Thames Water Utilities Ltd & Anor v Heathrow Airport Ltd & Anor

This case raises a short but commercially significant question on the construction of an agreement dated 16 February 1993. The provision in issue concerns the calculation of the amounts payable in respect of the sale of the land on which Terminal 5 at Heathrow Airport was built. I shall call the claimants (who were the sellers of the land) “Thames Water”, and the defendants (who were the buyers) “Heathrow”. These terms include their various predecessor bodies and parent companies. The parties have already reached extensive agreement, but have not been able to reach agreement about everything. They have cooperated in bringing the matter to Court under CPR Part 8 with the minimum of delay. It is hoped that the Court’s ruling will enable them to take matters forward.

As I shall explain, part of the consideration payable on the sale includes the additional costs involved in operating the new works which were required to replace those which Thames Water had previously operated on the site. The provision which is the subject of this action requires the chief executives of the respective parties to try to reach agreement as to the basis of calculation of these additional costs. If they are unable to do so, the matter is to be referred to an independent expert for determination. The parties are in dispute as to the scope of the expert’s role. In broad terms, the issue is whether as Thames Water submits the expert has to make a one-off determination, or whether as Heathrow submits a one-off determination can nevertheless make provision for periodic adjustment in the light of such developments as changes in legislation.

The primary facts are not in dispute. In the 1930s, London’s burgeoning population required new arrangements for sewage disposal. A new sewage treatment works was opened at Mogden, which is west of London in Twickenham. At the same time, a sludge disposal works was constructed on a 250 acre site situated at Perry Oaks, which is seven miles north west of Mogden. When it opened in October 1936, Mogden was considered to be the most advanced and largest sewage treatment works of its kind in Europe. I take the description of how the two sites worked together from the Case Memorandum. Prior to 1993, raw sewage from premises in and around west London arrived at Mogden where it underwent a number of treatment processes. Sludge from Mogden was then pumped along two pipelines to the works at Perry Oaks, and allowed to lie there in deep lagoons for a prolonged period. As a result, it thickened and became decontaminated by a natural bacterial process. Eventually, sludge from Perry Oaks was taken away and used as agricultural fertiliser or landfill.

At this time, London’s main airport was at Croydon, which is to the south of the city. There was an airfield close to the Perry Oaks site, and it was called the “Great Western Aerodrome”. During the war, an airport was constructed on the airfield. It was named after the hamlet “Heath Row” which was demolished to make way for it. As Heathrow airport grew following the end of the war, the Perry Oaks site was an obvious location for the airport’s expansion. During the 1980s the parties (which were then both in the public sector) were in negotiation about the possibilities. On 7 June 1989, which was about three years after Terminal 4 was opened, they reached an interim arrangement. It envisaged the preparation of a scheme for the replacement of the existing sludge operation at Perry Oaks and its removal to an alternative site. At the same time, a planning application was to be submitted for the development of Terminal 5 on the land thereby vacated.

On 16 February 1993, the parties entered into the Agreement which is the subject of this case. The parties’ obligations under the Agreement were guaranteed by the second claimant and the second defendant respectively, which explains why they are joined to the proceedings. So far as presently relevant, there were three elements to the amounts that Heathrow was to pay Thames Water. To adopt the summary in Heathrow’s skeleton argument, in simple terms the compensation package provided for Thames Water to be paid for the land it sold to Heathrow, to be paid for the capital costs of building replacement sludge works, and to be paid over a period of some thirty years the “additional costs” to it of running the replacement works as opposed to the costs it would have incurred in running the works at Perry Oaks. The dispute is as to the calculation of these “additional costs”.

Unfortunately, the implementation of these arrangements was delayed because of the over running of the Terminal 5 Public Inquiry. I am told that it was the longest running planning enquiry in British history. The result was that through no fault of their own, the parties’ original timing proved to be hopelessly optimistic. To deal with the consequences of the delay, they had to enter into various supplemental agreements which are dated 23 October 1998, 27 March 2002 and 26 July 2002. Handover, which was when the plant and equipment of the new sewage scheme was handed over to Thames Water, occurred on 1 June 2006. The building works then proceeded apace, and Terminal 5 was opened on 14 March 2008.

Both sides served witness statements in support of their positions, but agreed that there was no need for witnesses to attend to give oral evidence at trial. I have been assisted by their written evidence, though not all of it is admissible as a matter of law in construing the agreement (I summarise the approach of the court to the construction question below). Given the relative absence of disputes of fact so far as this trial is concerned, I restrict myself to identifying a number of points that are made by the witnesses.

