Fiona Parker, Solicitor, Shepherd and Wedderburn LLP

This article was first published by Lawtext Publishing Ltd in the Journal of Water Law, 2006 Volume 17, issue 4

Many with an interest in the application of competition law and economic regulation to utility industries, will have been watching the progress of Albion Water Ltd's challenge to Ofwat. Essentially, Albion, a new entrant water undertaker, claimed that the price quoted to it by Dŵr Cymru, an incumbent water undertaker, for 'common carriage' across part of Dŵr's network was excessive and created a margin squeeze and so was abusive in terms of Chapter II of the Competition Act 1998. Ofwat's [1] original determination of the complaint found no breach of Chapter II and Albion appealed to the CAT, which published its summary judgement on 6 October 2006 [2].

The CAT is still to decide on the correct approach to determining the question of whether or not Dŵr is dominant, but it has come out strongly, stridently at times, in favour of Albion's complaint against Ofwat's decision. The impact of the CAT's ruling in this case may be heightened by its timing; coming in the midst of a rather public debate about the success of Ofwat's efforts to implement the Water Act 2003, which extends the scope for competition in the English and Welsh water market and as the first steps are taken towards competitive water and sewerage services markets in Scotland. This judgement could provide inspiration for would be entrants to the water, or other regulated utility markets, who are frustrated by seemingly slow progress of market liberalisation. It could also serve a warning to regulators, (particularly economic regulators who have concurrency of powers with the OFT) about the way in which they conduct themselves and the level of scrutiny they give to the information provided to them by their regulated companies.

This case raises challenging and important issues in relation to the law on excessive pricing and margin squeeze, as well as points on statutory interpretation (specifically the 'costs principle' in section 66E of the Water Act 2003). In particular, the CAT judgement engages with the Efficient Component Pricing Rule ("ECRP") or 'retail-minus' approach to calculating charges for use of monopoly infrastructure. This article outlines the background to the case and highlights the main points coming out of each of the key areas of the CAT's judgement.

Background
Legislative background
The water industry in England and Wales was privatised in 1989, at which time a specific water company was assigned to each geographic area. Those water companies own the water supply system in their area and are responsible for providing water and/or sewerage services to customers within that area. The Water Industry Act 1991 ("WIA91") demanded that each water company be, effectively, licensed to own the infrastructure and provide the water and/or sewerage services within their area [3]. These 'incumbent' water companies are subject to economic regulation in the form of price controls, which Ofwat impose in 5 yearly cycles, limiting the increase in the companies' prices to a set factor above or below inflation. These price controls also set background assumptions in relation to the scale and pace of the companies' investment programmes, the cost of the companies' capital infrastructure, and the return on that capital the companies' should be expected to earn.

As with nearly all other monopoly utility services, recent years have seen a push towards competition at the edges of the English and Welsh water industry [4]. Whilst recognising that pure competition would not be efficient (nor, in some cases, socially desirable) in all elements of the water supply chain, government policy has been to introduce new competitive forces at the customer facing, retail end of that supply chain. In the English and Welsh water industry, this policy has been manifest in two main pieces of legislation.

The WIA91 allows Ofwat to replace incumbent water undertakers with new entrant undertakers in respect of a specifically defined area, which cover premises that are likely to be supplied with at least 50ML of water per year [5], provided the customer of the premises in question agrees. These arrangements are known as 'inset appointments' [6].  Where a company holds an inset appointment, it must buy water in bulk from its adjoining, usually incumbent, company.

The Water Act 2003 ("WA03", which amends WIA91) takes matters a step further and allows new entrant companies to be licensed in two different ways: First, to provide water retail services (e.g. billing and complaints handling) to customers who use more than 50ML of water p/a. This licence is known as a 'retail licence' and allows the licensee to buy water wholesale, at the point of a customer's connection to distribution network and sell it on to the customer. Secondly, a 'combined licence' allows the licensee to buy water wholesale from one incumbent water company, transport that water along the infrastructure of another water company ("common carriage") and supply a customer who uses more than 50ML of water p/a. The Albion case relates to a decision taken by Ofwat before the WA03 was in force, but the Act is relevant because Ofwat subsequently used the 'costs principle' contained in section 66E of the WIA91, which WA03 introduces, in partial defence of its original decision.

