The last few months have seen a number of interesting developments in the water sector. Of particular note has been a rethink on the part of Ofwat in relation to the introduction of supply competition for large volume consumers. The attempt to implement water supply licensing has run into rough weather on account of difficulties with pricing and the so-called Costs Principle. Ofwat is now considering changes to the WSL regime as well as a raft of more farreaching measures (some of which will require new legislation) including accounting separation of functions, regional de-averaging of tariffs, extending supply competition to household customers and/or to sewerage services, introducing greater competition in abstractions rights, and more radical structural reform.

The Competition Commission has permitted the Mid Kent Water and South East Water merger, despite Ofwat opposition. The CC’s decision illustrates its current thinking as regards consolidation in the water industry and its willingness to take an independent line from Ofwat, but it is questionable whether the decision will open the floodgates to future mergers, as some commentators have suggested.

Turning to case law developments, the Court of Appeal’s decision in Thames Water v Ministry of Defence1 has clarified the ability of water companies to charge for sewerage on the basis of the total quantity of water supplied; the decision of the same Court in Welsh Water v Corus2 has focused attention on the drafting of a supply agreement with a non-domestic customer as regards any arrangements for continuation of supply after termination of the agreement; and a recent decision of the European Court of Justice in R (Thames Water Utilities Limited) v Bromley Magistrates Court3 raises the prospect of criminal liability of sewerage undertakers under the waste regime for leaking sewers.

The Water Supply Licensing Regime - dead in the water already?

Background

In late 2005, a new legislative regime to promote market competition in the sector in England and Wales came into force.

The Water Supply Licensing (“WSL”) regime, as introduced by the Water Act 2003, was designed to facilitate competition in the supply of water to large volume nondomestic customers (those purchasing at least 50 million litres per annum) by providing for the grant of two new forms of licences: 

  • Retail licences - authorising the licensee to purchase a wholesale supply of water from a water undertaker and to use the undertaker’s supply system to supply that water to customers 
  • Combined licences - allowing the licensee also to introduce water into a water undertaker’s supply system.

The system was underpinned by a requirement for water undertakers to publish access codes, setting out the terms (including indicative access prices) on which they would grant access to their systems to allow new licensees to supply customers. The basis on which access prices must be fixed, referred to as the Costs Principle, is set out in section 66E of the Water Industry Act 1991 (“WIA”), as inserted by the 2003 Act.

In September 2006, Ofwat published detailed Guidance to assist water undertakers in framing their access codes, including Ofwat’s interpretation of how the Costs Principle should be interpreted. In essence, the Guidance interprets the Costs Principle as a “retail minus” method of access pricing. (In broad terms, according to the Guidance the access price is the prevailing retail price charged by the incumbent undertaker, minus what the incumbent saves from not supplying the target customer.)

However, with the regime barely up and running, Ofwat has now announced that it believes the regime is unlikely to succeed in delivering effective competition or consumer benefits as intended. Ofwat has therefore recommended that legislative change, and possibly more radical change for the structure of the water industry in England and Wales, should be considered.

What has caused this review?

Although there had been expressions of dissatisfaction with the ability of the WSL regime to generate effective competition from the outset, the direct catalyst for Ofwat’s review was the judgment handed down by the Competition Tribunal (CAT) on 6 October 2006 in the Albion Water case. This did not directly concern the WSL system. Albion Water’s case - a dispute with Dwr Cymru in relation to Albion’s attempts to supply water to the Shotton Paper mill in North Wales - concerned a request by Albion for non- WSL common carriage pricing from Dwr Cymru.

In its judgment, however, the CAT also took the opportunity to comment on Ofwat’s interpretation of the Costs Principle. The CAT stated that it was not satisfied that Ofwat’s interpretation was legally correct, nor was it satisfied that any water company which followed Ofwat’s interpretation would be acting lawfully.

