Albion Water Ltd v Water Services Regulation Authority

Factual and Procedural Background

This judgment replaces a prior interim judgment and concerns a dispute involving the supply of non-potable water to large industrial customers in the appointed area of a statutory water undertaker, referred to here as Company B. The dispute primarily involves Company A, an inset appointee authorized to supply water within a limited area including a large industrial customer, Paper Mill, and the incumbent Company B, which supplies water and sewerage services in Wales and adjoining areas.

Company A was granted an inset appointment to supply Paper Mill, which uses a significant volume of non-potable water annually. Company A initially purchased water from Company B under a bulk supply agreement but sought to acquire water directly from a secondary water undertaker, Company C, and use Company B's infrastructure under a common carriage arrangement, paying a transport charge to Company B.

The dispute arose over the reasonableness of the common carriage price charged by Company B, which Company A contended was excessive and abusive of a dominant position. The Director (regulatory authority) issued a decision finding no abuse. Company A appealed to the Tribunal, which has considered extensive evidence and submissions, including expert economic evidence, on pricing, cost allocation, and competition issues within the water industry.

Legal Issues Presented

1. Whether the common carriage price charged by Company B to Company A for transporting non-potable water constitutes an abuse of a dominant position under the Chapter II prohibition of the Competition Act 1998.
2. Whether the Director's use of the Efficient Component Pricing Rule (ECPR) in assessing the reasonableness of the common carriage price was appropriate.
3. Whether a margin squeeze exists whereby Company A is unable to compete effectively due to the pricing structure.
4. Whether the Costs Principle in section 66E of the Water Industry Act 1991, as amended, supports the Director's decision.
5. Whether the cost allocation and pricing methodology used by Company B and accepted by the Director properly reflects the actual costs of supplying non-potable water, particularly distribution costs.

Arguments of the Parties

Appellant's Arguments

• The common carriage price charged by Company B is excessive and not reasonably related to the actual costs incurred, particularly the distribution costs, which are substantially overstated.
• The Director's reliance on average accounting costs and regional averaging is flawed because it ignores significant differences between potable and non-potable water systems, including geographic location, infrastructure complexity, maintenance, and regulatory requirements.
• The Efficient Component Pricing Rule (ECPR) applied by the Director is inappropriate as it preserves monopoly profits, deters efficient entry, and fails to account properly for avoidable costs, thereby effectively eliminating competition.
• There is a margin squeeze because Company A cannot earn a margin sufficient to compete effectively given the pricing structure imposed by Company B, contrary to guidance and case law on margin squeeze.
• Company A provides water efficiency services integral to its supply to Paper Mill, which were formerly provided by Company B and should be reflected in pricing to allow a margin for these services.
• The Costs Principle in section 66E of the Water Industry Act 1991 does not justify the Director’s approach, particularly as the retail price used as a starting point is not shown to be cost-based or reasonable, and the treatment of avoidable costs is unduly restrictive.

Respondents' Arguments

• Company B and the Authority contend that the common carriage price is justified on the basis of average accounting costs and regional averaging, which is consistent with regulatory practice and government policy.
• The ECPR is a legitimate pricing rule that ensures only efficient entry occurs, protects the incumbent’s sunk and common costs, and prevents inefficient duplication of infrastructure.
• There is no margin squeeze because Company A is duplicating, not replacing, Company B’s retail services, and Company B incurs no avoidable retail costs by supplying Company A.
• Water efficiency services provided by Company A are not part of the statutory water undertaker’s appointed activities to a significant extent and should be separately paid for by the customer.
• The Costs Principle in section 66E mandates a retail-minus approach using the incumbent’s retail price less avoidable costs, and this approach is consistent with the Director’s decision.
• Regional averaging and cross-subsidies are important features of the water industry pricing regime, and deviations from these would have adverse consequences for other customers and the regulatory system.

Table of Precedents Cited

Court's Reasoning and Analysis

The Tribunal conducted a detailed analysis of the Director’s Decision and the evidence, focusing on the cost basis of the common carriage price, the application of the Efficient Component Pricing Rule (ECPR), margin squeeze allegations, and the statutory Costs Principle.

Regarding costs, the Tribunal found that the treatment costs of non-potable water were likely overstated but accepted a range for treatment costs. More critically, the distribution costs used by the Director (16p/m) were not supported by verifiable accounting evidence and appeared excessive compared to the actual costs of the discrete non-potable systems, such as the Ashgrove system. The Director’s reliance on regional averaging and the assumption that distribution costs for potable and non-potable water are the same was flawed, as the Tribunal identified significant differences in system complexity, geographic location, maintenance, and regulatory requirements.

The Tribunal rejected the Director’s use of ECPR as a reliable cross-check for the reasonableness of the common carriage price. It noted that ECPR, as applied, preserved monopoly profits embedded in the retail price, failed to account properly for avoidable costs, and effectively eliminated the possibility of competition by requiring entrants to be “super-efficient.” The Tribunal found that the retail price used as the starting point in the ECPR calculation was not reasonably cost-based and was itself excessive.

On the margin squeeze issue, the Tribunal concluded that Company A was unable to compete effectively because the difference between Company B’s wholesale and retail prices left no margin. The Director’s finding that no abuse arose was erroneous because it failed to consider the margin required by a reasonably efficient downstream competitor and did not impute costs to a notional retail business of Company B. The Tribunal also found that Company A’s provision of water efficiency services, previously supplied by Company B, was relevant to the margin squeeze analysis and had been inadequately considered.

Regarding the Costs Principle in section 66E of the Water Industry Act 1991, the Tribunal interpreted the provision as requiring that the undertaker recover reasonable expenses and a reasonable return based on costs reasonably incurred and reasonably expected to be recovered from relevant customers, less avoidable costs (ARROW costs). It rejected the Director’s approach of taking the retail price as a starting point without demonstrating its reasonableness or cost basis. The Tribunal found that the Director’s narrow approach to avoidable costs was problematic and likely to preclude effective competition, contrary to the consumer objective of the legislation.

In summary, the Tribunal found the Director’s Decision unsupported by sufficient investigation, flawed in its assumptions and methodology, and inconsistent with competition law principles and statutory duties. The Decision’s conclusions that the common carriage price was not excessive, that ECPR justified the price, and that no margin squeeze occurred were all set aside.

Holding and Implications

The Tribunal’s final ruling is that the Director’s Decision is SET ASIDE in respect of the issues concerning excessive pricing, application of the Efficient Component Pricing Rule, margin squeeze, and the Costs Principle.

The direct effect of this ruling is that the common carriage price charged by Company B to Company A is found to be excessive and abusive, and that the margin squeeze identified constitutes an infringement of the Chapter II prohibition. The Decision upholding the price and rejecting the abuse claims cannot stand.

No broader implications or new precedent beyond the facts of this case are explicitly set by the Tribunal. The Tribunal noted the importance of properly investigating cost components and ensuring pricing methodologies reflect actual costs and promote effective competition, especially in the context of discrete non-potable water supply systems. The Tribunal also emphasized the need to consider the combined supply and water efficiency services offered by entrants in assessing competition issues.

Further procedural steps are anticipated concerning issues of dominance and essential facilities, which remain to be addressed by the Tribunal.