Factual background

Albion is the only new entrant water company to be granted an inset appointment under WIA91. In 1999 it was appointed in relation to the Shotton paper mill site in Deeside, which is supplied by the Ashgrove supply system, owned by Dŵr. Albion initially operated its inset appointment by purchasing water wholesale from Dŵr at the connection between the Ashgrove system and the Shotton mill, and then retailing the water onto the mill. In turn, further up the supply chain, at the other edge of the Ashgrove system, Dŵr purchased the water wholesale from United Utilities. Before Albion was appointed, Shotton paid Dŵr 27.47p/m3 for its water. Following Albion's appointment, Albion purchased water wholesale from Dŵr for 26p/m3 and sold it onto Shotton at the same price [7]. At 26p/m3 Shotton was paying £1.7m p/a for its water.

In 2000, Albion approached Dŵr, asking it to quote a price for common carriage across the Ashgrove system. Albion intended to purchase the water necessary to supply Shotton wholesale from United Utilities, pass it through the Ashgrove system and be able to both reduce the overall price Shotton paid and make a profit. United Utilities quoted Albion 3p/m3 for a wholesale supply in 2001. Dŵr quoted Albion a common carriage price of 23.3p/m3. This price would have forced Albion to supply Shotton at a loss, or increase the charge to the mill.

Albion complained to Ofwat in March 2001 that Dŵr's quoted price was both excessive and constituted an abusive margin squeeze. Following a protracted investigation, Ofwat rejected Albion's complaint in May 2004. Ofwat reasoned that the quoted common carriage price could be justified by both an 'average accounting cost' analysis and the ECPR and that it was therefore not excessive. Ofwat also concluded that Dŵr would not actually save any costs by supplying Albion by way of common carriage instead of under the original arrangements, and so there was no abusive margin squeeze.

In July 2004, Albion appealed Ofwat's decision to the CAT. The rest of this article highlights some of the key points coming out of the CAT's judgement.

Excessive pricing

Albion's first leg of complaint was that the price quoted to it by Dŵr was excessive. The illegality of dominant undertakings charging excessive prices stems from the explicit recognition, in both Article 82 of the EC Treaty and Chapter II of the Competition Act 1998 ("CA98") that 'abuse' of that dominance can include "directly or indirectly imposing unfair selling prices". It was undisputed in this case that 'unfair' prices can include excessive ones and so the CAT used the United Brands v Commission case [8] and the European Commission's Notice on the Application of the Competition rules to Access Agreements in the Telecommunications Sector [9] (the "Telecommunications Notice") to extrapolate the following principles for determining 'excess':

  • A price will be excessive if it has "no reasonable relation to the economic value of the product supplied" [10];
  • Whether a price bears a 'reasonable relation' to the underlying 'economic value' is matter of fact and degree. Determining those questions of fact and degree may involve a 'considerable margin of appreciation' [11]; and
  • It is the direct costs of a particular product (or, by analogy, a good or service) that are relevant to a calculation of excess. Correct allocation of costs is therefore 'fundamental' [12].

In determining whether Ofwat's decision on excessive pricing was adequate and correct in terms of these principles, the CAT scrutinised the 'averaging accounting costs' approach that Dŵr had adopted and Ofwat sanctioned. This approach can be broadly characterised as 'top down', and, essentially, calculates the price for common carriage on the basis of average revenue for all customers, apportioning those revenues between different classes of activity (in this case resources, treatment and distribution) and then making adjustments for specific classes of customers.

Because Dŵr's revenue is limited by the price control Ofwat imposes on it, attempting to justify the non abusive nature of costs by relying on a method which uses the average revenue for all customers as its base, assumes that the regulated prices are reasonable (per United Brands) and cost reflective (per the Telecommunications Notice). It is out with the scope of this article to consider the detail of the CAT's analysis on this point and the economic arguments around the assumptions underlying Ofwat's determinations, but the CAT have judged that it is not necessarily the case that a regulated price will be reasonable and cost reflective (revenues, in the words of the CAT, are not a 'proxy for costs'). Further, whilst a top down approach to calculating costs and therefore prices is not contrary to Chapter II per se, the outcome of such an approach must be tested, perhaps against a bottom up approach.