The section of the CAT’s judgment dealing with the Costs Principle was not strictly speaking legally binding on either Ofwat or water companies, but the clear implication of the CAT’s judgment was two-fold: 

  • the CAT believed that Ofwat’s interpretation of the Costs Principle was liable to generate access prices which would leave no meaningful margin for licensees to supply to customers profitably 
  • therefore any water undertaker setting access prices in accordance with the Guidance risked being held to be infringing the Competition Act prohibition on abuse of a dominant position

This left water undertakers in a difficult position. Under the terms of their licences they were required to set access codes in accordance with the Ofwat Guidance. On the other hand, the CAT was signalling that by doing so they were liable to infringe the Competition Act.

On one view the CAT was wrong to suggest that following Ofwat’s Guidance would infringe the Competition Act. The Competition Act does not apply to conduct carried out in order to comply with a legal requirement. By virtue of their licence conditions, water undertakers are legally required to follow Ofwat’s Guidance; and Ofwat has emphasised, in a general letter to the industry (WSL 01/07) that it considers this to be a legal requirement for the purposes of the Competition Act.

However, Ofwat appeared to accept that it could not simply ignore the CAT’s criticisms, or underlying general feeling, that the WSL regime as interpreted by Ofwat simply was not capable of producing any meaningful levels of customer switching.

Ofwat’s response

Ofwat has now conducted an internal review of the WSL regime, including consideration of whether changes to the Guidance are required.

Changes to the guidance?

Ofwat has openly acknowledged the depth of feeling that the WSL regime has failed to deliver. But recognising the limited room for manoeuvre within the present statutory framework, Ofwat has concluded that the Guidance should not be changed substantially.

In other words, Ofwat is adhering to its view that the Costs Principle as defined in section 66E of the WIA does mandate a “retail minus” approach to setting access prices. Further, Ofwat maintains that it is correct in taking actual retail prices to the customer as the starting point in applying this formula.

Ofwat has concluded that some changes should be made to the Guidance as regards the “minus” part of the calculation - ie, those costs which the water undertaker must deduct in setting the retail starting point. Ofwat is therefore proposing a more prescriptive approach to ensure that this element is calculated on a more consistent and fair basis going forward. (Ofwat has also identified a number of more minor changes which it believes could provide some further stimulus to competition.) However, Ofwat’s view is that meaningful increases in competition are unlikely to emerge without legislative change and that the “Costs Principle” is one of the biggest obstacles to the department of competition in water supply.

Broader changes?

The first possible response which Ofwat has flagged, therefore, is simply to change the legislative framework, by amending or replacing the current Costs Principle with a pricing formula which would generate greater margins for licensees in practice. Ofwat has additionally signalled that it believes the current 50 million litre threshold must be lowered.

Ofwat has also suggested, however, that other options should be canvassed, including: 

  • accounting separation of functions 
  • exploring different tariff policies, including, regional deaveraging of tariffs 
  • extending the WSL regime to include household customers 
  • extending the WSL regime to cover sewerage services 
  • even structural separation of retail, or retail and production, from distribution – this would entail breaking up the vertically integrated structure long established within the sector

Further details of these proposals are set out in Ofwat’s report summarising the key findings of its internal review (“Outcomes of Ofwat’s internal review of market competition in the water sector”): http://www.ofwat.gov.uk/aptrix/ofwat/publish.nsf/AttachmentsByTitle/competitionreview_070404.pdf/$FILE/competitionreview_070404.pdf

What happens now?

Ofwat is currently consulting on the planned changes to the Guidance. A consultation paper on these proposed changes (“Consultation on changes to the water supply licensing (WSL) guidance”) is also available online: http://www.ofwat.gov.uk/aptrix/ofwat/publish.nsf/AttachmentsByTitle/wsl_cons_guidance020507.pdf/$FILE/wsl_cons_guidance020507.pdf

As regards possible broader changes, Ofwat has signalled that it intends to consult starting this month, possibly with further consultation in November.

Clearly therefore this is an important time for anyone concerned about the possible future direction of efforts to foster greater levels of competition for water undertakers to try to shape Ofwat’s and the Government’s thinking. Some of the options being flagged by Ofwat are likely to engage substantial debate.

Competition Commission Allows Mid Kent/South East Water Merger to Proceed Despite Ofwat Opposition

On 1 May 2007, the Competition Commission (CC) delivered its final report on merger between Mid Kent Water and South East Water. The CC has ruled that the merger should be allowed to proceed, despite its finding that the merger may be expected to prejudice Ofwat’s ability to make comparisons between water enterprises.

