OFGEM Case Study 2 – Energy Price Control Appeal

OFGEM Case Study 2

Energy price control appeal: British Gas Trading

British Gas Trading v Gas and Electricity Markets Authority; Northern Powergrid v Gas and Electricity Markets Authority

 CMA (2015): ‘Northern Powergrid (Northeast) Limited and Northern Powergrid (Yorkshire) plc v the Gas and Electricity Markets Authority – Final Determination

https://www.gov.uk/cma-cases/energy-price-control-appeal-british-gas-trading

Competition & Markets Authority (29 September 2015)

The appeals were made under section 11C of the Electricity Act 1989 and relate to price controls made for the 8-year period from 1 April 2015 to 31 March 2023. NPg is an electricity DNO. BGT is an electricity supplier which pays charges to each of the DNOs for use of their respective electricity distribution networks. Ofgem announced the details of the price controls in November 2014 (https://www.ofgem.gov.uk/publications-and-updates/ofgemannounces-%C2%A317-billion-new-investment-package-and-reduces-pressure-customer-bills) and published its final decision (https://www.ofgem.gov.uk/sites/default/files/docs/2015/02/slow_track_crcs_modification_notice_feb2015.pdf) on 3 February 2015.

The final determinations and all other information relating to the appeals are available on the Northern Powergrid (https://www.gov.uk/cma-cases/energy-price-control-appeal-northern-powergrid) and British Gas Trading (https://www.gov.uk/cma-cases/energy-price-control-appeal-british-gas-trading) case pages.

Ofgem new statutory licence modification appeal process- determination of the applicable price controls for electricity distribution for the next eight years.

In its determination on NPg’s appeal, the CMA dismissed 2 of the 3 grounds of appeal. It upheld one ground in relation to Ofgem’s adjustments to reflect potential savings available from the introduction of smart grids and other technological innovations. The CMA’s determination will increase NPg’s allowable revenue over the price control period by around £11 million.

In its determination on the BGT appeal, the CMA dismissed 4 of the 5 grounds of appeal. The CMA upheld, in part, one ground which sought to challenge the adjustment that Ofgem made to the up-front rewards and penalties for DNOs in its Information Quality Incentive scheme. The CMA’s determination increases the net penalty across the 10 ‘slow-track’ DNOs (those which did not reach an early settlement with Ofgem). After taking into account tax, the effect of the increase in the penalty is to reduce the amount of revenue DNOs are allowed to recover through charges by around £105 million over the price control period.

RRIO < Revenue = Incentives + Innovation + Outputs

  • Incentive-based regulation
  • RIIO-ED1 is the first price control conducted for electricity DNOs under Ofgem’s new incentive-based regulatory model: Revenue using Incentives to deliver Innovation and Outputs (RIIO).

Ofgem’s principal duty: In the interest of consumers that efficient network companies can secure finance in a timely way and at reasonable cost to facilitate their regulatory obligations

  • No bail-out if financial distress is due to own behaviour
  • No reward of inefficiency or unwarranted returns
  • Capital structure remains the responsibility of network companies‟ management

RRIO-T1 = The need for significant investment in the networks. Challenge of facilitating required investment while ensuing that both existing and future consumers get value for money.

Addressing uncertainty: Significant uncertainty over basis on which some investment would come forward and the associated costs. The need to put in place mechanisms that allow for flexibility to address the uncertainty during the RIIO-T1 period.

RRIO-D1= Fundamentally changed behaviour and Board discussions at companies

  • Significant step-up in stakeholder engagement to present well thought-out, detailed and better justified business plans
  • Ofgem staying true to RIIO principles:
  • Framework and key parameters clearly set out early on
  • Transparency of approach from early on– No „black box‟ dates
  • Increased stakeholder engagement – including investors
  • Proportionate treatment
  • Higher level of scrutiny focused on areas not well justified
  • Two Scottish TOs fast-tracked
  • Flexibility in allowed costs ensure customers pay only for necessary expenditure
  • Financeability not compromised – transition where needed

British Gas and Northern Powergrid brought appeals against Ofgem’s determination of the applicable price controls for electricity distribution for the next eight years. These are the first appeals brought under the new statutory procedure set out in section 11 of the Electricity Act 1989, so the CMA’s determinations are now the leading authority on the conduct of such licence modification appeals and the standard of review to be applied by the CMA.

CMA determination: In respect of British Gas’ appeal, the CMA rejected all but one of the six grounds of appeal advanced by British Gas, almost entirely upholding the price control determination applied by Ofgem to distributors.

On the one ground that the CMA partially upheld, the CMA determined that Ofgem had been entitled to recalibrate one of the incentives (the Information Quality Incentive), but that the quantum of the recalibration made was, on the facts, excessive. The CMA made a small consequential adjustment to that recalibration.

In respect of Northern Powergrid’s appeal, the CMA dismissed two of the three grounds of appeal in respect of real price and regional labour adjustments; and upheld one ground of appeal in respect of savings relating to smart technology. The CMA’s decision gives guidance as to the ambit of a sectoral regulator’s expert judgment in the context of a complex price control.

