What's the appeal of a price review? Competition Commission issues final findings in Bristol Water Price review

By Suzanne Rab, counsel and Alex Olive, associate in the Antitrust, Competition and Economic Regulation practice at Hogan Lovells in London.

On 4 August 2010, the Competition Commission (CC) announced its final findings on the appeal by Bristol Water Plc (Bristol Water) against the latest price control determination of the Water Services Regulation Authority (Ofwat).  The CC confirmed that Bristol Water can make a small increase in the prices it charges its customers above the limits originally set by Ofwat.  However, this increase falls short of what the regulated company was seeking and raises questions about what applicants in a price review appeal before the CC may stand to gain by disputing the regulator’s determination.

Background

Water (and sewerage) charges are capped under the conditions of appointment of the water undertakers.  Condition B sets a charges limit, which is the percentage calculated as RPI+K+U, meaning:

• the percentage change in the retail price index (RPI) in the year to November from the preceding November;
• plus the relevant Adjustment Factor, "‘K";
• plus unused price charges carried forward, "U".

Every five years, Ofwat determines, following a review, whether the Adjustment Factor K should be modified. Ofwat made its final determination on future water and sewerage charges for the period 2010 - 2015 on 26 November 2009.  The water companies had until 26 January 2010 to either accept or reject Ofwat's determination. Bristol Water was the only company to reject Ofwat's determination, arguing among other things that it would not allow for crucial maintenance work to take place in the Bristol area.  This triggered a reference to the CC for a redetermination of Bristol Water's charges.

The determination and appeal

Ofwat had determined that Bristol Water could impose an average 1.7 per cent price increase each year, after inflation, between 2010 and 2015.  Bristol Water's appeal challenged Ofwat's determination of K.  In bringing the appeal, Bristol Water sought to bring the determination closer to a 6 per cent increase.  Bristol Water argued that Ofwat’s decision on price limits was ‘unacceptable’ and stated that “we will not put customers at risk and need to increase the level of investment, and this directly affects bills.”

Bristol Water made submissions that it was seeking to replace vital pipes, many of which are over 100 years old and that, in light of the growing Bristol population, it was eager to ensure “we have enough water and system capacity available to meet increasing demand at the lowest cost possible.”The CC was required to re-determine the value of K, having regard to various regulatory principles, namely the duties to:

• further the interests of both existing and future water consumers (the consumer objective);
• secure that water companies properly carry out their functions;
• secure that water companies are able to finance those functions, in particular, by securing reasonable returns on their capital;
• promote economy and efficiency on the part of water companies;
• secure that there is no undue preference or discrimination in the fixing of charges; and
• contribute to the achievement of sustainable development.

The CC is also required to have regard to principles of best regulatory practice.

The CC’s decision

The practical effect of the CC's decision is that Bristol Water is permitted to increase its bills to customers by an average of about 15 per cent over the five year review period.  This is still significantly below the 29 per cent increase sought by Bristol Water over the control period but above the 7 per cent increase that Ofwat had originally permitted.  The impact on customer bills is a rise from £157 in 2009/10 to £180 by 2014/15.

In making its decision, the CC had to consider a number of factors, balancing the desire to keep customer bills low, while taking account of extra expenditure by the regulated company to improve quality, which ultimately benefits consumers.

Appeal Group Chairman, Laura Carstensen, justified the increase on customer bills by stating that

“any decision to raise bills, even only modestly, should only be taken after very careful consideration.  We have agreed to some of the extra expenditure, which will mean a small rise for customers above the price limits set by Ofwat, but equally we have also rejected several other projects, which would have further increased bills, as well as upholding Ofwat’s judgment in a number of other areas.”

This recent appeal and decision yields lessons about the setting of price controls and the scope for challenge by the regulated water companies.  It is interesting to note that Ofwat met with firm opposition from across the industry during its review process which preceded the latest control, but only Bristol Water challenged the regulator's final decision all the way to the CC.