The CC’s decision was the first on a water merger reference since 2002, and only the second since 1997. It was also the first water merger decision applying the Water Industry Act regime as amended by the Enterprise Act. It is therefore a valuable and timely indicator of current CC thinking on water mergers.

The fact that the CC has allowed the merger to proceed despite its findings on prejudice, and despite Ofwat signalling its preference for a structural remedy, is potentially a significant development for the possibility of further consolidation in the UK water industry. It certainly does indicate that the CC will not bow solely to Ofwat’s concerns. (The CC also noted that other regulated industries function effectively with significantly fewer independently-owned comparators than Ofwat currently has available to it.)

The decision should not, however, be interpreted as signalling an opening of the floodgates to further mergers. Clearly a key factor in the CC’s decision to allow the merger to proceed was its finding that the likely prejudice to Ofwat’s ability to make comparisons would only be limited.

The CC found: 

  • no likely loss of a potential benchmark 
  • no likely adverse impact from loss of a comparator for the purpose of standard cost-base estimates in most cases 
  • a likely small adverse impact arising from the reduction in the dispersion of standard cost-base estimates in a relatively few cases 
  • a likely small adverse impact on Ofwat’s ability to make other qualitative comparisons 
  • a likely small adverse impact on the precision of Ofwat’s econometric models

The CC also identified significant consumer benefits likely to result from the merger.

Balancing these factors, the CC was satisfied, despite Ofwat’s protests that the CC was underestimating the likely impact of the merger associated with the overall loss of a comparator generally, that a remedy in the form of a price reduction by the merged entity was the appropriate remedy. The CC recognised that this remedy would only benefit the merged entity’s customers, and not consumers elsewhere in England and Wales who may be affected by the impact on Ofwat’s ability to make comparisons, but the CC did not consider this decisive.

Thames Water Utilities Ltd v Ministry Of Defence [2006] EWCA Civ 1620

In this important case for the water industry, the Court of Appeal confirmed the wide scope of undertakers’ charging powers under section 142 of the Water Industry Act 1991 and reversed a decision in the High Court which could have proved troublesome in practice for the industry.

Thames Water Utilities Limited (“TWUL”) calculated its sewerage charges by reference to the metered volume of water supplied. However, the Ministry of Defence (“MOD”) discovered that a significant volume of water supplied to military barracks between 1996 and 2004 was not in fact returning as waste water, but rather was lost through leakage from MOD’s own pipes. MOD claimed that it had therefore been overcharged for sewerage services and sought restitution on the basis that it had paid invoices under a mistake.

MOD argued that TWUL’s statutory power to charge under s.142(1) of the Water Industry Act 1991 was limited to “services provided” and that, to the extent of waste water not exiting the site, it had paid for a service which had not been provided. At first instance MOD’s claim succeeded, the High Court holding that TWUL’s power to charge for waste water services was limited to a power to charge for services actually provided (ie, disposal of a volume of waste water) and that TWUL must therefore have regard to actual leakage rates on customer sites when setting its charges.

The Court of Appeal reversed this decision. It concluded that, on a proper construction, section 142 of the 1991 Act confers a wide discretion on the undertaker as to the principles to be adopted when calculating charges; and that the expression “services provided” has a broader meaning than contended by MOD, which includes the provision of facilities.

The Court of Appeal accordingly concluded that TWUL could properly charge for sewerage services on the basis of the volume of water supplied by it, a conclusion reinforced by the provision in section 144A(9) of the 1991 Act (obligation of sewerage undertaker to charge by reference to volume of water supplied where domestic customer elects for metered supply – in force since 1 April 2000). The Court also dealt with a separate jurisdictional issue. TWUL contended that the customer’s only remedy, in the event of overcharging, was by way of recourse to Ofwat, with a possible resort to judicial review in relation to any decision Ofwat took. The Court effectively rejected this contention, holding that if overcharging could in fact be established (it couldn’t), a restitutionary claim would be possible and is not necessarily excluded by section 18(8) of the 1991 Act.

