Consolidated Water, whose subsidiary Cayman Water supplies piped water to businesses and households in West Bay and parts of Seven Mile Beach, has filed for permission to apply for judicial review with the Grand Court over a change to its pricing structure. Consolidated Water has been in negotiations with the Cayman Islands government, and subsequently Water Authority-Cayman, over the renewal of the licence in its service area since July 2010.
In these negotiations, the government and the Water Authority maintained that the application of a “rate of return on invested capital” model under a new licence is in the best interest of the public and the company’s customers.
The suggested pricing model is fundamentally different from the existing model, which adjusts the rates for movements in energy prices and has been in place since 1979, said Consolidated Water Chief Executive Officer Rick McTaggart. The new model is similar to the electricity transmission and distribution licence held by Caribbean Utilities Company, based on regulating the rate of return, he said. “We would like the Water Authority to explain why they impose the new pricing model.”
Consolidated Water’s Grand Court filing is seeking an order quashing the decision by Cayman Water to impose the new pricing model. It also states that certain provisions of the Water Authority Law 2011 and the Water (Production and Supply) Law 2011 appear to be incompatible. “In the filing we set out what our concerns are. The RCAM model is only part of it,” Mr. McTaggart said.
“We have only recently been advised who we are negotiating with,” he said referring to correspondence from the Cayman Islands government stating that under the new laws the Water Authority is now the principal licence negotiator.
In particular, the dual role of the Water Authority, as both a regulator with the ability to grant licences and a water utility that provides water in all other districts of Grand Cayman and Cayman Brac not serviced by Cayman Water, is questioned by Consolidated Water.
“The Water Authority’s role of statutory regulator and competitor to [Consolidated Water] put it in a position of hopeless conflict,” Consolidated Water said in a filing with the United States Securities and Exchange Commission.
In addition, the decision by the Water Authority to replace the Consolidated Water’s rate structure under its current exclusive licence with a rate of return on invested capital model “was predetermined and unreasonable”, the utility company claimed.
Consolidated Water has consistently argued against such a pricing model in its negotiations with the government and the Water Authority, stating that it would not promote the efficient operation of the company’s water utility and could ultimately lead to an increase in water rates to the company’s customers.
The RCAM model is similar to the licence CUC operates under and is also employed to the sale of water in many US municipalities. In the US, the pricing model is based on the premise that water rates should reflect the actual or projected cost of providing the service and also offer a rate of return that is comparable to returns on investment in other companies that are subject to similar risks.
It aims to give water companies the opportunity to recover reasonable operating expenses and earn a fair return on the invested capital necessary to provide reliable service to customers. The question what constitutes a reasonable investment and a fair return has been extensively litigated in the US.
Mr. McTaggart said that a US model is not necessarily transferrable to Cayman. “We are manufacturing water from the ocean [through reverse osmosis plants]. Nobody in the US does it. They take water from a natural resource, treat it to a minimum and deliver it to the consumer. It is a capital intensive business to build a treatment plant.”
The RCAM model would also see additional regulatory costs, he said, referring to the process required for establishing rates annually. This process is extensive in the US water industry.
It would add “a new level of costs that somebody is going to bear” and probably means more civil servants, Mr. McTaggart said. “All those things need to be reviewed.”
The Water Authority said it was unable to comment on the matter at this time.
The Cayman retail water segment is an important part of Consolidated Water’s business. In the first quarter of 2012, the utility company generated 39 per cent of its consolidated revenues and more than half, 54 per cent, of its consolidated gross profits from its retail water operations in Cayman under exclusive licence.
In its SEC filing, Consolidated Water outlined several scenarios that could follow the court application. If the court agrees with the issues raised by Consolidated Water, the government and the Water Authority would have the opportunity to present their position in a trial proceeding. If the Grand Court does not agree, Consolidated Water has the right to appeal. The utility could also simply continue its negotiations for a new licence. In the meantime, the company expects to be permitted to supply water to Seven Mile Beach and West Bay.
The terms of any new licence, however, may not be as favourable to the company as the ones it is operating under at the moment. A new licence could reduce both the operating income and cash flows compared to historic financial results.
Consolidated Water is also carrying $3.6 million in goodwill, which may be impaired under a new licence. This could be material to the company’s results of operations, Consolidated Water said.
Consolidated Water’s original licence expired in July 2010 but the company and the government agreed to extend the licence short term seven times during the negotiations of a new long-term licence agreement. The existing extension expired 30 June, 2012, and Consolidated Water is awaiting another extension. Cayman Water has the first right of refusal to renew the licence on terms that are not less favourable than those offered to a third party.