CMA (2015): ‘Northern Powergrid (Northeast) Limited and Northern Powergrid (Yorkshire) plc v the Gas and Electricity Markets Authority – Final Determination/

Whilst the CMA recognised the importance of smart grid solutions, SGBs and the role they are likely to play during RIIO-ED1, it concluded that neither the evidence, nor the reasons put forward by GEMA, were sufficient to justify its proposed SGBs adjustment for NPg.

In competitive industries, pressure to adopt disruptive and innovative technologies can normally be expected to take place through new entry and competition tension within the market. In network sectors, the incentive for innovation and delivery of savings for consumers is far more reliant on the revenue control regime applied by the regulator.

 

Smart grid technologies and solutions are expected to play an increasingly important role in the future delivery of energy network services. The CMA’s final determination – and indeed, the RIIO-ED1 review process more generally – raises some important questions for how SGBs, smart grid solutions and perhaps innovation more generally should be accommodated in cost assessment and industry business plan treatment looking forward.

In competitive industries, pressure to adopt disruptive and innovative technologies can normally be expected to take place through new entry and competition tension within the market. The natural monopoly nature of network services, however, makes adoption of new technologies, and their delivery of savings for consumers, much more reliant on the incentives and scrutiny processes applied by the regulator through the revenue control regime.

The CMA in its final determination, has placed significant emphasis on the role of efficiency incentives under RIIO-ED1 for DNOs to adopt and propose solutions with benefits for consumers, rather than requiring intervention from the regulator. The longer term question is can these incentives be considered sufficient to drive the scale and pace of change in industry thinking and delivery in consumers’ best interests?

Privatised network companies and their management which operate under incentive regulation, face a range of corporate objectives and incentives, alongside their price control cost efficiency targets. The business planning process at the time of the price review has to consider a range of balancing factors and, therefore, the clarity of financial incentives for innovation when considered through an efficiency incentive “lense” is important.

The CMA’s view on how SGBs were assessed by GEMA also highlights the challenges for the regulator of accommodating the impacts of new technologies and processes within industry benchmarking and cost assessment processes. Benchmarking tools – particularly in the distribution sector – can provide confidence of the relative efficiency of network companies under current industry processes and solutions, but have perhaps been less successful in helping to justify whether the scale and the pace of innovation and proposed ongoing efficiency targets are sufficiently challenging for the control period. Technological change and its impact on ongoing efficiency is also normally captured through methodologies used to establish targets for frontier shift / ongoing efficiency.

The RIIO-ED1 review process is perhaps testament to the challenges that face regulated sectors that have large potential opportunities for innovation with adoption of new technologies. Viewed collectively the issues would suggest that the CMA is right to place its emphasis and trust in the role of incentive based regulation to deliver such innovation. The challenge is ensuring the structure, clarity and strength of incentives is sufficient to drive good long term outcomes for consumers, particularly given the investment that has been made in early pilot innovation funding schemes such as the low carbon networks fund.

The appeal to the CMA however, perhaps raises the question, are the two ‘Is’ in RIIO – incentives and innovation – sufficiently calibrated and aligned for network companies to drive good long term outcomes for consumers in their delivery choices, particularly in the presence of business process and technology change such as smart grid solutions?

Finally the appeal process on SGBs itself also provides potentially important precedent for making price review referrals to the CMA.

In this case, the CMA’s task was to assess whether the decision appealed by NPg was ‘wrong’ on the available grounds for appeal including but not limited to, the decision being based wholly or partially on an error of fact, or that GEMA had failed to give proper regard, or appropriate weight, to matters it should have given regard to in carrying out its principal duties and objectives.9 In the case of SGBs, the CMA agreed with NPg that GEMA had been ‘wrong’ as NPg was able to demonstrate to the CMA that the principles and approach which GEMA had followed had not been consistent with earlier guidance in the price review process and the CMA was not convinced GEMA was able to justify its change in approach, given the technical challenges with treatment of SGBs discussed above.

On 29 September 2015, the UK Competition and Markets Authority (CMA) published its final determinations on two appeals against elements of the 2015–23 electricity distribution price control review (RIIO-ED1) by Ofgem, the GB energy regulator. One appeal argued that Ofgem had been too stringent in setting allowed revenues; the other that it had been too generous to the distribution network operators (DNOs). What were the CMA’s findings, and what are the implications of its decisions for these appeals?

 

The first appeal came from Northern Powergrid (NPg), an electricity DNO. The second came from British Gas Trading Limited (BGT), a buyer of DNO services, and is the first example of an appeal by a network user against an Ofgem price control. In its determination on the BGT appeal, the CMA dismissed four of its five grounds, but partly upheld one ground that challenged the adjustment that Ofgem made to the upfront rewards and penalties for DNOs in its Information Quality Incentive (IQI) scheme. The CMA’s determination reduces the amount of revenue that the

DNOs can recover by around £105m in total over the

RIIO-ED1 price control period (a reduction of less than 0.4%).1 In its determination on NPg’s appeal, the CMA dismissed two of the three grounds of appeal, but upheld

one in relation to Ofgem’s adjustments to reflect potential savings available from the introduction of smart grids. The CMA’s determination increases NPg’s allowable revenue by around £11m in total (an increase of less than 0.3%).2 The various areas of appeal are shown in the box.