Granularity, it therefore seems, is the key. The CAT were fierce in their criticisms of Dŵr for the lack of 'any detailed or verifiable break down of the components of cost' [13] and did not accept the argument that the information which was available was that which the regulatory system demanded. It seems that Dŵr might have been better able to defend its position had it been able to produce the kind of management accounting information unregulated companies would usually hold [14]. Here is a future lesson for dominant companies – know your actual costs and make sure you are in a position to justify your prices on the basis of them.

The CAT's judgement on cost reflectivity goes further, it rejects the way in which Dŵr grouped some if its assets and the emphasis Ofwat placed on the practice of 'regional averaging'. Detailed arguments were held over the distinction between potable and non-potable water supply pipes and the cost drivers that exist in relation to each of them. Because separate cost drivers were identified as being in operation, the CAT judged that Dŵr should not have grouped the different types of pipe together for the purposes of common carriage price calculation, a pipe, it seems, is not just a pipe [15]. Further, the CAT cast doubt on the compatibility with Chapter II of any approach which accepts cross subsidy between users who are supplied by discrete systems and whose supply costs are different [16]. The impact that this view will have on future government policy and regulatory determinations in utility industries both north and south of the border remains to be seen.

Margin Squeeze
Albion's second head of complaint against Dŵr was that, in addition to being excessive, the common carriage price it was being quoted created an abusive and illegal 'margin squeeze'. Again, the CAT relied on the Commission's Telecommunications Notice to specify what a 'margin' (or 'price') squeeze is, i.e.:

"A price squeeze 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…In appropriate circumstances, a price squeeze could also be demonstrated by showing that the margin between the price charged to competitors on the downstream market … for access and the price which the network operator charges in the downstream market is insufficient to allow a reasonably efficient service provider in the downstream market to obtain a normal profit." [17]

The general legal terms, margin squeeze is a form of refusal to supply, which, according to a long line of European and domestic case law, including Oscar Bronner [18]; Commercial Solvents [19], Telemarketing [20] and Burgess v OFT [21], is abusive where the dominant undertaking's refusal will (i) eliminate all competition from the person requesting the goods or services; (ii) the refusal is not objectively justifiable and (iii) the goods or services are essential to allow the new undertaking to compete [22].

Ofwat's decision found that Albion's presence in the supply chain did not save Dŵr any retail costs because Dŵr was simply supplying services to one customer (albeit a inset appointee) rather than another. Linking back to the arguments raised in relation excessive pricing, Ofwat concluded that the common carriage price quoted to Albion did not therefore create a margin squeeze. Albion challenged this position by arguing, on the basis of the CAT's Genzyme [23] decision, that Ofwat should have assumed a reasonably efficient, hypothetical, supplier of water, acting in competition with Dŵr and determined whether the price quoted by Dŵr would have allowed that hypothetical operator to make a reasonable profit. Further, Albion argued that adopting the approach to assessing margin squeeze that Ofwat did, would require any new entrant to be more efficient than the incumbent and therefore create its own margin. Albion suggested that this approach creates a 'super efficiency' test that is not reflected by the case law, or anticipated by the relevant statutes.

In support of Ofwat's decision, Dŵr argued that Albion had no 'right' to a margin and to allow one in circumstances where the incumbent was not already separated would be the equivalent to allowing any undertaking to impose itself at any level of an incumbent's supply chain and demand a profit [24]. In deciding on these arguments, the CAT have identified some general principles that could prove to be useful supplements to the established legal position on margin squeeze noted above. Essentially these are that:

  • Although the facts of many of the cases on margin squeeze are such that the entrance of the new company generates savings for the incumbent, it is not the case that a margin should only be made available where the incumbent avoids costs, nor is the appropriate margin necessarily equal to the sum of any avoided costs;
  • In margin squeeze cases, where the dominant undertaking is not separated at different levels of the supply chain, a correct analysis will create a notional part of the dominant undertaking's business at the level of the supply chain in question, allocate costs to that business and use it as a comparator for the new entrant; and
  • It is not necessary for the new entrant company to operate more efficiently than the nominal arm of the dominant undertaking. The introduction of competition can generate efficiencies in and of itself and new entrant companies do not need to demonstrate 'super efficiency' in order to be protected from market foreclosure.

