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Are Scottish Water's charges excessive?

This entry was added to http://www.reckon.co.uk/headlines-franckblog on 26 June 2006.

A couple of weeks ago, Jim Mather MSP, the Scottish National Party shadow enterprise minister in the Scottish Parliament, complained to the OFT about Scottish Water's non-residential charges.

According to the SNP press release:

"Mr Mather today wrote to the Director General of fair Trading setting out his case for an investigation under the Competition Act. The letter states that:
• Business charges in Scotland are materially higher that those charged elsewhere in the UK.
• Revenue is running at a rate that is 40 to 50% higher than operating costs.
• 86.6p in every pound of capital expenditure in the three years to 31st March 2005 has been paid by current water charge payers.
• The chairman of the Scottish Water Commission refuses to discuss the Strategic Review of Charges 2002-06 that is at the root of the over-charging regime."

A subsequent SNP press notice today mentioned the complaint to the OFT again, citing press reports of a further piece of work by Jim and Margaret Cuthbert alleging that inadequate accounting methods in the regulator WICS' price control calculations have led to unnecessarily high prices — a line of argument that these two experts have been developing for some years. (The reference to the Competition Commission in the second SNP press notice is plainly an error.)

I imagine that Mr Mather's letter to the OFT said a little more than his press notices. Otherwise, I suspect that it will be rather easy for the OFT to ignore the complaint by saying that no reasonable grounds to suspect an infringement of the Competition Act 1998 are raised in the SNP's published statements. Even though the second SNP press notice quotes from OFT guidance documents, this does not really point to a clear abuse by Scottish Water, and the OFT text quoted is in any event littered with "may", "it is possible" and other get-out clauses.

Taking the facts alleged in the SNP press releases and in the press on trust for the purposes of this exercise, here is my guess of what Mr Mather's letter to the OFT might have said.

Dear Mr Fingleton,

I am writing to suggest that your office should investigate whether the charges levied by Scottish Water on non-residential users of water and sewerage services in Scotland might infringe UK or EC competition law.

Specifically, I suspect that the current level of charges may represent an exploitative abuse of Scottish Water's dominant position in the supply of water and sewerage services in Scotland, in possible breach of Section 18 of the Competition Act 1998 and/or Article 82 of the EC Treaty.

The problem

Water and sewerage charges for businesses in Scotland are materially higher than elsewhere in the UK. Although Scottish Water's volumetric charges are not high (perhaps reflecting the wet Scottish weather?), a major issue arises from the annual fixed charges.

Scottish Water's fixed charges are set by reference to the diameter of the supply pipe, as in England and Wales; but Scottish Water's charges are much higher and much more dependent on pipe size.

As an example, a comparison of Scottish Water's charges (9 pages, PDF) (now a broken link: see update) with Welsh Water's charges (29 pages, PDF) shows that:

Update, November 2006: Scottish Water's scheme of charges has been removed, breaking the above link. The information is now available in Scottish Water Business Stream's scheme of charges (20 pages, PDF).

In fact, the variation of Scottish Water's charges with diameter is so large that it would even seem worthwhile for a large user with a 400 mm supply pipe and meter to replace it with one hundred 40 mm supply pipes and one hundred separate meters in order to reduce his Scottish Water's fixed charges!

The effect of these differences in fixed charges between Scotland and Wales vastly exceeds any benefits to Scottish users of volumetric charges being set up to a few dozen pence per cubic metre lower: the normal consumption of the 40 mm customer would be unlikely to be more than a few thousand cubic metres, and the consumption of a very large customer is unlikely to exceed a few million cubic metres.

I cannot imagine that there is any doubt about Scottish Water's dominant position in markets (however defined) for the supply of water and sewerage services to business customers. This dominance will continue once retail competition under the Water Services etc. (Scotland) Act 2005 is in place, with the relevant market becoming that for water and sewerage services supplied by Scottish Water to customers at the request of a retail licensee responsible for billing and payments matters.

The problem is therefore that Scottish businesses are placed at a competitive disadvantage as a result of charges imposed on them by a dominant supplier.

