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To:

Mr Bryan Symonds Commercial Director Access Water Management Ltd Bordersley House Alvechurch Birmingham B48 7QB

Mr Michael Samorzewski Managing Director Aquavitae (UK) Ltd Royal Albert House Sheet Street Windsor, Berkshire SL4 1BE

Dr Jeremy Bryan Managing Director Albion Water Ltd 71 Clarence Road Teddington Middlesex TW11 0BN

Ofwat is obliged to apply the legislation that Parliament has enacted. The Act, as amended, specifies that the charges payable by a licensed water supplier to an appointed water company under an access agreement (or under a determination by Ofwat) shall be fixed in accordance with the costs principle. In simple terms, the costs principle provides for a retail-minus approach to calculating access prices for wholesale supplies and combined supplies. The access price payable by a licensed water supplier to a water undertaker comprises:

• any expenses reasonably incurred in performing any duty to give access under the Act,
• plus the retail price the undertaker would otherwise have charged the customer,
• minus the costs that the undertaker can avoid or reduce and minus any amount that is recoverable in some other way (other than from the undertaker's other customers). We refer to these as ARROW costs.

The costs principle was designed to encourage efficient competition, with appropriate protection for ineligible customers.

The Tribunal is considering an appeal made on 23 July 2004 against our Competition Act 1998 (CA98) decision in the complaint by Albion Water Limited against Dŵr Cymru Cyfyngedig relating to common carriage for the supply of water to the Shotton paper mill (Case 1046/2/4/04). In the main hearing before the Tribunal, on 9-11 May 2005, Albion Water Limited and Aquavitae (UK) Limited raised questions concerning the interpretation of the costs principle. (The same arguments were repeated in another appeal to the Tribunal.) The Tribunal's judgements are pending. We cannot predict what, if anything, the Tribunal may state in relation to the costs principle. We will consider the implications of the Tribunal's judgements after they have been handed down.

The costs principle is similar to the Efficient Component Pricing Rule (ECPR). Both use a 'retail-minus' approach, but neither specifies how to measure the avoidable or ARROW costs. In the early discussions about the costs principle, Ofwat raised as one option whether LRMC could be used as a proxy for avoidable costs. However, after further analysis of the costs principle and discussion by an industry advisory group (comprising customer representatives, potential licensees and appointed water companies), we decided it was more appropriate for the avoidable costs to be calculated on a case-by-case basis. Therefore, because LRMC numbers are not case specific, we have used the case-specific method as set out in our guidance.

The Act establishes a specific regime for water supply competition in England and Wales and the appointed water companies are legally required to follow the costs principle when calculating access prices. To the extent that companies will be deemed to be engaging in conduct (or entering into agreements) to comply with a legal requirement in calculating access prices, the Chapter I and II prohibitions of CA98 will not apply to such conduct (or agreements).

The approach to calculating access prices as outlined in our guidance follows the costs principle. The aim of the costs principle is to produce prices that fully compensate each appointed water company for the net costs (or expenses) that it unavoidably incurs when providing a combined or wholesale supply, compared with it continuing to supply the final customer. It should allow efficient competition to develop and should ensure that customers who do not participate in the new regime do not subsidise those who do. As in other markets, licensees and their customers will benefit from any added value they can generate.

The letter refers to a draft discussion paper on Ofwat's approach to reviewing the water supply licensing regime, which was presented to the water supply licensing sponsor group on 26 April 2005. The sponsor group, which comprises customer representatives, potential licensees and appointed water companies, provides an overview on the implementation of the new regime. Discussions are continuing in the sponsor group, and no decisions have yet been made on Ofwat's approach to reviewing the water supply licensing regime. However the criteria we propose using to review the regime will include quantitative measures such as how many customers change supplier, how many licensees there are and how much 'new' water is offered.