Investigation into Wessex Water’s compliance with its transfer pricing obligations

Case Summary

In Wessex Water’s PR19 final determination we concluded that its proposals for 2020-25 appeared to include making an inappropriately low charge for the supply of biogas to an associate company. As a result, as part of our PR19 Final Determinations, we intervened to reduce the amount of revenue Wessex Water could raise through customer bills by £8.5 million over the period, to ensure that customers were protected from paying more for their wastewater charges than they should. Our final determination said we would consider if any further action was required to satisfy us that Wessex Water’s costs and charging arrangements for bioresources comply with its transfer pricing obligations.

In February 2020 we opened an investigation to look further into this issue – specifically the arrangements between Wessex Water and its associate, Wessex Water Enterprises Ltd (WWE). Wessex Water sells biogas and, until April 2020 had sold biosolids, to WWE. It buys electricity, some of which is generated by the biogas, from WWE in return and is also provided with free heat by WWE. Both biogas and biosolids are by-products of Wessex Water’s sludge treatment process.

During our investigation, Wessex Water took steps to address our concerns about its approach to setting transfer prices. In particular to ensure that it more clearly assesses the value of the product or service being transferred to avoid the risk of cross-subsidy, which would disadvantage its customers. In June 2021 we decided to close our investigation.

Summary of Ofwat’s decision to close the case

Our investigation identified improvements required to Wessex Water’s internal processes and controls relating to its transfer pricing arrangements for biogas and related services. This is relevant to its compliance with the relevant parts of Condition I of its licence and the Regulatory Accounting Guidelines (RAGs). These obligations are there to protect customers by ensuring that there is no inappropriate cross-subsidy between the regulated water company and any of its associated businesses.

Within the framework of RAG 5.07 (Guideline for transfer pricing in the water and sewerage sectors) companies should pay and receive a fair price for services and products. Companies are also required to develop and maintain processes and procedures to ensure compliance; these processes and procedures should meet their own specific circumstances and ensure that transactions are supported and documented.

Specifically, we had concerns that Wessex Water:

  • could not sufficiently demonstrate how its approach to date robustly ensures that the transfer price set for biogas reflects its value (in particular as a source of renewable energy generation and income);
  • could not sufficiently demonstrate how it has been regularly reviewing and, as a consequence, adapting to developments in growing markets for and related to bioresources (specifically biogas) – including looking at the scope to market test through competitive letting to determine transfer prices;
  • was unable to demonstrate that it has been adequately checking compliance with its transfer pricing obligations and auditing its arrangements in a detailed and independent manner, with sufficient Board level oversight in this area; and
  • had made a long-term commitment to WWE but had not formalised the contractual terms of the agreement, which demonstrated a lack of transparency in the arrangement.

Assurances from Wessex Water and steps taken

We discussed our concerns with Wessex Water and offered it the opportunity to address these. Following notification of our decision to open an investigation, Wessex Water brought forward its own internal audit to assess the compliance of its arrangements with WWE.

Following our discussions with Wessex Water it has now provided an overarching commitment, in writing, to assure us that its transfer prices (including for biogas and electricity) are, at all times, set in a way that:

  • ensures the appointed business pays a fair price for services and products received and receives a fair price for services and products it provides to other businesses in the appointee or other associate companies;
  • reflects the value of the product or service being transferred;
  • is transparent and enables others to understand the process taken and to reach the same or similar conclusions; and
  • is compliant with Wessex Water’s legal obligations – ensuring that transactions are at arm’s length and avoid cross subsidy so that customers of the regulated business are not disadvantaged.

Wessex Water has taken several steps and given additional assurances which follow from the above including:

  • bringing the sale and management of biosolids back in-house from April 2020. In addition it has increased the share of income from the sale of biosolids allocated to itself, backdated to 1 April 2019, resulting in additional income (approx. £400,000) for Wessex Water from this activity for the year 2019-20;
  • putting in place several new and updated internal policies and guides. One of these is a new “how to” guide specifically on market testing of bioresources related services, which includes a commitment to annually review any changes and developments in relation to the markets for and related to bioresources from April 2021;
  • committing to market testing (via a competitive letting process) the bioresources related services and products that are currently transferred between itself and WWE. This will take place as soon as possible, subject to an annual market review exercise, but, in any case, will be completed by March 2025 at the latest;
  • engaging external consultants in Spring 2021 to feed into its annual market review. The consultants will carry out a review and assessment of:
  1. biogas market developments to identify the scope for competitive letting; and
  2. alternative market testing options where competitive letting is not viable. This includes looking at comparisons to list prices, third party evaluation, benchmarking and assessing the costs that can be attributed or allocated to the products or services being transferred;
  • putting in place formal agreements with WWE, the terms of which are subject to annual review;
  • committing to both internal and external independent annual audits of its transactions with WWE. The results of these audits will be reported to Ofwat, Wessex Water’s Audit Committee and summarised in its Annual Performance Report;
  • giving a commitment to ensure that the contractual arrangements with WWE are managed such that any changes to be implemented can be made in a timely manner; and
  • giving its consent to a modification of its licence (see below).

 

Licence modification

We have proposed, and Wessex Water has given its indicative consent to, a modification of its licence to include the requirement for it to have adequate systems of planning and internal control to enable it to carry out its Regulated Activities. We will complete a statutory consultation proposing to make this change.

All water companies have a section in their licence setting out “ring-fencing” obligations to ensure the regulated business has adequate means and protections in place to carry out its Regulated Activities.  Across the 11 largest water and sewerage companies, Wessex Water is the only company for which this section does not refer to having adequate systems of planning and internal control to enable it to carry out its Regulated Activities. We consider this to be an anomaly.

We believe having this requirement in its licence will help prevent the issues we identified in our PR19 determination and picked up during our subsequent investigation from arising in future.

Wider lessons for water companies

Companies should regularly review their transfer pricing arrangements updating these, where necessary, to ensure they are and will remain compliant with their obligations – particularly in emerging and developing markets.

We expect companies to take their transfer pricing and arm’s length trading obligations seriously and engage their Boards effectively on these matters.

Companies that enter into arrangements with associated companies should do so in a transparent manner that engenders the trust of their customers.

Companies should be able to demonstrate how transfer prices are fair for their customers and reflect the value of products or services being transferred.

Competitive letting is the most objective way of demonstrating compliance and setting transfer prices.

Where companies adopt alternative methods of market testing, they must be able to show how these alternative methods have been selected and the principles and criteria against which those methods have been assessed. This includes being able to demonstrate the level of internal challenge and independent scrutiny applied.

Where companies are unable to show clear and robust evidence of the above, Ofwat will take account of this at price reviews to ensure that customers do not pay more than they should. We will also consider using our enforcement tools to take action and secure compliance with relevant licence obligations.

Allocating costs and income to the appropriate company and price control is becoming increasingly important to support separate price controls and setting efficient cost allowances in price reviews. We expect companies to understand what is expected of them under cost allocation and transfer pricing obligations and guidelines. We are undertaking further work to ensure companies’ cost allocations are robust, consistent, and accurate ahead of the next price review.

Date opened

February 2020.

Date closed

June 2021.

Relevant powers

Section 18 of the Water Industry Act 1991.