However, I accept that mere differences in charges between parts of the UK do not, by themselves, amount to any evidence of abuse by Scottish Water. There could be operational or historical differences between the companies on both sides of the border; or one might argue (albeit against the SNP's views) that the difference demonstrates the efficiency benefits of privatisation. If this were so, the lack of competitiveness of Scottish Water's charges would be attributable to environmental, historical and/or legitimate policy factors, and there would be no abuse.

The causes of high charges in Scotland

But further investigation into the reasons for the high charges suffered by Scottish businesses raises real suspicions of exploitative abuse by Scottish Water.

First, it appears that Scottish Water's revenue is running at a rate that is 40 to 50 per cent higher than operating costs. This compares to an uplift of less than 30 per cent in England and Wales: according to Ofwat's figures, the water industry in England and Wales had operating profit margins of 29 per cent (=£2.14bn/£7.33bn) on a current cost accounting basis, and 22 per cent (=£1.58bn/£7.33bn) on a historic cost accounting basis.

As a result of these large operating margins, it seems that 86.6 per cent of the capital expenditure undertaken by Scottish Water in the three years to March 2005 has been paid for by current customers, even though most of the assets in question are designed to last for decades. Again, a comparison with England and Wales is instructive: according to Ofwat's figures, over 2000-2005, aggregate capital expenditure of £17.7 billion has been financed out of aggregate profits from consumers of about £7 billion (after current taxation but gross of deferred taxation), a ratio of less than 40 per cent.

There appear to be two main factors at play to explain Scottish Water's high business charges, and the high profits (in relation to investment) that are flowing to Scottish Water from these charges.

The first factor is the financial regime which limits the amount of borrowing that can be undertaken by Scottish Water: any Scottish Water borrowings are counted against a cash limit set by the Scottish Executive, who cannot under the devolution settlement spend more than the amount allocated to it each year on the basis of the Barnett formula. Some commentators have argued that the limit on Scottish Water's borrowing was set wrongly as a result of errors by the Executive and/or the Water Industry Commission in the use of the resource accounting and budgeting (RAB) system, and that more borrowing could have been planned within the Scottish Executive budget. Whatever their exact basis, these limits on Scottish Water's borrowing, which have no real connection with the economics of financing a water and sewerage system, presumably explains why so much of Scottish Water's capital expenditure is being recovered from today's customers rather than from the future customers (even though future customers will share in the benefit of these investments). In essence, the restriction on Scottish Water's financing options causes greater costs to be borne by customers than if Scottish Water could raise debt finance (whether externally or from the Scottish Executive if it had not made errors in its calculations) to the extent of its reasonable needs and financial capacity.

The second factor is that the Water Services etc. (Scotland) Act 2005 prohibits customers from seeking most competitive sources of supply for water or effluent treatment services, except by entirely bypassing the Scottish Water network. Access to any water source or sewage treatment works that requires any use of Scottish Water's network is prohibited unless the whole service is delivered to the customer by Scottish Water, on Scottish Water's terms. The prospective ability to choose a licensed retailer to undertake some billing activities instead of Scottish Water, but leaving Scottish Water as the supplier, does not detract from the fact that Scottish Water is and will remain, both in law and in practice, a monopoly supplier (except perhaps for the minority of customers who can realistically bypass the public network altogether and thereby escape the hidden water tax).

These two factors taken together prevent Scottish Water's business customers from obtaining the benefit of an efficient financing structure for the investments required on the water and sewerage infrastructures that they use.

Scottish Water has pointed out that household charges are likely to be lower in Scotland than in England and Wales. This may mean that more of Scottish Water's high profits are being recovered in large part from business users. I suspect that this is only possible because of the second restriction above. If businesses could switch to alternative suppliers whilst retaining some access to the Scottish Water network then perhaps Scottish Water would not dare impose, and could not have sustained, the major increases imposed and to be imposed on Scottish businesses.

These restrictions and their adverse consequences appear to have come about in part because of the recent changes to the regulation of the water industry in Scotland. As Diageo, a major water user in Scotland, pointed out in its 2004 submission to a Scottish Parliament committee considering what became the Water Services etc. (Scotland) Act 2005:

Diageo does have concerns, however, that there appears to be no flexibility in the current proposals to allow for local negotiation on charges for water and sewerage services. There would therefore be less opportunity for large users to benefit from economies of scale or discuss potential partnerships.
An example of these special agreements is when we negotiated a long-term deal with WoSWA for the disposal of effluent from Port Dundas Distillery in Glasgow. It was at the time of a private funded initiative to expand and upgrade the treatment plant at Dalmuir. To enable this development to go ahead with some financial certainty, a five year deal between ourselves and WoSWA was agreed.