Notably, the regime in electricity distribution is one of appeal against specific areas of a price control, which differs somewhat from a regulatory-reference approach where all areas of a price control may be re-examined—as happens, for example, in the water sector. The standard applied is also of interest—the CMA may uphold an appeal only where the particular decision appealed was ‘wrong’ (although the legal wording around ‘wrong’, as specified in the Electricity Act, covers a number of issues).3 However, the CMA interprets this as meaning that it is not just limited to conventional ‘judicial review’ grounds; rather, it must consider the ‘merits’ of the decision appealed (albeit by reference to the specific grounds of appeal laid down in law).4

This article focuses on cost assessment and IQI issues. However, BGT’s appeal also covered two finance issues. First, BGT challenged Ofgem’s decision to introduce a transition regime for depreciation on new assets, which

BGT considered provided more depreciation upfront (than otherwise) to deal with financeability issues.5 Second, while BGT did not challenge the principle of using an index for the allowed cost of debt, it did question Ofgem’s decision on how to calculate this index. Both of these challenges were dismissed by the CMA.

Cost assessment

As shown in the box, NPg’s appeal centred on three issues around cost assessment. Of these, SGBs was the main area of contention—and the only area of appeal granted to NPg.

The RIIO-ED1 appeals

The issues covered by the CMA in the RIIO-ED1 cases (and the results of the appeals) were as follows.

NPg appeal (DNO)—exclusively cost assessment issues

  • Smart grid benefits (SGBs)—upheld
  • Real price effects (RPEs)—rejected
  • Regional labour cost adjustments (RLCAs)—rejected

BGT appeal (DNO purchaser)—exclusively incentive and finance issues

  • Double recovery allegation—rejected
  • Incentive targets—rejected
  • Information Quality Incentive—partially upheld
  • Asset life policy change—rejected
  • Change in cost of debt indexation—rejected

 

SGBs are the forecast cost savings that result from the application of smart grid technologies. Ofgem changed its approach to the assessment of SGBs between its March 2013 Strategy Decision and its July 2014 Draft Determinations (DDs). This was because, in its view, companies had materially underestimated SGBs in their business plans—to the extent that separate adjustments were required, over and above Ofgem’s more general cost benchmarking exercise. In the DDs, Ofgem applied a downward adjustment to DNOs’ total expenditure (TOTEX), based on the difference between SGBs identified by DNOs in their business plans (‘embedded SGBs’) and the level of SGBs that Ofgem thought DNOs should achieve (‘potential SGBs’). The latter had been based on a combination of external evidence and industry modelling.

Ofgem also altered its approach to assessing embedded SGBs and potential SGBs between its Draft and Final Determinations (FDs). The scale of embedded SGBs increased markedly, as Ofgem broadened the definition of what constituted a ‘smart’ solution.6 However, Ofgem also altered the approach it used to derive potential SGBs, following industry criticism regarding the use of external evidence. In its FDs, the assessment was based solely on comparative benchmarking of the business plan data submitted by the DNOs. In one area, Ofgem set the benchmark at the upper quartile (UQ), or 75% of the highest identified level of DNO SGBs. In another area, the benchmark was set at the frontier (the highest level of SGBs identified by a DNO).

NPg argued that there were a number of methodological, conceptual and implementation issues with Ofgem’s approach.7

However, the CMA considered that Ofgem erred on the second point. Given the significant change of definition of smart solutions between DDs and FDs,10 and the resultant increase in embedded SGBs, the CMA considered that Ofgem should have reassessed its original judgement of an underestimation of SGBs in the DNOs’ business plans. The absence of such a reassessment did not give the CMA confidence in the new level of savings identified at FDs.11 Taking all the evidence into consideration, NPg’s appeal on SGBs was upheld.

In reaching this judgement, the CMA also provided some specific views on the SGB benchmarking undertaken at FDs. Some of these views also have implications for other sectors. In particular:

  • the use of benchmarks based on single observations. The CMA questioned the appropriateness of Ofgem’s approach to determining the level of SGB adjustment for fault-level reinforcement costs,12 noting that the benchmark was based on a single data point, which it considered to be clearly an outlier. The CMA further noted that this method was not ‘adequately tested’,13 and might not truly reflect a shortfall in cost savings;
  • introducing new approaches during the process. The CMA also highlighted that the benchmarking exercise was a ‘novel’ introduction to the price review process undertaken after companies submitted their business plans; that Ofgem had altered the definition of what comprised a ‘smart’ cost saving at FDs; and that there was an absence of established reporting rules. The CMA concluded that Ofgem should have exercised more care in concluding that this method reflected a true shortfall in savings.14

In contrast, the appeals on RPEs and RCLAs were disallowed.

