Tim Briggs, partner, Herbert Smith Freehills Domestic water retail, Water, Water networks, Water treatment, Opinion

In mid-January, the Government opened a consultation on ways to improve water management. While focused predominantly on technical matters, tucked away at the back is a proposal likely to be of real concern to water companies and their investors: Ofwat is to be given the power to modify water company licences without their consent.

Since privatisation, water companies have operated subject to conditions set out in a licence, which Ofwat can enforce through statutory orders and fines.  Investors take comfort from the fact that licences cannot be modified without the company’s consent or, failing that, a reference to the Competition and Markets Authority (CMA).  That restricts the ability of Ofwat to force through radical changes to water company licences to the detriment of shareholder value.

That is about to change.

Now Government proposes to give Ofwat the power unilaterally to make changes to company licences, with limited rights of appeal.

To my mind, there are three consequences of this approach.

First, it would have a profound effect on the dynamic between Ofwat and water companies when it comes to implementing regulatory change.  Today, Ofwat has to persuade each company (or the CMA) to accept a licence modification.  Under this proposal, the onus will be on water companies to challenge the regulator by means of a formal appeal to the CMA.  That will be expensive and resource intensive, and is likely to mean that Ofwat will find it easier to drive through unwelcome reforms.

Second, there may be implications for water company financing arrangements.  The consultation refers directly to the possibility that the introduction of a new licence modification regime may breach financing covenants – but does not offer any solutions if that proves to be the case.

Third, the consultation acknowledges that the proposed changes may “impact on credit rating agencies’ assessment of the credit worthiness of the sector if they are perceived to affect the stability and predictability of the regulatory regime“.  Yet it concludes that “by any objective measure the water sector will continue to remain an attractive destination for investment“.  Many would disagree and question whether investor confidence has been taken for granted.

Attempting to draw parallels across the utilities sector, the consultation notes how Ofgem has had the power to modify licences held by energy companies since 2011.  It argues that this is ‘a more modern, flexible and transparent process’.  Yet it ignores the fact that Ofgem previously operated a ‘consent or CMA’ model and that changes were made only to comply with EU law – a driver that does not exist for water.

What can we expect the new licence modification regime for water to look like?  Details are limited in the consultation but drawing on the position in energy:

  • Appeals will be allowed only on specified grounds, such as where Ofwat ‘failed properly to have regard to’ its statutory general duties. Interestingly, the consultation holds out the prospect of an additional ground of appeal not available in energy – that is, the change being in the public interest
  • There might be scope for third parties, as well as water companies, to appeal licence modification decisions
  • Any application for an appeal must be made within 20 working days of the licence modification decision, meaning companies must move quickly if they wish to challenge a decision

A particularly topical question is whether these proposals will impact the position with respect to price control appeals, including for PR19.   When Ofgem was given the power unilaterally to modify energy company licence conditions, it turned the price control appeal mechanism upside down.   Rather than triggering a redetermination of the entire price control by the CMA (as occurs in water), energy price controls may now only be appealed on specified grounds – which opens up the prospect of companies ‘cherry picking’ parts of the determination.   The positon is different in water in that price control determinations are not implemented through licence modifications, and the consultation is silent on whether the Government intends the new appeal mechanism to apply also to such determinations.

Views are being sought until 12 March 2019.  It will be interesting to see the balance of responses and whether, as appears often to be the case, this is just a consultation in name only.