A lower cost of capital

The CC’s decision also provides some insights on the application of the methodology of water price controls, which may be relevant for further iterations of business plans, financial ratios and prices in the sector.  Of particular interest is that the CC has confirmed its view that the cost of capital should be 5 per cent.  This is actually slightly lower than the figures put forward by Ofwat of 5.5 per cent and Bristol Water itself (6.7 per cent).  It is a reminder that a challenge to a regulator's decision can cut both ways, with the final review body ultimately taking a more stringent approach than the original decision-maker on certain elements.

By examining an appeal in which a challenge to a price control has not produced a significant uplift for the regulated company, observers might question whether such appeals are worth pursuing.  An applicant will always need to keep in mind exactly what it plans to gain by an appeal - whether in terms of the amount of money or the legal or regulatory principle at stake.

If the only arguments that the applicant can put forward are that the original decision-maker’s reasoning was faulty, it must think hard before pursuing a case.  In some situations, even if the applicant is successful in challenging the regulator’s reasoning, this may not yield a tangible benefit in terms of the monetary impact if the alleged violation did not determine the final result.

This does not mean that there are no circumstances in which an appeal will result in a significant and beneficial (from the company’s perspective) departure from the regulator's own approach.  And if the point of legal or regulatory principle (such as differential treatment or cost of capital) is worth pursuing, it may well be worth the legwork (and legal costs), irrespective of the bottom-line impact in the case at hand.

However, a survey of recent water appeals before the CC in this area suggests that such circumstances are rare and that cases to be brought will need to be chosen carefully.  Recent experience on an interim determination as reviewed by the CC is not encouraging.  In August last year, the CC rejected an appeal from Sutton and East Surrey Water to increase its prices to customers in 2009/2010.

Implications for potential price increases before 2015

The full ramifications of the CC's reasoning may, however, be of most interest in the medium term as water companies decide throughout the period of the current price control (2010 - 2015) whether to accept the current limits.  Alternatively, they may decide to bring forth further evidence to support an interim determination before the next five year control is determined.  Such companies and their advisors will no doubt wish to crawl over the CC’s report for insights to be gained on areas which might be worth pursuing on the basis that Ofwat’s reasoning was not water tight.

Whether water companies will have to return to Ofwat for a redetermination of their price controls in the event of significant changes in their circumstances (for example, on account of an increase in bad debts or additional costs arising from legislative changes) in the next five year period, remains to be seen.

Developments in price regulation for water – Beyond limits

The CC's final decision brings to an end the current chapter in terms of Bristol Water’s own challenge of the latest Ofwat determination. While a further appeal by way of judicial review of the CC’s own decision is an option, it presents a high hurdle.  The grounds for judicial review are illegality, irrationality and procedural impropriety in the decision-making (which can extend to denial of a company's legitimate expectations).  In practice, a potential applicant may consider this option if could show that the CC took into account irrelevant matters and/or failed to consider relevant matters, had not substantiated its decision or that it followed an improper process.

The CC’s own decision must also be set against the publication by Ofwat only a few days earlier on 30 July 2010 of a paper considering how prices for regulated water and sewerage services should be controlled going forwards.  The paper identifies three hypothetical scenarios against which options for price setting can be tested, depending on the level of reform and vertical disaggregation in the sector (i.e. unbundling of the different functions of a water company).  (See Box below)

The development of competition in the water sector raises important questions about what degree of legal, business and accounting separation will be required over time.  In the event that more extensive changes are finally adopted, which could include the creation of a network licence allowing entry into the operation of the network, it is assumed that Ofwat will operate separate price controls at different stages in the value chain (such as resources, treatment, network and retail).

This raises important questions in relation to the longer term implications of a price control and how regulatory capital will be allocated across different business activities as the industry embarks on the next period of regulatory development.  In this context, the challenges that regulated companies face in terms of a growing population, scarcity of water, climate change, meeting customer expectations and an uncertain economic climate should not be underestimated.