RPEs refer to the increase in input prices over a price control period, over and above general inflation. Several regulators take account of real input price inflation in their determinations. Broadly, NPg argued that Ofgem should have used data on DNOs’ actual pay settlements to calculate RPEs, rather than external indices. However, the CMA shared Ofgem’s view that the purpose of estimating RPEs is not to accurately reflect the costs faced by DNOs, but to reflect costs faced by companies in the wider economy. As such, the CMA considered that there was no need to use actual DNO pay settlements data. This also aligns with regulators’ approaches in other sectors. Indeed, the CMA ‘found no evidence, and none was put to [it], of any sector regulators using the actual wage settlements of the regulated companies subject to the price control to construct RPE forecasts for those companies’.

 

 

OFGEM Case Study 1-Automatic rollovers and contract renewals

Statutory Consultation on non-domestic automatic rollovers and contract renewals

https://www.ofgem.gov.uk/publications-and-updates/statutory-consultation-non-domestic-automatic-rollovers-and-contract-renewals

 On 30 July 2014 Ofgem published a statutory consultation on standardising the contract renewal process for micro-business consumers and increasing the amount of information in renewal letters (the July consultation). Ofgem decided that, as proposed, it will modify the gas and electricity supply licences by amending standard licence condition (SLC) 1 and SLC 7A. The overall effect of these modifications will require suppliers to:

  • allow micro-business consumers to give notice to terminate a contract no more than 30 days before a contract ends
  • provide current prices and annual consumption details on renewal letters for microbusiness fixed-term contracts, and
  • acknowledge a termination notice from a micro-business consumer within five working days of receipt, or as soon as reasonably practical after that.

All of the changes took effect on 30 April 2015.

The Authority’s decision

Having considered the responses to the July consultation, the Authority has decided to proceed with the modifications to the gas and electricity supply licences by amending SLC 1 and SLC 7A. The amendments to SLC 1 and 7A will take effect on 30 April 2015.

For contracts entered into before 30 April 2015, the maximum 30-day notice period (SLC 7A.6, 7A.11 and 7A.14) will apply when a micro-business consumer enters a new contract, or if a contract is extended in any way.

Notices to modify the standard conditions of all electricity and gas supply licences have been sent to all relevant licensees. They are also published on our website alongside this letter.

Maximum 30-day termination notice period

Most respondents supported this change. Two suppliers warned that letting consumers give only 30 days’ notice of changing supplier risks placing them on deemed or out-of-contract rates if there were any delays to the switching process.

Although we acknowledge this risk, we believe it will be mitigated by recent changes to reduce switching times. We have strengthened the licence requirements for three-week switching from 1 September 20146 and we have approved industry changes to further reduce switching times by the end of this year.7

The licence drafting is unchanged from the July consultation.

Current prices and annual consumption details on renewal letters

Most respondents agreed with our proposals. One supplier believed these changes were unnecessary and another two suppliers thought the additional information on letters could be confusing. Another supplier sought guidance on our additional rules in 7A.9(b) to give micro-business consumers clarity on variable-price contracts.

We believe it is important for consumers to be aware of their current prices and consumption when they renew their contract. This will help them to compare their current supplier’s prices before looking at what other suppliers can offer. The Standards of Conduct apply to all themes and matters covered by 7A, so this information needs to be presented and communicated fairly.

Other than the addition on current prices and annual consumption in 7A.8(e) and (f) we do not see the redrafted conditions 7A.8 (a) to (d) as additional requirements. They now explicitly describe what principal terms should be provided to consumers in different renewal scenarios. We believe this clarification will help to ensure consistency across suppliers. We have summarised these scenarios in Figure 1 below.

The new condition 7A.9(b) is drafted to ensure consumers know if their prices can change during a contract. These rules also apply to any fixed-term contract with variable terms. If prices can vary throughout the contract then we believe this should be absolutely clear to consumers in the principal terms before they enter a contract. If these variations are not explicitly agreed at the start of the contract, suppliers should tell the customer where they can find the current prices.

The licence drafting is unchanged from the July consultation.

 Acknowledging termination notice

Most respondents supported this change; for many suppliers it was already consistent with their current practice. One supplier agreed with the principle of notifying consumers on auto-renewal contracts but believed there were more effective ways to inform them of their contract status. A consumer group thought the proposal should go further and require suppliers to contact customers within 24 hours of any objection to switch.

As we stated in the July consultation, we agree that acknowledging customer termination notices is particularly important for auto-renewal contracts. However, suppliers can still require a notice period to terminate other contracts. We believe in all cases when termination notice is required the customer should be informed that their notice has been received and accepted by the supplier. This way they can enter a new contract without facing an objection10 or being billed on deemed or out-of-contract prices.

The licence drafting is unchanged from the July consultation. Banning auto-rollover contracts

Six respondents still believed we should ban auto-renewal contracts or stop suppliers from including termination fees for any automatically renewed contracts.