Mr Robert Collington (a Waste Water Services Director of Thames Water) sets out some of the factual background which I have recited above. He says that Heathrow wanted to reach agreement so as to avoid having to seek a Compulsory Purchase Order in respect of the Perry Oaks site. He describes the arrangements under which Heathrow would pay for the decommissioning of Perry Oaks and the building of a new sewage treatment works together with a contribution towards the increased costs, saying that in return Thames Water “agreed to transfer ownership of the Perry Oaks site to Heathrow for a nominal consideration”. The amount in question was £3 million. Ultimately, a site at Iver South in Uxbridge was identified as the site for the replacement plant for Perry Oaks. But this site was much smaller, and Mr Collington explains that it became apparent that the upgrade and enhancement of the sludge treatment procedures at Mogden would also be required.

Mr Paul Fox, who is Heathrow’s Transformation Assurance Director, says that there are likely to have been changes in the method of operation which would have been implemented by Thames Water even if it had continued to use Perry Oaks for sludge disposal. Changes in legislation, codes of practice and so on may have necessitated changes in the way in which both Mogden and Perry Oaks operated. He explains that Heathrow’s position is that it is entitled to be given credit for the hypothetical costs which Thames Water would have incurred in operating sludge treatment facilities, and that those costs should be based upon the facilities which would hypothetically have been required from time to time if Perry Oaks had continued in operation. He takes issue with the description of £3 million as a “nominal” consideration, saying that it was agreed to be a fair value for the land within the context of the full agreement. He also exhibits some of the correspondence that has passed between the parties’ lawyers. This makes it clear that the ambit of the dispute has to some extent been clarified since proceedings were began on 11 June 2008.

Heathrow has also put in evidence of a technical nature from Ms Ingrid Lagerberg. She is a civil engineer with Halcrow Group Limited with long experience in waste water engineering. She describes the work done by Heathrow and Thames Water working together to try to reach agreement on the additional costs issue. Apparently, their respective teams did not agree the “bases of operations”, but went straight into calculating the costs. She says that establishing the costs which Thames Water was incurring through operating the works comprised in the new Scheme is relatively straightforward, because each annual estimate can be tested against actual costs incurred. The more difficult aspect of the work is to establish the costs which would have been incurred in operating the old replaced works at Perry Oaks. She exhibits a document issued in November 2006 setting out how operating costs are calculated, invoiced and paid. It does not state the “bases of operations”. She explains how she considers that three elements need to be included to establish the costs which would have been incurred in operating the old replaced works. These are (1) actual costs prior to decommissioning, (2) the inflation of such costs, and (3) the costs of complying with changes affecting the sewage and sludge part of the regulated water industry. For example, relevant changes that have had an impact on the new works and would have had an impact on the old works, she says, include amendments to the Common Agricultural Policy, the voluntary Safe Sludge Matrix and a Code of Practice on odour nuisance. Her suggestion is that some of the questions within (3) reflect changes that have impacted on the industry since the Agreement was signed in 1993. Further changes, she says, are to be expected before 31 May 2036 when Heathrow’s payment obligations come to an end. She says that in her view it makes more sense that the bases upon which the old works would have operated and the new works will be operated “both include the requirement that they would/will be operated to comply with all relevant sewage and sludge industry drivers throughout the period until 2040”.

Andrew Gosling is a Principal Project Manager with Thames Water. He was involved during the period 1988 to 1990 as part of the “Relocation of Perry Oaks Facilities Steering Group”. From 2000 onwards, he has been involved with the construction of the replacement works at Mogden and Iver South, and in the decommissioning of the replaced works at Perry Oaks. He exhibits a November 1990 Strategy which he says was the only long term proposal for the future operation of Perry Oaks. It provided for the development of a further seven deep lagoons. He says that the interim agreement (that is arrangement) reached in 1989 marked an emphasis towards the emptying of existing lagoons. He says that it is his understanding that the purpose of clause 7.3.2 of the Agreement was to introduce a simple mechanism which could be used in each year after Handover without any need for any third party involvement. As regards to legislative changes, he says that at the time of the interim agreement, these were not a significant issue for Thames Water, which operated to a far higher standard in any event.