Dwr Cymru Cyfyngedig (Welsh Water) (Claimant) and Corus UK Limited (Defendant)

In the course of proceedings for the recovery of amounts claimed by Welsh Water to be payable by Corus in respect of the supply of non-potable water to its steelworks at Llanwern, a ruling by the High Court on a point of construction concerning a term of the supply agreement was the subject of an appeal to the Court of Appeal. Although the point of construction turned on the particular wording of the term in question and has little precedent value as such, the case serves to emphasise for those drafting non-domestic supply or “special” agreements that, if on termination of the agreement (by expiry or otherwise) it is intended to revert to a statutory supply arrangement based on the tariffs applying under the undertaker’s charges scheme, it is advisable to make this explicitly clear. A general reference to the future supply being on such terms as may be agreed or, failing agreement, be determined by Ofwat under section 56 of the Water Industry Act 1991 may be construed (as in the Welsh Water case) as excluding the application of any charges scheme, with the effect that section 56(5)(a) does not apply and Ofwat’s discretion to determine charges for the particular supply is not excluded.

R (Thames Water Utilities Limited) v Bromley Magistrates Court

Last year, in a case involving United Utilities,4 the Court of Appeal held that the Pollution Prevention and Control (England and Wales) Regulations 2000 (“PPC Regulations”) do apply to sewage treatment plants5. In that case United Utilities sought to argue that six of its waste water treatment plants did not require permits under the PPC Regulations (which seek to transpose the Integrated Pollution Prevention and Control Directive (96/61/EEC) into English law) as they were not “installations” under those regulations. The principal issues were: 

  • whether the PPC Regulations applied to wastewater treatment generally or only to limited industrial activity 
  • whether sewage sludge was waste 
  • whether the activity of treating sludge was covered under the underlying European directive in the first instance 
  • whether treating of by-products of industrial effluent plants was covered under the PPC Regulations.

The Court of Appeal in upholding Nelson J’s judgment at first instance answered issues 1,2 and 3 above in the affirmative and United Utilities conceded the last.

A recent decision of the European Court of Justice involving Thames Water6 now raises the possibility of criminal liability under the waste regime for leaking sewers. The Environment Agency brought a prosecution against Thames Water as sewerage undertaker for illegally depositing controlled waste in respect of sewage which had leaked from its pipes and seeped into the soil. The undertaker disputed the fact that such leaks are subject to regulation under the waste regime. Since the definition of controlled waste relies on the meaning of waste in European environmental law, the matter eventually made its way to the ECJ. The ECJ decided that the waste regime does indeed apply unless the English courts can now determine (on the basis of a test laid down by the ECJ) that the Water Industry Act 1991 and/or Urban Waste Water Treatment Regulations 1994 make regulation under the waste regime unnecessary. To do this, those instruments would have to contain specific rules on the management of leaked sewage as waste, offering a level of protection at least equivalent to the domestic waste regime.

The case raises difficult questions regarding the application of the waste management licensing regime to leaks across subterranean network, the practicalities of maintenance and repair programmes adequate to protect undertakers against criminal liability in the absence of a licence, and the boundary with laws establishing liability for contaminated land. It also begs the question how any necessary capital expenditure to prevent such leakage may be funded within the terms of the price capping regime. We discuss these issues in a full note on the case and its implications which you can find on http://www.herbertsmith.com/NR/rdonlyres/59BA95A2-BAF3-4DD7-9CF7-6868A3AF6714/4113/WaterEnvironment_ebulletin_June07.html

Scottish and Southern Energy Inset Appointment

Scottish and Southern Energy has moved to becoming a multi-utility services provider after obtaining its first inset appointment to provide water to a housing development in Old Sarum, Salisbury within Wessex Water’s region. It has also made an application to Ofwat for another inset appointment in southwest London. Ofwat has assured that consumers in the inset area will not be charged more than the rates charged by Wessex Water in the rest of its licence area.

Financial Penalties

The penalty which Ofwat proposes to impose on United Utilities for breach of licence conditions (F 6.1 and 6.8 – non compliance with transfer pricing and market testing requirements) is, at £8.5 million, substantial. It raises speculation as to the substantive amounts of the fines which Ofwat has already announced it intends to impose on Severn Trent, Southern and Thames.