While these responses haven’t persuaded us to ban auto-rollovers outright, we do appreciate the risks they pose. We do believe they can be problematic for some consumers if prices are significantly higher than an equivalent negotiated contract. In the next six months we expect to:

  • Update our micro-business factsheet before the new rules take effect to explain these changes to consumers.
  • Issue another information request in early 2015 to give us an up-to-date view of micro-business prices and the number of meter points on different contracts. This is likely to have a similar format to our information request in August 2013.
  • We will publish our findings and say whether we intend to make any further changes.

We will also monitor the changes seven suppliers have already taken to end auto-renewal contracts with termination fees.

Other comments

Several responses pointed out a typographical error in the proposed changes to Annual Consumption Details in SLC 1 of the electricity supply licence. This has been corrected and highlighted in the modification notice. In addition, we have amended the drafting in both the electricity and gas modification notices so that the term “fixed-term” is hyphenated throughout for consistency.

 

 

 

 

OFCOM Case Study 2: Renewable Contracts

Renewable Contracts – OFCOM Statement 13 September 2011

Ofcom’s decision to amend General Condition 9 (-1-) (GC 9) in order to prohibit Automatically Renewable Contracts (ARCs also referred to as rollover contracts or rollovers) to residential customers and small businesses with no more than ten employees in the fixed voice and broadband sectors

Background

In communications retail markets, ARCs are those that, at the end of each minimum contract period (MCP), roll forward to a new MCP by default unless the customer proactively informs their Communications Provider (CP) that they do not wish this to happen. An MCP is a fixed period of time for which a customer commits to taking services from a CP. While under an MCP, a customer is usually subject to an Early Termination Charge (ETC) should they wish to end the contract.

Since they first became a prevalent feature of the residential fixed voice sector in 2008, Ofcom has been concerned that ARCs are damaging to consumers and competition in communications markets. We recognise that ARCs may have benefits for some consumers for example, those who wish to remain with their CP and who value the ability to move into a new minimum contract period unless they opt out. However, we believe these benefits are relatively limited and are outweighed by the costs.

Ofcom has been monitoring ARCs in UK residential and business fixed voice markets since they emerged, and has carried out targeted research on their effects. While we have not carried out such specific research with respect to small businesses, we are confident that the results we have identified for residential ARCs customers can be extrapolated to small business customers. BT is the largest CP currently offering ARCs in these markets.

Economic Evidence

Econometric analysis on the switching behaviour of BT customers, indicated a clear causal link between ARCs and reduced levels of consumer switching. This effect stems from the opt-out nature of the process for contract renewal and that any example of such a contract is likely to be harmful to consumers and to effective competition.

 

 

 

 

 

 

 

OFCOM case study 1: Termination Charges Dispute

OFCOM Case Study 1: Termination Charges Dispute

 

OFCOM decision <Appeal to the CAT < Appeal to the Court of Appeals < Appeal to the UKSC

The case concerned a dispute about the termination charges which BT is entitled to charge to mobile network operators for putting calls from the latter’s networks through to BT fixed lines with associated 08 numbers. It raises issues of great importance to the telecommunications industry, to its regulator, and indirectly to millions of consumers.

Background

In principle, the cost of a call is charged to the caller by the originating communications provider to which he subscribes (a “CP”). Out of its charges to the caller, the originating CP must pay charges to the terminating network or to an intermediate carrier if there is one. 08 numbers are known as non-geographic numbers. They are allocated to fixed line subscribers, and automatically translated into the appropriate geographic number in the course of transmission. Where the call originates from another fixed line, an 08 number allows the subscriber to whom that number has been allocated to receive it on the basis that the caller will be charged at a standard, and generally reduced, charge. Calls to 080 numbers are free to fixed line callers except where charges are notified at the beginning of the call. Calls to 0845 numbers are charged to fixed line callers by the originating CP at its standard local call rate. Calls to 0870 numbers are charged to fixed line callers by the originating CP at its standard national call rate except where different charges have been published. In each case, the terminating CP will collect a termination charge from the CP from which it received the call. However, where calls originate from a mobile network operator, that operator will commonly charge the caller for a call to a 080 number, or charge him more than the standard local or national rate for a call to a 0845 or 0870 number.

In 2009, BT notified mobile network operators of a revised scheme of termination charges for 08 numbers. According to the new scheme, mobile network operators (MNOs) would be charged at a rate which varied according to the amount which the originating network charged the caller. The higher the charges, the greater the termination charge. The four MNOs rejected the scheme. The issue was referred to the OFCOM under its statutory dispute resolution powers.

Appeal lies from Ofcom to the Competition Appeal Tribunal, and from them on points of law only to the Court of Appeal. Ofcom decided that BT should not be allowed to introduce the new charging scheme. The Competition Appeal Tribunal overturned that decision and decided that they should. The Court of Appeal restored the original decision of Ofcom.

Ofcom’s determinations

Ofcom issued a final determination dated 5 February 2010 in relation to 080 numbers, and a second final determination dated 10 August 2010 in relation to 0845 and 0870 numbers. Ofcom decided that it would permit the changes to be made only if they were “fair and reasonable”, judged by three governing principles (OFCOM’s analytical framework).

All three principles can be related to objectives set out in Article 8.2 of the Framework Directive.