The loss of this flexibility and its replacement with a rigid scheme of charges approved or set by a central regulator has therefore strengthened the strangle-hold that Scottish Water's monopoly has over its business customers. Given this, it is not therefore altogether surprising that complaints about Scottish Water overcharging have only relatively recently hit the headlines, or that I should be calling for an OFT investigation only now.

I also note that Diageo's submission criticised the very high standing charges imposed by Scottish Water, arguing instead for higher variable charges to encourage water efficiency. Is it not the hallmark of a monopoly exploiting its position that it imposes very high charges on the least elastic elements of demand (the connection to the system) instead of trying to work with its customers to minimise total costs by improving water efficiency?

Grounds to suspect an abuse

The two restrictions on competition highlighted above probably go some way towards explaining why some business charges are so much higher in Scotland than in England and Wales.

This explanation seems to combine all the ingredients necessary for a finding of exploitative abuse under the Competition Act 1998 and Article 82:

There is no State action defence

An OFT policy note from 2004 casts doubts on the OFT's ability to apply competition law to some State bodies. Scottish Water is a State body. However, as I understand it, the policy note relates primarily to procurement activities of State bodies, and I do not think that it affects the analysis of the potential abuse identified above.

Scottish Water may nevertheless seek to raise a State action defence, arguing that the level of charges is outside its control, as its charges are set by a statutory scheme subject to the prior approval of the State, in the shape of the Water Industry Commission, under the arrangements introduced by Section 21 of the Water Services etc. (Scotland) Act 2005.

Thus, the argument would go, any unfairness in charges is attributable to the legislature and/or the regulatory regime that it established and/or the actions of a statutory regulator, and cannot therefore be an abuse by Scottish Water.

This argument was in fact advanced by legal advisers to WICS and to Scottish Water (4 pages, PDF) at the time of parliamentary debates on what became the Water Services etc. (Scotland) Act 2005. For example, Scottish Water's lawyer thought that challenges on pricing issues should lie with WICS and not with Scottish Water.

I was pleased to see that you were of the view that:

In Europe, we are fortunate in not having a State action defence as strong as that in the US, and in having rules like Article 86 that requires State restrictions on competition to be proportionate to the public policy objective being attained. ... There is, in my view, serious under-enforcement of Article 86.
John Fingleton speech (10 pages, PDF), 9 December 2003

Given this, and the go ahead recently given by the High Court in London to a possible competition law challenge against Ofwat's approval of a non-residential water charges scheme as part of private civil litigation over charging levels, I probably do not need to go beyond pointing out that any WICS approval of a Scottish Water charges scheme that would include excessive charges would be unlawful under the Competition Act 1998, and/or would need to be "disapplied" by the OFT (to the extent that the abusive charges affect cross-border trade with other EC countries) in order to ensure that Community rights granted by Article 82 prevail over national law, and/or would expose the UK to claims under Article 86(1).

And without getting too much into Scottish constitutional matters, it does not seem to me that the Water Services etc. (Scotland) Act 2005 could or did implicitly repeal any aspect of the Competition Act 1998 or of the European Communities Act 1972.

Thus it seems to me that, even if any kind of fault (such as negligence or intention to abuse) might be attributable to WICS rather than to Scottish Water, it remains the case that the charges that I am complaining of would seem to represent a potential abuse by Scottish Water, which falls within your office's Competition Act 1998 or Article 82 jurisdiction.

In any event, even if I am wrong about the law on State action, I imagine that you would wish to investigate the matter and highlight possible tensions between competition law and the Scottish system of water industry regulation as part of your competition advocacy role.

There is no Article 86(2) defence

A second point that Scottish Water or WICS might raise as a defence is whether the objectionable charges might be justified under Article 86(2) and/or under Paragraph 4 of Schedule 3 of the Competition Act 1998.

As I understand it, WICS' lawyers thought in 2004 that the special rights and obligations placed on to Scottish Water by the Water Services etc. (Scotland) Act 2005 could support an Article 86(2) justification for the Act's prohibition on common carriage on Scottish Water's network.