As regards Ms Lagerberg’s statement, he says that work to reach an agreement as to additional costs took place between 2002 and 2006. He says that there was no mention of future legislative changes until a late stage in the process. In that regard he cites differences between the 2006 draft referred to by Ms Lagerberg, and the first draft prepared around November 2005. He draws attention to what he describes as the “future loss of capacity, cost effectiveness and versatility that Perry Oaks’ vast 250 acre site would have offered”. Contrary to Ms Lagerberg’s opinion, he considers that a periodic re-evaluation of the additional costs would be impossibly complex to administer.

Finally, Mr David Tanner was a Principal Project Manager with Thames Water from 1990 through the time of the public enquiry. He says that the primary goal of Heathrow throughout was to ensure that timely planning permission was secured in respect of the Scheme (whatever form it took) to ensure that possession of the Perry Oaks site was secured for the development of Terminal 5, and that this was far more important than the cost effectiveness of the alternative Scheme adopted.

As has been seen, the broad structure of the payment package in the Agreement had three elements. As summarised in paragraph 5 of the Case Memorandum:

So far as the second of these three elements is concerned, that is the calculation of the additional costs incurred by Thames Water in operating the works comprised in the Scheme, the relevant provision is clause 7.3 of the Agreement. In its amended form, this provides that Heathrow shall pay to Thames Water:-

The first part of the clause is not controversial. The twenty and ten year periods run from Handover on 1 June 2006 rather than 1 January 2000. It is the following part of the provision which is in issue, which envisages the parties trying to reach agreement as to the “bases” of operation referred to in sub-clauses (a) and (b) “in order to calculate the amount of such additional costs to be paid by [Heathrow]”. In the absence of agreement, the matter is to be referred to an independent expert, who is to decide which party’s position is to be preferred. The parties have not reached agreement and will, therefore, need to refer the matter to an expert for determination.

Written submissions have been brief in this case, and oral submissions were even briefer. In summary, Thames Water contends that the expert is required to determine, once and for all, how a sewage treatment works for the site at Perry Oaks would have been operated from 1989 to 2040 on the assumption that no agreements were entered into between the parties concerning the site. Having determined the hypothetical basis of operation, the costs that would have been incurred by Thames Water in operating the site on that basis during the 30 year period from Handover may then be calculated. In short, Thames Water contends that there should be a single or “one-off” determination by the expert, which would enable the additional costs payable by Heathrow pursuant to clause 7.3.2.1 to be calculated by the parties as an accounting matter. This (Thames Water submits) ought to present no difficulties as between sensible commercial parties. In the unlikely event of a dispute as to the figures, this would fall to be determined by an expert chartered accountant pursuant to clause 10.4 of the Agreement.

In summary, Heathrow contends that in order to calculate the additional costs of the new works there must be two sides to the equation. The first side is the actual costs to Thames Water of running the new works. That is easy to calculate because actual costs incurred can be readily ascertained on a yearly basis during the life of the agreement. (I believe that the point on the calculation is common ground.) The second side of the equation is the putative costs of running the old works. It is this figure which is subtracted from the actual costs that brings about the calculation of the additional costs. Heathrow submits that Thames Water’s construction of the agreement has the effect of ensuring that clause 7.3.2 does not actually bring about the payment of the additional costs because as environmental standards get more stringent, the actual running costs of a sludge plant will increase by more than simple inflation. To give effect to the two sides of the equation, Heathrow contends that a distinction is to be drawn between “basis of operation” and “mode of operation”. According to Heathrow, whilst the expert is to determine the hypothetical basis of operation of the Perry Oaks site over the relevant period (1989-2040) on a “one-off” basis, the expert may leave open, for subsequent review and determination or re-determination, the hypothetical mode of operation of the Perry Oaks site to take account of future events, such as changes in legislation or regulation. The outcome would be a set of bases which would enable the parties to ascertain the putative costs pursuant to later annual agreement.

Both parties seek declarations. Thames Water seeks declaratory relief in its Amended Particulars of Claim as follows:

“A declaration that an expert appointed pursuant to Clause 7.3.2.1 of the Agreement is to make a single determination of the matter referred to him or her, and does not have jurisdiction to review that determination on an annual or other periodic basis, or at all. For the avoidance of doubt, the matter to be referred to and determined by the expert shall be the bases referred to in sub-paragraphs (a) and (b) of Clause 7.3.2.1 of the Agreement, which bases shall include the hypothetical mode of operation of the sewage treatment works for the Perry Oaks site as from 1989 until 2040 on the assumptions set out in sub-paragraph (a) of Clause 7.3.2.1.”