  • Principle 1 was that mobile network operators should be able to recover their efficient costs of originating calls to the relevant numbers. < OFCOM found this principle to be satisfied.
  • Principle 2 was that the new charges should (i) provide benefits to consumers, and (ii) not entail a material distortion of competition. < Principle 2 was “not sufficiently likely to be met”.

As regards Principle 2(i), which is known as the “welfare test”, Ofcom distinguished between three potential effects on consumers: the “direct effect”, essentially the effect on consumer prices for calls to 08 numbers; the “indirect effect”, which referred to the possibility that revenue gains by BT would feed back to the consumer in the form of lower charges or higher standards of service by service providers who use 08 numbers; and the “mobile tariff package effect” (or “waterbed effect”), by which it meant the potential for mobile network operators deprived of one revenue stream to try to compensate themselves by seeking to raise prices elsewhere. It thought that the direct effect was likely to be positive for consumers, because a tariff based on the originating network’s charge to the caller was likely to lead mobile network operators to reduce their charges to callers, although it could not say by how much. It thought that the indirect effect was also likely to be positive, because over time some of the benefits to BT would be passed on to service providers using the 08 numbers in question, although callers to 08 numbers would not necessarily benefit. Ofcom’s concern was about the mobile tariff package effect. It thought that this was likely to be negative because mobile network operators would probably try to recoup the higher termination charges by raising charges for other services.

  • Principle 3 was that implementation of the new charges should be reasonably practicable < it was not satisfied < Ofcom was overruled by the CAT

Taking the three effects together, Ofcom’s conclusion was as follows:

9.31 Our judgement in respect of Principle 2 is therefore finely balanced. We recognise the possibility that consumers could benefit from NCCNs 985 and 986. However, we also recognise the risk of harm to consumers from NCCNs 985 and 986, particularly in light of our conclusions on the Mobile tariff package effect.

9.32 Given the uncertainty which we have identified as to whether BT’s NCCNs would result in a net benefit or net harm to consumers, and in light of our overriding statutory duties to further the interests of consumers, we consider it is appropriate for us to place greater weight on this potential risk to consumers from NCCNs 985 and 986.”

Turning to the competition test at Principle 2(ii), Ofcom concluded that while there were some concerns on this count, the risk of a material distortion of competition arising from the changes was “relatively low”.

  1. Taking the welfare test and the competition test together, Ofcom concluded that Principle 2 was not satisfied, because BT could not positively demonstrate that the proposed tariff changes would be beneficial to consumers. In summary, what Ofcom decided was that although the direct and the indirect effect of BT’s proposed price changes could be expected to result in lower prices for consumers, BT should not be allowed to make the changes because it was not possible to forecast how far mobile network operators would be able to compensate themselves by increasing other charges.

CAT judgment  [2011] CAT 24

Under section 192 of the Communications Act 2003, an appeal to the CAT is an appeal on the merits. It is a rehearing, and is not limited to judicial review or to points of law. This reflects the requirements of Article 4 of the Framework Directive.

The CAT allowed BT’s appeals. The tribunal agreed with the approach embodied in Ofcom’s three principles, but they had a different starting point. In their view, BT was prima facie entitled to change its charges for three reasons.  The first was that BT had a contractual right to vary its charges, subject to Ofcom’s determination if the dispute resolution procedure was operated. The second was that the introduction of innovative charging structures was itself a mode of competing, and that interference with it would restrict competition. The third was that “price control is an intrusive form of control which elsewhere in the 2003 Act can only be introduced by SMP condition” (para. 442). It was therefore inappropriate for Ofcom to use its dispute resolution powers as a way of controlling the charges of a CP like BT which did not have significant market power in a relevant market. Summarising their view of these points, the CAT said:

“396. The crucial question is what is a regulator to do in the context of such uncertainty? Essentially, the regulator has two choices:

(1) To prevent change unless it can be demonstrated that the change is beneficial- in which case it may well be said that the dead hand of regulation is constraining behaviour which may actually be beneficial to consumers. We stress that our conclusion regarding Principle 2(i) was that the welfare assessment was inconclusive, not that consumers would be harmed.

(2) Alternatively, to allow change despite the uncertainty, even though there is a risk that the change may result in a disbenefit to consumers, recognising that an undue fetter on commercial freedom is itself a disbenefit to consumers.”

It followed that, if Principles 1 and 3 were satisfied (as they were), Ofcom could reject a proposed change in a CP’s termination charges only if the welfare test distinctly showed that they would adversely affect consumer welfare.

  1. The CAT reached substantially the same conclusions about the welfare test as Ofcom did, namely that it was inconclusive. They expressed their conclusion as follows at paragraph 379:

“Fundamentally, the welfare analysis is inconclusive, due to a lack of empirical evidence. Even with the assistance of the simplifying assumptions that we have described, a reliable assessment of elasticity of demand is not possible. Whilst it is possible to conclude that prices for 080, 0845 and 0870 calls will, on balance, fall, it cannot be said how far they will fall, nor what volumes of calls there will be at any given price. Equally, the extent of the Mobile Tariff Package Effect is essentially unknown.”

