MD163

TO MANAGING DIRECTORS OF ALL

WATER AND SEWERAGE COMPANIES

AND WATER ONLY COMPANIES

30 June 2000

PRICING ISSUES FOR COMMON CARRIAGE

1. Introduction

The Government's consultation paper on competition in the water industry⁽¹⁾ said that the properly managed development of effective competition is desirable. Common carriage is one route through which competition can develop further. It presents a challenge to existing companies, but it also creates opportunities for companies to develop and grow their businesses. Many companies have recognised this and I welcome their positive response.

Companies have already produced Statements of Principles regarding access to their networks and are now preparing full access codes. As part of this process, MD162 (April 2000) provided companies with feedback on progress so far. It also promised a further letter on pricing issues for common carriage.

This letter sets out the principles that will underpin how Ofwat views access pricing issues. It reviews the main approaches that companies have considered in formulating policies for pricing access to their networks and explains how Ofwat will apply the Water Industry Act 1991 and the Competition Act 1998 to individual cases. It goes on to discuss the relationship between access prices and tariff policy more generally.

2. Principles

The principles that will govern Ofwat's assessment of companies' access prices (elaborating on those described in MD154) - and wider tariff issues relating to competition - are set out below. These principles follow directly from the Director's (and companies') existing duties, and from the Competition Act 1998.
i. The Director General has a duty to facilitate effective competition. Consistent with this duty, and with the Competition Act 1998, companies will be expected to offer access to essential facilities on reasonable terms.
ii. Each company should charge entrants as it would charge itself and should be able to demonstrate this, both to entrants and to the regulator, if asked to do so. Companies should also charge different entrants on similar terms for access under similar circumstances.
iii. Access charges should allow incumbents to recover network operating costs reasonably incurred and capital maintenance charges, without over- or under-recovery.
iv. Companies may wish to adjust their tariffs to respond to competition. Any such response should not be discriminatory (i.e. it should apply to all similar customers in a class, not just to one); should not be predatory (i.e. each set of charges should cover long run marginal costs); and should not be exploitative (i.e. each set of charges should bear a reasonable relation to the economic value of the service provided).
v. If companies respond to competition by adjusting their tariffs to reflect local costs more closely, they will need to do so with reference to the Director's duty – and their own responsibilities – to protect customers' interests, and particularly the interests of customers in rural areas. Similarly, having regard to the Secretary of State's guidance on fairness and affordability in water charging, the Director will expect companies to take into account the impact on customers of changes to their tariffs. Companies would be expected to manage the pace of any re-balancing.
3. Main approaches to access pricing

In assessing disputes or complaints about access prices, Ofwat will focus on the effect of the price on competition in individual cases, and on the cost information on which it is based. Nevertheless, it is instructive to review the approaches that companies have considered.

There are many different ways of calculating access prices, but the list of alternatives can be grouped into three main approaches. Specifically, access prices can be based on:

1. Accounting costs (i.e. the book value of the assets to which access is sought).
2. The long-run marginal cost (LRMC) of that part of the incumbent's system to which access is sought.
3. The Efficient Component Pricing Rule (ECPR).

Most companies have indicated that they intend to charge for use of their systems principally on the basis of the book value of their assets. Some companies have indicated that entrants will, where appropriate, be charged for any incremental costs associated with providing access (e.g. including the costs of new investment), although none has suggested that it would charge purely on the basis of LRMC.

Two companies have indicated that they may use the ECPR. This approach can be summarised by a simple equation in which the access price is given by the incumbent's final product price less the costs it would avoid by providing access. For example, a new entrant wishing to access an incumbent's arterial and local distribution network would be charged the difference between the incumbent's final product price and the avoidable costs of resources, treatment and customer service.

3. Comparing the approaches
The key differences between the three approaches concern the degree to which they are likely to encourage entry and the effect that will have on the total costs of meeting customers' demands in the long term.

The ECPR would result in prices that encourage access only when to do so would reduce the total costs of supply in the short run. In contrast to the other two approaches, the ECPR takes account of the costs of wholly or partially stranded assets. It forces new entrants to compensate incumbents for the costs associated with these assets, ensuring that entry only occurs if a new entrant can compensate the incumbent and still provide the service at lower cost to customers. The ECPR requires reliable information on avoidable costs, which can be open to subjective interpretation.

In general, the accounting cost and LRMC approaches are likely to produce lower access prices than ECPR, making entry more likely. In some cases, such entry might result in a temporary increase in total costs. New entrants could, however, bring innovative approaches to service delivery, reducing costs over time. Moreover, the threat of new entry creates an additional and continuing incentive for incumbent companies to reduce their costs.

4. Acceptable pricing conduct

Companies' pricing policies must be consistent with the Competition Act 1998 (CA98) and with the Water Industry Act 1991. The guideline on the application of CA98 to the water and sewerage sectors, and the other CA98 guidelines, explain how CA98 will be applied. Refusal by an undertaking to allow access to essential facilities (without objective justification) would constitute an infringement of CA98. Similarly, setting unreasonable terms for access would infringe the Act. If the Director receives a complaint about a company's terms of access, or if he suspects that a company may be in breach of CA98 or its licence conditions, he will need to determine whether those terms are reasonable.

In particular, terms could be deemed unreasonable if they:

• limit markets to the prejudice of consumers; or
• apply dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage.
Terms could limit markets to the prejudice of consumers if they prevent entry which would have led to a reduction in the total costs of meeting customers' demands. Deterring entry that would have reduced these costs in both the short run and the long run is likely to be a clear infringement of CA98. Companies may also infringe CA98 if they set access prices to deter entry that would have reduced costs only in the long run.

