MD 162

TO THE MANAGING DIRECTORS OF ALL
WATER AND SEWERAGE COMPANIES
AND WATER ONLY COMPANIES

12 April 2000

COMMON CARRIAGE - STATEMENTS OF PRINCIPLES

1. Introduction

The Competition Act 1998 (the Act) came into force on 1 March 2000. Companies have prepared statements of the principles that will govern the shared use of their networks. These statements are available from the companies to all interested parties. Reference copies can be inspected in the Ofwat library.

All companies should now be preparing full access codes. Some companies have made more progress than others and submitted draft codes with their statements.

This letter comprises two sections. The first provides an overview of companies' submissions and discusses some of the key points raised by companies. Our objective is to bring the key issues to a wider audience and to help share ideas between companies. The second section answers some of the questions raised by the companies in response to MD154 and MD158.

This letter does not cover pricing issues for common carriage. These will be the subject of a further MD letter in the summer, which will comment on proposals put forward by companies, in terms of their consistency with existing charging policy and the Act. It is likely that there will be more than one approach to charging that meets this consistency check.

2. Companies' Statements of Principles

2.1 Overview

Each company has submitted a statement of principles. Some are comprehensive, including details of the process that applicants can expect to follow and how the incumbent would assess the application. Most statements, however, are brief.

They are a useful starting point for discussions with potential competitors, but those companies now need to make substantial progress on preparing full access codes. The onus remains with companies to comply with the Act.

Several companies have already received enquiries about common carriage from potential competitors. These companies will be able to draw on their experience of discussing common carriage cases with applicants, to enable them to prepare their full access codes. Companies that have not yet been approached by potential common carriage applicants should not use this as a reason for delaying the development of their access codes.

All companies should be able to use their statements of principles as a basis for drafting their access codes. These will include more specific detail on technical and operating parameters, price and contract terms for common carriage. It seems reasonable that your first full version of the code should be prepared no later than 31 August 2000, six months after the Act came into force. I would be interested to hear from you on progress with your code and would like to be informed when you have completed it.

There is a degree of commonality between companies in the content of their statements. The companies agree with many of the important issues raised in MD154 such as safeguarding quality, co-operating on emergency procedures and responsibility for controlling the physical operation of the network remaining with the incumbent. Half the companies commented on the issues of criminal liability and metering, and most mentioned leakage. All of the companies offered views on access charges and the status of the applicant.

The remainder of this section discusses in more detail some of the issues raised by individual companies in their statements of principles.

Trial Periods

Network modelling can be an important tool in assessing applications for common carriage. DWI recommends, in its guidance on quality, that all companies should use modelling tools and keep those models up to date. However, problems that were not predicted by modelling may be experienced in practice. In some cases, therefore, it may be appropriate to use a period of evaluation to assess the physical impact of common carriage on the operation of the network and on other customers' supplies. A trial period could provide flexibility to deal with problems before committing both entrant and incumbent to a longer term arrangement.

Trial periods should not be so long that they create too much uncertainty for the applicant, particularly if it has made significant capital investment. If problems are identified, the incumbent and the applicant should work together to resolve them. We expect in most cases that these problems could be addressed, but there might be circumstances in which the common carriage arrangement may have to be terminated. The provisions for termination, including any payment of compensation and the apportionment of costs incurred, is a matter for the parties to agree.

Eligibility of customers

Some companies have stated explicitly that all customers are eligible for competition. This is an important point. The inset appointment mechanism has qualifying criteria and most inset appointment applications so far have been on behalf of large users. However, the current legislative framework does not preclude any group of customers, including households and unmeasured customers, from being supplied by a new entrant through common carriage.

Connectivity

Several companies have argued that common carriage should take place only if there is a continuous physical link between the entrant and its prospective customers. However, companies should not automatically refuse to consider cases where there is no such physical link.

There may be cases where there are benefits to both the applicant and the incumbent, in allowing greater flexibility in the distribution of resources. For example, an incumbent might have two areas that are not connected, but one is short of water and the other has spare resources. An applicant might want to put water into the former area and take water out of the latter area, to serve its customers in what would be a common carriage case if the areas were linked. Without the link, there could still be a benefit to the incumbent, as well as the applicant, by helping to even out the resource position.

Essential facility

Many of the companies, in their statements, require the applicant to demonstrate that the asset they wish to share is essential. This seems to be onerous and unnecessary. Incumbents need 'objective justification' for their actions, if they have an essential facility. My view is that many of the incumbents' capital assets are likely to be essential facilities. If they refuse access (or set terms that are unreasonable), the Director may be called upon to decide whether the incumbent's behaviour is illegal. Incumbents risk infringing the Act if the Director finds they have no 'objective justification' for a refusal to allow access.

Time limits

Some statements include minimum and maximum time limits on the length of common carriage contracts. This might reflect incumbents' uncertainty about common carriage. However, there is a degree of inflexibility in requiring contracts to be time-limited. It is important to provide applicants, particularly new entrants, with sufficient incentive to invest in common carriage. Time limits that are too short might preclude this.

Companies should not use time limits as a means of deterring entry. Companies might show more flexibility by stating that, in some circumstances, contracts may be time-limited. Contracts might, for example, be linked to the period over which an applicant holds an abstraction licence. In any event, it would be prudent to have a mechanism for regularly reviewing the impact of common carriage (perhaps linked to the use of trial periods).

Leakage

The companies employ a wide range of methods for accounting for water lost via leakage. These include the incumbent providing all water lost, so that the entrant does not put in more water than is to be taken by its customers. Other methods of measurement include the regional average level of leakage, the Ofwat target level, the greater of these two, the economic level of leakage both at a regional level and the zonal level, and simply an agreed level of leakage. Some companies do not mention leakage or do not specify how it is to be taken into account.