But even if this opinion about the legitimacy of denying third-party access was and remains valid, this does not mean that the excessive charges that I am complaining about are also justified under Article 86(2). I cannot see any legitimate public service purpose that requires that excessive and unfair charges be applied and that cannot be achieved in a less restrictive way.

Indeed, I would argue the very purpose of the prohibition on exploitative abuse is that it is a second line of defence in cases to avoid undue detriment to customers in cases where abnormal restrictions on competition have had to be permitted for whatever reason. In the present case, the prohibition on exploitative abuse should protect customers against exploitation in the context of a State-induced absence of normal and sufficiently effective competition.

The legal advice received in 2004 does not mention the possibility of justification under the other leg of Article 86(2), that relating to revenue-producing monopolies. This was, and remains, an appropriate omission: deliberately exploiting water customers as a form of taxation (beyond any legitimate environmental charges for processes such as abstraction or landfill) is not part of the current or prospective objectives of any Scottish Government.

Thus, Article 86(2) or the corresponding provisions of the Competition Act 1998 are no bar to OFT intervention against exploitative excessive charges by Scottish Water.

Lower charges would not amount to discrimination or State aid

WICS has also raised the possibility that the little flexibility that has been retained in Scottish Water's non-residential charging arrangements, in the shape of transitional caps to prevent very steep rises in individual customers' charges, may themselves infringe the Competition Act 1998, Article 82, or Article 87, because they might be discriminatory.

WICS' proposed solution to this alleged problem is to force Scottish Water to increase its charges on these customers faster.

I accept that it is not beyond the realm of possibility that some of these caps may indeed result in differences of treatment between competing customers, and that this might affect trade and/or competition in such a way as to trigger the prohibitions on discriminatory abuse or State aid. However, WICS' paper did not appear to present much evidence that this is in fact the case.

But I do not think that you need to divert any of your resources to investigate this point in order to determine whether and to what extent Scottish Water's tariffs are excessive. There may well be customers that compete with each other but whose local circumstances are so different that the restrictions on competition identified above as the root cause of Scottish Water's potential exploitative abuses affects them to different extent; if so, in order to comply with the law Scottish Water may need to reduce its charges on some customers by more than on others (or it could choose to reduce charges on all customers). But any such differentials would then be justified by the difference in circumstances, and be no more abusive than the fact that water users in Wales face different prices than in East Anglia.

It may also be argued that reducing Scottish Water's charges would render direct aid from the Executive necessary in order to balance its finances, and that this goes against a general objective of reducing and targeting State aid.

This argument would rest on a misconception of the concept of exploitative abuse: all that compliance with the law on unfair prices would entail is for Scottish Water to set prices to be no higher than they would be in the absence of the abnormal restrictions on competition identified above. If the Executive or WICS wish to maintain such restrictions — e.g. keeping Scottish Water in an undue financial straight jacket by preventing it from raising a normal level of borrowing for a water utility — then it is neither surprising nor undesirable that they should have to provide the funding to compensate Scottish Water for these restrictions. Competition law is only doing what it would be expected to do by prohibiting the exploitation of customers to fund this financial gap that is not caused by any actions of customers.

The case deserves administrative prioritisation by the OFT

A final point that I need to address is the administrative priority that the OFT should give to an inquiry into Scottish Water's business charges, given the other pressures on your resources.

I do not underestimate the effort that will be required to analyse the effect on prices of the restrictions identified above, and to complete the investigation into the relevant markets to the standard that would enable you to make a finding of abuse.

Against this, I should say that I am not alleging negligent or deliberate abuse by Scottish Water in this respect. There is no call for any financial penalty, and therefore the presumption of innocence that arises from human rights legislation in penalty cases probably does not need to be rebutted in this case.

Still there is no doubt that a major inquiry will be required. I think it is justified by the following factors:

I hope that you will be able to allocate an appropriate amount of resources to this important case.

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Entry added by Franck Latrémolière on 26 June 2006

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Last changed by Franck at 12:13 PM on Saturday 17 February 2007.

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Reckon Open "Are Scottish Water's charges excessive? | viewpoint: Franck" 2007-02-17T12:13:47