed expenses to 25% of the relevant ARROW costs.

Following its analysis, Ofwat concluded access prices that ranged from 0.43% to 1.89% deductions from the existing retail charges levied by Anglian. Whilst these represent up to a four fold increase in the discounts originally offered by Anglian, Ofwat itself expresses disappointment at the absolute level of discount (or retail margin) available (paragraph 7.3 of its determination, published on 28 March 2008). Given that new entrant water suppliers such as Aquavitae need to meet their own costs, slim retail margins such as these make competitive challenge much less viable.

Considering the overall theme of this determination, it seems that a clear and detailed definition of a water supplier and water undertaker's respective functions (and risk in relation to performance of those functions) may help to reduce duplication of activities. In turn that would support a wider retail margin, even within the context of Ofwat's current interpretation of the costs principle.

However, the interpretation of the costs principle that Ofwat applied in this case does not provide for a full assessment of the efficiency with which an incumbent water undertaking's costs have been incurred. Broadly speaking it will therefore continue to reward inefficiently incurred costs, to the detriment of a viable retail margin. Recognising this problem, Ofwat is calling for a change in the legislation to abolish the costs principle but absent that positive action from the Houses of Parliament, what may be done to overcome this obstacle to competitive development?

Where can aspirations for a competitive market go from here?
As has been suggested above, there are different interpretations that may be applied to the costs principle. For example, the 'appropriate amount' defined in subsection (3) may not simply be the retail price that the water undertaker currently levies on the customer. When one considers that a return will already be embedded within that retail price, then the separate provision for a 'reasonable return' on that appropriate amount (in subsection (1)(b)), seems to support an alternative interpretation. Further, the widespread use of the concept of 'reasonableness' through the section argues in favour of scrutiny of the reasonableness (which would perhaps include some notion of efficiency) with which the incumbent's costs have been incurred. Such a 'reasonableness' assessment could well require more than consideration of whether the incumbent could have designed its systems differently in anticipation of water supply competition.

It is therefore possible that other legal interpretations of section 66E would generate wider retail margins. Indeed, the Competition Appeal Tribunal (CAT) in its summary judgment in the Shotton Paper Mill Case (CAT Case No: 1046/2/4/04, summary judgment dated 06 October 2006 and available on the CAT's website at: www.catribunal.org.uk) considered an access price that was apparently compliant with Ofwat's interpretation to be excessive and an abusive margin squeeze, in breach of Chapter II of the CA98.

Both the domestic and EC case law on the abuse of margin squeeze support the idea that, from a competition law perspective, the correct approach to establishing access prices will be to assume a notional part of the incumbent's business and allocate costs to that business and use it as a comparator, rather than simply relying on the costs actually incurred by that business. (See in particular the CAT's judgment in the Genzyme case, case 1016/1/103, judgment dated 11 March 2004 and available on the CAT's website at www.catribunal.org.uk and the CFI's recent judgment in the Deutsche Telecom case, Case T-271/03.) Were the requirements of 'reasonableness' within section 66E to be used in support of such a notional tool, then it may be possible to create an interpretation of the costs principle that complied, at least in this respect, with the competition law rules on margin squeeze.

The significance of such a possibility is that, in the case of undertakings to which member states have granted special or exclusive rights (such as water undertakers) Article 86 of the EC Treaty prohibits that member state from enacting or maintaining in force any measure "contrary to the rules contained in [the] Treaty … in particular to those rules provided for in … Articles 81 to 89". So far as the costs principle in section 66E has to be interpreted in the way that Ofwat suggests (i.e. supporting apparently abusive margin squeezes), then the 'rule' may be contrary to Article 82 and so put the UK in breach of Article 86. (On the assumption that Article 82 would be engaged, which, given the relatively broad interpretation given to the requirement for an 'affect on trade between member states' in cases such as Bagnasco (Cases C-215/96 and C-216/96, [1999] ECR 1-135, may be a safe assumption). On that basis a court may well interpret section 66E in a way that conforms with the provisions of the EC Treaty, including Article 82.

Therefore, by taking the interpretation that is has, Ofwat has arguably committed an error of law, that is to say acted illegally and its decision could be open to challenge by way of judicial review. Were a successful judicial review to be brought against this decision (although any such challenge must be brought promptly and at time of writing it does not appear that such a challenge has been brought) then it may be open for the court to make a declaration as to the correct interpretation of the costs principle outlined in section 66E. On the basis that that interpretation would be one which allowed a more substantial retail margin (i.e. conformed with the prohibition on abuse of dominance contained in both Chapter II of the CA98 and Article 82 of the EC Treaty), then repeal and re-statement of that piece of primary legislation may not be necessary in order to overcome "one of the most significant barriers to the development of effective retail competition."

Interpretation of the costs principle has proved to be controversial and strategically important. Ofwat's recent decision in relation to Aquavitae's attempts to negotiate access with Anglian's provides a worked example of how the regulator has, thus far, interpreted section 66E of the WIA91. There are other interpretations, the application of which may prove to be more supportive of the development of retail competition in the English and Welsh water industry.

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

Back to Search