December 2011 witnessed the publication not only of the Water White Paper but also Ofwat’s consultation on its proposals under section 13 of the Water Industry Act 1991 to modify the conditions of appointment of all water-only and water and sewerage companies. This stemmed, in part at least, from the regulator’s November 2011 Future Price Limits (FPL) consultation.
FPL states that it is Ofwat’s wish to move away from a single price limit that covers the entirety of the activities carried out by a water company, to setting two price limits: one for wholesale services and one for retail services. However, the conditions of appointment currently in water company licences are drafted on the basis that a single price limit will be set every five years. Hence licence changes are needed. Ofwat is concerned that without licence amendments, its determinations could be open to legal challenge.
The section 13 paper begins by calling itself a consultation, inviting comments on the proposal to modify the price review elements of company licences. However, on the same page Ofwat also states, somewhat confusingly, that “This document and the attached appendix is a Notice under section 13 of the WIA91”. Thus the paper purports to be both a consultation on which comments are invited and a statutory notice to which a formal response may be required.
The paper tells us that Ofwat wishes to make licences more flexible, thus allowing it to make price determinations that best incentivise companies (but not necessarily committing it or the companies to changing the number of price controls from one to more than one). This increased flexibility would give Ofwat the freedom to decide on the nature, form, number and duration of price limits at each review, such decisions to be made in consultation with the industry.
The proposed changes are to condition B of water company licences. Condition B sets out the process for price reviews, but is part of a regulatory framework which, says Ofwat, has become insufficiently flexible and should be replaced by a framework that incentivises efficient, flexible, innovative and sustainable responses to challenges.
The illustrative example of a proposed licence modification, appended to the paper, removes reference to five-year periods, refers to price controls (plural), and does not contain an automatic link between the price cap and an inflation index. The proposed new wording states: “The appropriate nature and form of each control will depend on the circumstances of each case.” Understandably, industry commentators and the companies themselves are unsure about what this will mean in practice.
Of some comfort is the confirmation that Ofwat will continue to use regulatory capital value as the main mechanism for cost recovery for the wholesale price limit and in allowing companies to finance their functions, and that this limit will remain linked to the retail price index.
Nevertheless, it seems inevitable that water sector stakeholders will consider an amended regime to pose increased regulatory risk for water businesses, due to Ofwat’s much wider discretion and the inevitable uncertainties that result. Consequently, credit ratings, cost of capital, and ultimately prices would all be affected. This comes as no surprise to anybody involved with the sector except, it seems, Ofwat.
The regulator cannot proceed to modify the licence of a water company unless the company consents to the modifications. A company that does not object to a proposed modification does not thereby consent to it. In the absence of consent, Ofwat can only proceed by making a reference to the Competition Commission, requiring the commission to investigate and report on whether matters specified in the reference operate or may be expected to operate against the public interest, and if so, whether those adverse effects could be remedied or prevented by licence modifications. The commission would have six months in which to report.
Ofwat had given companies until 1 May to accept its proposals or face a Competition Commission referral. However, in the face of widespread concern from companies and investors, it has pushed back this deadline to allow more time for discussion. It originally wanted to have the modifications in place ahead of a consultation in autumn 2012 on proposals for the next price review. More recently, the regulator said its intention was to have the licence changes settled before spring 2013 in time for the 2014 price review.
So what happens now? If companies agree to the modifications, Ofwat will amend licences accordingly. It would appear unlikely, though, that any company will have felt able to give its unconditional agreement to the modifications without seeing the precise wording proposed for its licence, as opposed to an illustrative example. How can a water company’s board of directors agree to a licence change without knowing categorically what is to change?
If Ofwat has no agreement from a company, it will refer the matter to the Competition Commission. The commission has been forewarned to be ready to deal with a reference. Where the commission concludes that licence modifications are required, Ofwat will make the modifications it (Ofwat) considers appropriate, taking the commission’s suggestions into account. Before doing so, it must publish a notice specifying the proposed changes and giving at least 28 days for representations or objections to be made. Having considered any representations or objections, Ofwat must give notice to the commission of its proposed modifications.
The commission then has four weeks to respond. It may direct Ofwat not to make the proposed modifications (either wholly or partly) and Ofwat must comply. The commission would then give notice setting out its proposed modifications, allowing a further 28 day period within which representations or objections may be made. If any were made (and not withdrawn), the commission must consider them, and would make such modifications as appear to it to be requisite to remedy or prevent the adverse effects.
One might be forgiven for thinking that Ofwat’s realisation that its price review proposals necessitated licence modifications came somewhat late in the day – hence this apparent haste now to push modifications through without specifying the actual wording proposed for each company.
One final thought. The Water White Paper tells us the government is working with Ofwat to explore the case for enabling changes to licences to be implemented where agreed by a qualified majority of water companies. This may be the last time we see Ofwat’s “shoot first, talk later” approach to licence modification, which is unlikely to be missed.
Clive Mottram, head of water regulation, at international law firm Eversheds
This article first appeared in Utility Week’s print edition of 11 May 2012.
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