ECPR and the costs principle
In support of its application of an average accounting cost analysis and conclusion that Dŵr's offer was not an excessive one, Ofwat applied the ECPR, sometimes also known as the Baumol-Willig rule, or a retail-minus assessment, as a cross check against its conclusions. In this context, an ECPR analysis will, in broad terms, seek to derive an appropriate charge for use of infrastructure by taking the whole price charged by the incumbent operator for its end to end supply and deduct the proportion of that price which can be attributed to the costs of the retail end of the supply chain i.e. the costs which the incumbent avoids incurring because of the new entrant's activities (hence 'retail-minus'). The balance is taken to be an appropriate price or reward for the incumbent operator for the services (in the form of access to its infrastructure) it continues to provide.

The use of this method has historically been justified on three grounds: (i) a desire to protect an incumbent's ability to recover the sunk (i.e. already sustained and relatively long term) costs of its infrastructure; (ii) a desire to ensure that new entry is only feasible where the new entrant can perform the same functions as the incumbent at a lower cost (both to itself and, via the price that is charged to the customer, society as a whole); and (iii) by protecting the incumbent's position, the use of this method will protect customers who are not able to choose suppliers from price rises caused when the incumbent seeks to recover any lost profit.

Ofwat and Dŵr used all three of these arguments in support of Ofwat's decision, but the final point, in relation to the potential impact on non-contestable customers, was rejected by the CAT as irrelevant an unfounded on the facts [25]. In relation to the other defences, Albion's submissions focused on the obvious corollaries of the above listed benefits: (i) the use of this method can entrench any inefficiencies that exist within the incumbent's existing price; (ii) it requires the new entrant to operate more efficiently than the incumbent in order to even get the opportunity to compete and (iii) even if there are no inefficiencies within the incumbent's existing price, an access pricing structure which guarantees the incumbent the same income as it already receives, arguably removes any incentive on the incumbent to improve its efficiency

The ECPR has proved controversial in other jurisdictions - its use has been banned in the New Zealand telecommunications sector following the Clear [26] case; it was rejected by the US Supreme Court in the Verizon [27] case, has never been applied in the UK electricity and gas industries and although Oftel, Ofcom's predecessor, used a form of ECPR on occasion, Ofcom have also rejected it as a useful approach to determining appropriate access charges.

The legal significance of this largely economic debate hinges on whether the price charged by a dominant undertaking can be shown to be reasonable and cost reflective (and so not abusively excessive) through the application of this rule. In determining that question, the CAT recognised that, even on its own terms, the ECPR method is only partial and must be accompanied by effective price regulation. As with its analysis of the excessive pricing arguments noted above, the CAT recognised that whilst it may be the case that an incumbent's prices are regulated in such a way as to eliminate any inefficiencies and excess, it is not necessarily so. More intriguing however, is the CAT's analysis of the arguments about how efficient competitive entry should be before the rules on excessive pricing swing in favour of the new entrant rather than the incumbent.

The CAT recognised that, in cases such as these, there will always be a balance to be struck between the legitimate aim of protecting the incumbent from not being able to recover the costs associated with its existing infrastructure (i.e. preventing stranded assets) and allowing access prices which don’t stifle developing competition. Whilst the benefits of competition per se are, strictly speaking, a matter more for government policy than legal application, the CAT judged that an economic approach which requires new entrants to be 'super efficient' effectively eliminates any chance of competition from developing and so can not be justifiable in the face of the government's policy direction, made clear through the succession of liberalising statutes noted at the beginning of this article. The lesson here appears to be that competition can generate goods of itself and, whilst the Chapter II prohibition should not be used in a way that unduly penalises incumbent, dominant undertakings, it should provide protection for fledgling new entrants and the competition they bring.

The CAT was at pains to stress that its judgement should not be taken to mean that the use of ECPR is necessarily contrary to Chapter II of the CA98. In this case the CAT's analysis of the average accounting justification for the access price had already shown that Dŵr's quote was not cost reflective and so the application of the ECPR had to fail. However, the detailed analysis and criticism which the method received, coupled with its difficult international history, must cast doubt whether it will ever again be confidently used by UK regulators or dominant undertakings.