An inconclusive welfare test could not in the CAT’s view be enough. The CAT’s conclusion on this point is conveniently summarised at paragraphs 447-448 of their judgment:

“447. If, therefore, the test to be applied is whether the NCCNs can be shown to provide benefits to consumers, then that test is not met. However, we do not consider this to be the correct test in the circumstances of the present case, because it places undue importance on Ofcom’s policy preference, at the expense of the two other relevant factors that we have identified as forming a part of Principle 2 (namely Principle 2(ii) [the risk of a distortion to competition arising from restricting CP’s commercial freedom to price] and BT’s private law rights.

  1. We consider that whilst Ofcom’s welfare analysis could override these other factors, it should only do so where it can clearly and distinctly be demonstrated that the introduction of the NCCNs would act as material disbenefit to consumers. In short, given the presence of the two other factors that we have identified, it is not enough for the welfare analysis to be simply inconclusive. The welfare analysis must demonstrate, and demonstrate clearly, that the interests of consumers will be disadvantaged.”

The  Court of Appeal judgment [2012] EWCA Civ 1002

Appeal lies from the CAT to the Court of Appeal on a point of law only. The Court of Appeal (Lloyd, Etherton and Elias L.JJ) overruled the CAT and restored the decision of Ofcom. The leading judgment was given by Lloyd LJ, with whom both the other members of the Court agreed.

Lloyd LJ rejected the CAT’s starting point:

  • In the first place, he held that the tribunal had been wrong to treat BT as having a prima facie right to change its charges, which needed to be displaced. It had no more than a right to do so subject to the determination of Ofcom if the counterparty objected.
  • Secondly, he held that they had been wrong to attach weight to their view that a restraint on BT’s freedom to set its own charges would itself distort competition.
  • Thirdly, he held that the CAT had been wrong to attach weight to the fact that BT, not having significant market power in a relevant market, was not subject to ex ante control of its prices on competition grounds. Having disposed of the three considerations that led the CAT to put the burden of justifying their objection to the new charges on the mobile network operators, Lloyd LJ held that it was for BT to justify its charges as being fair and reasonable. This, he thought, required them to establish positively that consumers would benefit by them, something which the inconclusive outcome of the welfare test made it impossible for them to do.

Lloyd LJ attached considerable importance to the nature of the function which Ofcom is performing when it resolves disputes about charges under an interconnection agreement: “dispute resolution is a form of regulation in its own right, to be applied in accordance with its own terms”. (para.63; See also Article 20 of the Framework Directive). In his view, the terms of the Interconnection Agreement were of little if any relevance because their effect was that any new charges introduced by BT were liable to be overridden by Ofcom in the exercise of its regulatory powers. This led him to regard interconnection charges as an essentially regulatory construct. Much of the rest of his analysis follows from these premises. Because Ofcom’s determination of the dispute was a regulatory function, Lloyd LJ considered that the balancing of the various factors relevant to Principle 2 was a value judgment for it. Since it was not shown to have erred in principle, its decision should be restored.

The Welfare Test

Ofcom rejected the new charges was that the welfare test having been inconclusive, it had not been demonstrated that BT’s new schedule of charges would produce consumer benefits.

Supreme Court  [2014] UKSC 42 found that this was wrong in principle, for substantially the reasons given by the CAT.

BT were contractually entitled to vary their charges unless the proposed variations were inconsistent with the Article 8 objectives, including the objective of ensuring consumer benefit in accordance with Article 8.2(a). Ofcom have not found that they were inconsistent with those objectives. They have found that they would produce direct and indirect consumer benefits of unquantifiable value, and that these benefits might or might not be exceeded by disbenefits arising from the attempts of mobile network operators to increase revenue in other directions. The latter factor was found by the CAT to be “essentially unknown”.

‘43. In my opinion, it is not consistent with either the contract or the scheme of the Directives for Ofcom to reject charges simply because they might have adverse consequences for consumers, in the absence of any reason to think that they would. It is not consistent with the contract because it prevents BT from exercising its discretion to alter its charges in circumstances where there is no reason to suppose, and Ofcom has not found, that the limits of that discretion have been exceeded. It is inconsistent with the scheme of the Directives because it involves applying an extreme form of the precautionary principle to a dynamic and competitive market, in a manner which is at odds with the Directives’ market-oriented and essentially permissive approach. Logically, given the inherent difficulty of forecasting the extent of any direct or indirect effects, and the practical impossibility of forecasting the mobile tariff package effect, it would rule out any increases in termination charges other than those justified by reference to underlying costs. On this point, therefore, I think that the CAT were right and that the Court of Appeal were wrong to overturn them.’

‘44. In its submissions on the appeal, Ofcom submitted that the degree of risk which is acceptable must be related to the gravity of the adverse effect if the risk materialises. It expressed concern that it should not, for example, be inhibited from blocking a price variation which on a balance of probabilities was unlikely to be adverse, but which if things went wrong would be catastrophic. I agree. This would be an example of a case where the existence of the risk was itself adverse to the interests protected by Article 8. But on the facts found by Ofcom and the CAT, we are a long way from that kind of situation in the present case. It is right to add that if and when sufficiently adverse effects were to materialise at some point in the future, Ofcom has power to intervene to address them at that stage.’