Taking responsibility for water lost to leakage does give the incumbent a clear incentive to reduce leakage to an economical level. It would also simplify the common carriage negotiations.

However, if companies instead choose to require entrants to include an amount of water for leakage, additional to the water taken by their customers, then the most appropriate figure would be the incumbent company's economic level of leakage (ELL) appropriate to the part of the system involved. The method of calculating this figure, and the data used, should be shared with the applicant, to encourage robust challenge. Where the incumbent does not have a robust ELL figure, it should use the Ofwat leakage target.

Applicant's status

MD158 sets out my view that it is not necessary for common carriage applicants to hold a licence under the Water Industry Act 1991 (WIA91). The guidance produced by the Drinking Water Inspectorate supported this view.

I welcome the approach taken by some companies in recognising this in their statements. They are prepared to deal with applicants that are not licensed under the WIA91, as long as they have the necessary experience, technological skills and financial backing. Underpinning the agreement would be a comprehensive contract setting out the terms for all the aspects of a common carriage arrangement. This seems to be a balanced approach.

If incumbents require applicants for common carriage to be licensed undertakers, then they should co-operate in achieving this. Under the WIA91, new licences can be granted only via the inset appointment mechanism. While the onus remains on applicants to formulate serious and well-considered applications, incumbents should be prepared to explain to applicants about inset appointments, including their geographic nature, which involves the incumbent giving up a part of its area to the applicant. The incumbent should be prepared to consent to an inset appointment application under section 7(4)(a) of the WIA91.

Secondary Connections

The focus of debate so far has been on the initial connections made by applicants to the incumbents' existing networks. As common carriage develops, there is likely to be an expansion of the overall network, some of which is owned by the applicants. There may be circumstances in which other entrants and undertakers will want to apply for common carriage via these new networks. In these cases, the networks owned by both the first applicant and the incumbent will be affected.

While the first applicant will be responsible for negotiating terms of access with the second, the incumbent will want to maintain the integrity of its system. It is reasonable, therefore, for the incumbent to look for a relationship with the second applicant that addresses these concerns. Before the two applicants agree terms, the incumbent should be consulted. The incumbent should not use this process to deter entry or delay the process unnecessarily.

Charging for processing applications

MD154 set out my view that the direct costs of competition should be borne by those who benefit from it, and not spread across the entire customer base. A few companies have suggested in their statements that applicants should be charged for the work that the incumbent carries out in processing their applications.

It is important that incumbents do not raise barriers to entry by setting unreasonable costs for processing applications. In particular, incumbents need to be careful not to risk infringing the Act by requesting charges for every aspect of an application.

For example, I would not expect incumbents to charge for initial discussions with potential applicants. This could be construed as an abuse of a dominant market position. However where issues of a substantive nature are being assessed (e.g. network modeling) then some charge for this service, if it is undertaken by the incumbent, may be appropriate. Also, where possible, incumbents should take advantage of economies of scale to keep costs down. Such scenarios could include processing several applications from the same potential entrant.

3. Specific questions

Some companies asked questions about the development of common carriage in their comments on MD154 and MD158. We have held meetings with many companies, in which most of these questions have been discussed. The questions about pricing will be dealt with by a further MD letter. I have set out below some further clarification requested by companies on a number of issues.

Arbitration

If two parties cannot agree on terms for common carriage, I will judge whether the incumbent's behaviour infringes the Act. Under the Act, my decision is subject to appeal to the Competition Commission's Appeal Tribunal

There may be circumstances in which the parties cannot resolve a dispute after terms have been agreed. It seems sensible for the common carriage contract to contain a mechanism to resolve disputes. The parties should agree to accept the decision of an independent arbitrator. The resolution of disputes by such an arbitrator does not fetter my ability to investigate potential abuses by the incumbent of a dominant position, or other anti-competitive behaviour.

Reasonableness

In deciding a complaint, I will judge whether the incumbent has 'objective justification' for its behaviour, especially when the issue is access to an essential facility. I have given examples of reasonable behaviour in MD 154, when describing the principal elements of common carriage. For example, if an incumbent can show that the technical operating parameters for its system that will apply to the entrant are the same as those it uses in its normal operation, this might be acceptable. However, it would not be appropriate to pre-judge any decision on what is or is not reasonable, as each case would be decided on its facts.

Terms of contracts

I said in MD154 that incumbents and applicants should be able to agree many of the terms of access without the need for regulatory intervention. Issues such as provision for termination of the contract, compensation payments, duration and review mechanisms, can and should be agreed between the parties. If the parties cannot agree, I can decide if the incumbent's requirements are justified.

4. Next steps

In the next few months several important steps will be taken in developing competition. The Department of the Environment, Transport and the Regions will publish its consultation papers on competition in the water industry and on the use of economic instruments for allocating abstraction licences. Also, in

MD159 I invited companies to review their long run marginal cost estimates and, if they wish, to submit revised estimates by 31 July 2000. Before this date I will write in more detail on the pricing issues for common carriage. We expect the draft Water Bill to be published later in the year.

None of this affords any reason to defer preparation for common carriage. On the contrary, companies should be striving to be at the forefront of competition. Much work has already been done to prepare the statements of principles by 1 March 2000. With the Competition Act now in force, you should keep this momentum going by developing detailed access codes as soon as possible. A version should be ready to discuss with potential applicants by 31 August 2000, with the expectation that these will be revised as experience grows. My office will continue to be available to meet and discuss issues.

I C R Byatt

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