The relevance of an incumbent's avoided costs does not, however, end there. After Ofwat had made its decision, the WA03 came into force and brought a new formulation for determining the price payable for access to an incumbent's infrastructure – section 66E, the 'costs principle'.

Schedule 4 of the WA03 amends the WIA91in a number of ways, including the insertion of a new section 66E, which is designed to guide Ofwat when it is asked to make a determination in respect of the terms offered for access to monopoly infrastructure or for the supply of wholesale water. In such cases, Ofwat may have to determine the price which the incumbent can charge the new entrant and, in doing so, should follow section 66E. That section provides that the incumbent should be entitled to recover its expenses reasonably incurred when entering into the agreement with the new entrant (which is relatively uncontroversial) and, in terms of subsection (1)(b) "the appropriate amount in respect of qualifying expenses and a reasonable return on that amount" (to an extent net of any other financial benefit the incumbent receives because of the new entrant's participation in the market).

In determining the 'appropriate amount of qualifying expenses', section 66E provides that 'qualifying expenses' are those that the incumbent reasonably (emphasis added) incurred or will incur in carrying out its functions and the 'appropriate amount' is that which the incumbent reasonably expected to recover from the customers but is unable to recover because those customers are now being supplied by someone else (again, emphasis added). This formulation is supplemented in subparagraph (4) by what is known as the ARROW provision – that is that nothing should enable the incumbent to recover amounts that can be Avoided or Reduced or are Recoverably in some Other Way. At first glance this appears very like a retail minus approach to cost determination.

A leg of Ofwat's defence relied on the fact that, had WA03 been in force at the time it made its decision, it would have been required to reach the same conclusion. The CAT agreed that if Ofwat's decision did conform with the section 66E costs principle then, even though the relevant section was not in force at the relevant time, it would have been a suitable defence. However, because the CAT had already found that the price Dŵr had quoted was excessive and constituted a margin squeeze, to find the decision in conformity with section 66E would necessitate a finding that section 66E allowed anti-competitive behaviour, in direct conflict with the CA98.

Ofwat argued that paragraph 5(2) of schedule 3 to the CA98, an exemption to the Chapter II prohibition where the conduct complained of is engaged further to a legal requirement, meant just that – the WA03 should trump the CA98. Had that argument succeeded, it would also have had significant implications for the future scope of the Chapter II prohibition and statutory interpretation exercises where two, possibly conflicting, pieces of legislation are involved [28].

The CAT found that the requirements of section 66E were consistent with Chapter II by reading the established competition law requirements for 'reasonable relation' to the underlying economic value and cost reflectivity (noted above) into the ubiquitous 'reasonable' references within the section. It justified this stance, in part, by taking the view that had parliament intended to create an exception to the Chapter II prohibition, they would have made some explicit recognition of that fact within the statute itself. Essentially, the CAT reached the view that a reading the ARROW formulation in a way which generated a retail minus approach to access price determination "precluded virtually any effective competition or market entry, is in potential conflict with the consumer objective set out in section 2(21)(a) and (2B) of the WIA91 and the Chapter II prohibition, and thus open to serious question."

Future application of section 66E must be cognisant of that statement and so, arguably, any further development of a competitive water market in England and Wales must clearly incorporate the competition laws prohibiting excessive prices and margin squeezes that this case emphasises [29].

Conclusions
There will be many who hope that the CAT's strong stance in favour of market entry and criticisms of Ofwat's management of this case will cause a rethink in the Birmingham offices of the regulator and create a culture shift towards detailed actual cost reporting and robust analytical scrutiny – A pipe is not simply a pipe and in the areas where law and economics meet assumptions must be tested and, further, be applied in a way which generates cost reflective, reasonable, access prices.

There is still mileage left in this Albion case; not least resolution of the prior question of dominance, which was not determined, by Ofwat (who, having found no abuse did not need to assess it) and so was not a question before the CAT. It does however now need to be concluded and in its most recent ruling in this case, the CAT indicated that a further hearing should take place on the 14th or 15th of November to decide on the best way forward. In that ruling, the CAT raised questions about the circumstances in which construction costs might not constitute a barrier to entry and so more interesting competition analysis can perhaps be expected from the CAT before the year is out.