The second condition corresponds with principle ii (in section 2 above); i.e. each company should charge entrants as it would charge itself. In order to demonstrate that their access charges meet this criterion, companies will need to make significant progress to ensure that their cost allocation is robust and transparent. In this regard, companies need to consider whether costs can be allocated to particular customers or whether they represent a common cost that benefits a wider group of customers. Transparency might best be achieved by separating companies' accounts by function or by formal business separation. Options for improving the transparency of companies' accounts – including separation – will be discussed in the forthcoming consultation on the Regulatory Accounting Guidelines later in the summer.

3. Information requirements
In the event of a complaint regarding the price offered for access to a company's network, Ofwat would require robust information regarding the costs and benefits of providing access. In particular, companies will be expected to provide a comprehensive comparison of present and expected future costs and benefits over the whole of the relevant period. This must include investment to be advanced or deferred as a consequence of providing access, the implications for water quality and the effect on supply margins. Companies should quantify the cost of any standby facilities sought by the new entrant on behalf of its customers.

Ofwat will consider cost information on the basis of whether entry will result in an increment, substitution or decrement of throughput via the network. Cost information and access prices should be appropriate to the length of the agreement, with prices indexed appropriately to allow for inflation.

Ofwat will make extensive use of comparisons to assess the robustness of companies' cost information. Comparisons will be made between the approach companies take to charging for access to their own networks and the approach they expect other companies to use when charging them for access under similar circumstances. The Director will apply a condition of reciprocity such that companies should be prepared to offer access on the same basis as they expect access to be offered to them by other companies. Equally, companies should have no cause for complaint when access is offered to them on a basis similar to their own access charges. In a similar vein, companies should charge all entrants on similar terms for access under similar circumstances, consistent with licence condition E.

4. Supplier of last resort
In their Statements of Principles, some companies assumed that they might be expected to fulfil the role of supplier of last resort, and indicated that they would do so subject to receiving appropriate compensation from the new entrant. The entrant is responsible for ensuring that its water resources are sufficient to provide a sustainable supply to its customers, particularly its household customers (bearing in mind the restriction on interrupting supplies for households). It will need to identify the overall security margins for which its prospective customers are willing to pay. It will also need to identify the extent to which it could deliver that security of supply from its own resources. The parties involved should then seek to agree between themselves contractual arrangements consistent with the level of security that the incumbent is asked to provide. New water supplies from entrants can increase the incumbent's security margin. This has a value which should be offset against the costs of providing the supplier of last resort function for the new entrant's customers.
5. Treatment of stranded assets
Stranded assets have not proved to be a significant barrier to competition in other industries. Ofwat expects that they should not be a barrier in the water industry either. When competition develops via common carriage arrangements, the extent to which assets are stranded may be limited to those parts of the system to which new entrants do not seek access. In practice, these are most likely to be resources, treatment and customer service, although new entrants might also be able to locate close to local distribution networks so that trunk distribution is not required either.

Companies should seek alternative uses for capacity that is made available if they lose customers to a competitor. Alternative uses might not be difficult to find. Several companies in the South East of England report inadequate supply/demand margins even in the short term. Others across the country expect margins to be eroded by demand growth and/or reductions in licensed abstractions. In the longer term, asset stranding should not be a cause for concern if climate change puts pressure on companies' supply/demand margins.

When stranding occurs between Periodic Reviews, any loss of revenue will be borne by shareholders in the first instance. As part of each Review, the Director will need to consider whether to continue to remunerate stranded assets through the regulatory capital value. In particular, the Director will expect companies to evaluate fully the use of stranded assets in addressing any expected future supply/demand imbalances either within their own region or within other companies' regions.

6. Relationship with general tariff policy
As competition develops, companies may wish to bring their regional average tariff structures more closely into line with local costs. Should they choose to adjust their tariffs, companies would need to develop further their methods of cost allocation. Any de-averaging would also have to be consistent with the Director's duty to protect the interests of customers, particularly those in rural areas. In the electricity sector, for example, a standard price to some groups of customers, irrespective of where they live, has provided such protection. Moreover, de-averaging in electricity has been phased in order to minimise any potentially adverse impact.

Companies may wish to go further to respond reasonably to a competitive threat by pricing down to avoidable cost (i.e. the costs that a company would avoid if it lost customers to a new entrant). European case law offers a precedent for using average variable cost as a floor below which prices can be assumed to be predatory. Average variable cost may be considered an appropriate measure of avoidable cost over short time horizons. As the Competition Act guideline stated, however, LRMC might be more relevant in the water industry. I consider, therefore, that companies should be able to price down to LRMC provided that they do not seek to finance this policy by increasing prices to other customers. They should be prepared to offer the same terms to other, similar customers, consistent with licence condition E.

7. Next steps

I welcome Ministers' consultation on Competition in the Water Industry and I anticipate that it will provide further opportunities for the development of competition in water. However, companies must be aware that they cannot wait until this consultation is concluded, or any decisions made, before making further progress in preparing full access codes and agreeing individual terms for access. To do so puts them at risk of infringing the Competition Act - which is in force now. It is reasonable for companies to make full access codes available by 31 August 2000, and I look forward to receiving confirmation from companies when they have achieved this.

Companies should also continue to develop a better understanding of their own costs. They have been asked to review their LRMC estimates in the light of MD159, and to submit any revised estimates by 31 July 2000. Companies should also be thinking now about options for improving the transparency of their accounts – including separation. The forthcoming consultation on the Regulatory Accounting Guidelines will give companies an opportunity to express their views.

The future development of competition in the water industry depends upon progress in all these areas. I look forward to seeing that progress.

Sir Ian Byatt

⁽¹⁾Competition in the Water Industry in England Wales, Department of Environment, Transport and the Regions, April 2000.  Copies of Ofwat's response to this paper are available from Ofwat's website and library.