Bristol Review has implications for AMP5

The outcome of the Competition Commission review of Bristol Water's appeal against its price control may have lessons for future business plans and price setting now and in the future, says Suzanne Rab, counsel at Hogan Lovells legal practice

On 4 August 2010, the Competition Commission (CC) announced final findings on a challenge by Bristol Water against the latest price control of the water service regulator, Ofwat.

The CC decided that Bristol Water can increase the prices it charges its customers beyond the limits originally set by the water regulator, yet this increase falls short of what Bristol was seeking in its appeal. In the wake of this latest price control challenge, there are lessons water companies may take away from the appeal when planning future business, regulatory and investment strategies.

In making its final 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. The CC decided that Bristol Water is permitted to increase its bills to customers by an average of about 15% over the five year review period.

This is still considerably below the 29% increase sought by Bristol Water over the control period yet above the 7% increase that Ofwat had originally determined. As a result, customers’ bills will increase from £157 in 2009/10 to £180 by 2014/15.

The CC 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.”

Looking beyond the immediate impact on bills, the CC’s decision provides some insights into the application of the methodology for water price controls, which may be relevant for business plans, financial ratios and prices going forwards. The CC confirmed its provisional view that the cost of capital should be 5%.

This is actually slightly lower than the figures put forward by Ofwat of 5.5% and Bristol Water itself (6.7%). In this instance, the final review body (the CC) ultimately took a more stringent approach than the original decision-maker (Ofwat) on this element.

However, whether an appeal is worth pursuing may not hinge on any one element. It will tend to be a complex interplay between the importance of the legal or regulatory principle at issue for the relevant case and future cases, its (monetary and non-monetary) impact on the disputed decision, and the costs and timing in pursuing the appeal itself.

While Bristol Water was the only water company to challenge Ofwat’s determination it is still open to the regulated water companies to present further evidence to support an interim determination before the next five year control is determined.

Such companies and their advisers will no doubt examine the CC’s report for insights to be gained on areas of Ofwat’s reasoning and the application of the price control methodology which might be worth pursuing.

Whether water companies will find cause to return to Ofwat for a redetermination of their price controls in the event of significant future changes in their circumstances in the next price control period, remains to be seen. However, experience on recent appeals before the CC suggests that cases brought will need to be chosen carefully.

In August 2009, for example, the CC rejected an appeal from Sutton & East Surrey Water to increase its prices to customers in 2009/2010.

The CC’s decision in the Bristol Water case 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 regulated in the future.

The paper sets out three hypothetical scenarios against which price setting options can be tested, depending on the level of reform in the sector (that is, in terms of unbundling of the different functions of a

water company).

The development of competition in the water sector raises significant issues about what degree of legal, business and accounting separation will be required over time.

If extensive changes are finally adopted, 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 that context, the issues that regulated companies face in terms of an expanding population, scarcity of water, climate change, meeting customer expectations and an uncertain economic climate will no doubt be revisited.

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