In the meantime, early signs of a culture shift are appearing. In a city briefing on 1 November, Ofwat's Chairman, Phillip Fletcher and Chief Executive, Regina Flinn, signalled the need for a rethink on the approach to competition in the English and Welsh water industry. The CAT's judgement recognised that, as things stand, contestable customers still do not have any effective choice of supplier and that, despite legislative reforms, virtually no common carriage has occurred. Perhaps ultimately this case will be seen as something of a turning point in the history of the English and Welsh water market and future developments in the industry will be watched with much interest.

[1] At the time the appealed decision was taken, the Director General of Water Services had not been replaced by the Water Services Regulation Authority but for ease of reference, this note shall refer to 'Ofwat' as a phrase covering both bodies.

[2] In summary form pending confidentiality submissions from the parties, the full judgement was published on 12 October.

[3] The WIA91 also makes it Ofwat's duty to ensure that all areas of England and Wales are covered by a company required to provide water and/or sewerage services.

[4] Scottish Water remains state owned and the sole wholesale provider of water and sewerage services in Scotland. As this article went to press, a new retail subsidiary of Scottish Water, Scottish Water Business Stream, had been licensed (on a provisional basis) to provide water and sewerage retail services to non-household customers. It is anticipated that new entrant private competitors will be able to enter the Scottish water and sewerage retail markets from April 2008.

[5] 250ML in Wales. The threshold in England and Wales was originally 100ML, but was reduced to 50ML by regulation 2(2) of the Water and Sewerage Undertakings (Inset Appointments) Regulations 2005.

[6] Inset appointments are also available where the incumbent company consents to the appointment, where the appointment covers an area that does not contain any premises served by the incumbent or where the specific conditions of the incumbent's appointment provide for it – section 7 of the WIA91.

[7] Albion and Shotton were working together to arrange better terms for supply in the long run. Indeed, Shotton has been financially supporting Albion's legal action.

[8] [1978] ECR 207.

[9] OJ 1998 C265/2. Note that the CAT relied on S.60 of the CA98 to draw European case law and precedent into this, domestic, analysis of abuse under Chapter II of the CA98.

[10] United Brands judgement, noted at 8 above, paragraph 250.

[11] CAT judgement, paragraph 310.

[12] CAT judgement paragraph 314, drawing from the Telecommunications notice.

[13] CAT judgement paragraph 464.

[14] A point the CAT make at paragraph 468.

[15] As Dŵr had argued in defence, see CAT judgement paragraph 628.

[16] CAT judgement paragraphs 613 and 625.

[17] Paragraphs 117 and 118 of the Telecommunications Notice as cited by the Director in paragraph 342 of the Decision.

[18] [1998] ECR I-7791.

[19] [1974] ECR 223.

[20] [1988] ECPR 3621.

[21] [2005] CAT 25.

[22] As summarised by the CAT at paragraph 862 of its judgement.

[23] Genzyme v OFT [2004] CAT 4.

[24] The evocative analogy Ofwat used on this point, as described at paragraph 52 of the CAT's judgement, is that Albion was in "no better a position than a person who snatched a letter from the postman at the garden gate and demanded a margin for delivering the letter to the front door.".

[25] At paragraph 46 of its judgement.

[26] Telecom Corporation of New Zealand v Clear Communications, Privy Council decision of 19 October 1994.

[27] Verizon Inc v Federal Communications Commission 535 US 467 (2002), see CAT judgement paragraph 733.

[28] The argument may have also run into difficulties with the European case law on primacy, for example the Italian matches decision (Consorizio Industrie Fiammiferi v Autorita Garante della Concorrenza e del Mercato, EJC Case C-198/01), which requires national competition enforcement bodies to disapply provisions of domestic law which conflict with the European competition rules.

[29] In this context, the CAT's judgement will be of immediate relevance to Aquavitae's separate High Court appeal against the interpretation of section 66E, which was stayed pending judgement in this Albion case.

Fiona Parker is a solicitor specialising in energy and utilities with UK law firm Shepherd and Wedderburn. Fiona was part of the legal team that advised the Water Industry Commission for Scotland on the introduction of the new competitive market.

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