Anti-competitive effect of price control

‘45. The Court of Appeal’s second reason for thinking that it was for BT to demonstrate positively that there would be consumer benefits from the proposed changes to their charging structure was that they disagreed with the CAT’s emphasis on the anti-competitive effect of preventing the introduction of innovative charging structures. The Court of Appeal did not suggest that it was economically mistaken. But they considered that too much weight had been attached to it by the CAT. In their view, this was a matter of regulatory policy. Since Ofcom was the regulator and it was exercising a regulatory function in resolving the present dispute, the CAT should not have interfered with their conclusion unless Ofcom erred in principle. The Court of Appeal thought that since the CAT substantially agreed with Ofcom’s conclusion on the welfare test, there was no error of principle.

46. I think that in this respect also, the Court of Appeal was wrong. In the first place, as I have explained, in resolving this particular dispute, Ofcom was not exercising a regulatory function, but resolving a dispute under the unchallenged terms of an existing agreement. But the main problem about the Court of Appeal’s view is a more fundamental one. According to the CAT’s analysis, the effect of not allowing BT to introduce innovative charging structures was itself anticompetitive because innovative pricing structures are an effective mode of competing. This was clearly a relevant consideration, even if it was not a conclusive one: see Article 8.2(b) of the Framework Directive. It was not a consideration taken into account by Ofcom. Since the right to introduce the proposed pricing package brought benefits for competition, the mobile network operators should have to justify their demand that the package should be rejected by pointing to some countervailing detriments to consumers disclosed by the welfare test if it were to be accepted. An inconclusive welfare test could not be enough for this purpose. The CAT was hearing an appeal by way of rehearing on the merits. Their conclusion about the anti-competitive effects of restricting price changes and the weight to be attached to it was a factual judgment which it was perfectly entitled to make. It was, moreover, an economic judgment by an expert tribunal which had received a substantial amount of additional evidence, including economic evidence. Since appeal lay to the Court of Appeal only on points of law, the CAT’s findings on the distortion of competition liable to result from the rejection of the new charging structure were not open to rejection on appeal.

Inappropriateness of restricting prices in the absence of significant market power

  1. These considerations are enough to resolve the present dispute in favour of BT. It is therefore unnecessary to consider the CAT’s third reason for requiring the mobile network operators to show a distinct disbenefit to consumers in order to justify rejecting a proposed change to interconnection charges. This was that the rejection of BT’s proposed charges amounted to imposing price control on an entity such as BT which had not been designated as having significant market power in a relevant market. This, it was argued, was wrong in principle because there was no power under the Directives and the Act to regulate the prices of a firm without such power. BT put this point at the forefront of their submissions. For reasons which were never entirely clear but may have to do with their commercial and regulatory strategies, they were anxious to avoid relying on BT’s rights under the Interconnection Agreements or adopting those parts of the CAT’s reasoning which were based on them, and instead sought to obtain a ruling that the Common Regulatory Framework can never authorise Ofcom to reject a price variation unless it would leave an efficient operator unable to cover its costs.
  2. I will only say that as at present advised I am not convinced by this. It seems to me to be irrelevant to the question on which this appeal turns, namely whether BT must positively demonstrate consumer benefit if they are to justify their proposed charges. Moreover, the fact that BT does not have significant market power in a relevant market does not mean that the promotion of competition, which is included among the Article 8 objectives, is irrelevant to a dispute about charges. It only means that Ofcom may not exercise its regulatory power to control prices. Ofcom has not purported to do this. There is an important difference between (i) exercising a regulatory power to impose price control in order to correct market failure or control the abuse of a dominant economic position, and (ii) deciding whether a particular proposed tariff change advances consumer welfare for the purpose of determining whether there is a right to introduce it.

A hypothetical alternative analysis

  1. It will be apparent that I do not accept the basic conceptual framework within which the Court of Appeal reviewed these questions. It is, however right, in view of the way that the argument went and in the light of suggestions that there should be a reference to the Court of Justice of the European Union, to point out that the result would have been the same even if Lloyd LJ had been right to regard Ofcom’s dispute resolution functions as purely regulatory and the interconnection terms as being unimportant. The whole scheme of the Directives is to leave the arrangements for interconnection to the parties unless there are grounds for regulatory intervention. The permissible grounds of regulatory intervention in the case of a CP without significant market power are that the interconnection terms have been framed or are being operated in a manner which is inconsistent with end-to-end connectivity or conflicts with the Article 8 objectives. If the result of the welfare test and the competition test is that there is no positive reason to believe that the effects will be adverse, there is no justification for regulatory intervention.

Conclusion Supreme Court

In my opinion there was no justification for the Court of Appeal to set aside the careful analysis of the CAT on a matter lying very much within its expertise. I would accordingly allow this appeal. Counsel will be invited to make written submissions on the form of order unless this can be agreed.