Heathrow seeks declarations that:

On these contentions, the parties agreed to the formulation of an issue for trial in the following terms: “There is one essential issue in this case, which is a point of construction arising from Clause 7.3.2.1 of the agreement between the parties dated 16 February 1993 (as amended). The issue may be framed as follows:

The approach to construction is not in dispute between the parties. I summarise it so that it can be seen how the court has approached the question. In construing a contractual provision, the object of the court is to give effect to what the contracting parties intended. To ascertain the intention of the parties the court reads the terms of the contract as a whole, giving the words used their natural and ordinary meaning in the context of the agreement, the parties’ relationship and all the relevant facts surrounding the transaction so far as known to the parties. To ascertain the parties’ intentions the court does not of course inquire into the parties’ subjective states of mind but makes an objective judgment based on the materials already identified (Bank of Credit and Commerce International SA v Ali [2002] 1 AC 251, Lord Bingham, at [8]). The law excludes from the admissible background the previous negotiations of the parties and their declarations of subjective intent (Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] 1 WLR 896 at 913, Lord Hoffmann).

Some aspects of the operation of clause 7.3.2 are not in dispute. The following analysis in Thames Water’s submissions is not as I understand it challenged, and in any case appears from the wording of the clause.

The core of Heathrow’s submission is that if, as has happened and is expected to happen, sludge standards get more stringent, the actual running costs of a sludge plant will increase by more than simple inflation. Those costs it is said will increase by costs of purchasing, leasing or running the additional plant and machinery which has to be brought into use in order to comply with the new standards. The actual costs of running the Scheme plant will necessarily take those costs into account. So, to take Heathrow’s example, if in 2015 sludge plants need a new pasteuriser in order to comply with modern standards in the processing and disposal of sludge, then the costs of running the Scheme will increase by the costs of lease and running the new pasteuriser. If the new pasteuriser costs £5m annually to run, then under the Thames Water construction of the contract, £5m is taken into account as part of the actual costs of running the Scheme plant—but it is not included in the hypothetical or putative costs of running Perry Oaks because an expert determination would require it to be ignored if it was not specifically foreseen at the time of the expert determination. It is said that Thames Water will thereby receive an annual windfall of £5m. That, it is submitted, cannot be a sensible construction. It does not accord with the stated intention of clause 7.3.2 and it requires an interpretation of the term “bases” to mean costs.

Heathrow accepts that the expert is to make a single determination. The question, it says, is what that single determination is. It contends for a set of bases which would enable the parties to ascertain the putative costs pursuant to later annual agreement. There are a number of bases, it submits, which could be considered. One might be that improvements in standards which are either required of or adopted in the Scheme plant shall be assumed to be used in the putative plant had it been retained. If the expert is to provide for how matters which are unknown but in the future (like the effect of new technology or new standards or regulations), then there can be future agreement between the parties as to what the putative costs should be.

Thames Water submits that what the expert is required to determine is how a sewage treatment works for the site at Perry Oaks would have been operated from 1989 to 2040 on the assumption that the Agreement and the interim arrangement had not been entered into. The expert will, therefore, it submits, need to determine the hypothetical basis, mode or manner of operation—what equipment would have been needed, how many employees would be needed etc. It supports its view of the role of the expert by reference to the knowledge and experience which he or she is required to have—which is to include knowledge and experience of “a process which is the same or similar to that now adopted at the Site”. The reason (it says) why the parties required that the expert should have such knowledge and experience must have been because the expert would be required to determine the hypothetical basis or mode of operation of the Site during the relevant period. Once the bases of operation (or hypothetical operation) of, respectively, the works comprised in the Scheme and the sewage treatment works for the site at Perry Oaks, have been agreed between the parties, or determined by the expert, the additional costs payable by Heathrow may then be calculated, as an accounting matter. In the event of a dispute as to the figures, this would fall to be determined by an expert chartered accountant pursuant to Clause 10.4.

In oral argument, Mr McCaughran QC for Thames Water confirmed what is not entirely clear from its written submissions, namely that its position is that the Agreement does not admit of any adjustment to be made for future increased environmental costs in respect of the hypothetical running of the Perry Oaks site. Its position is that the question of the treatment of such costs is one for the expert.

There is at first sight considerable force in Heathrow’s case, which has been attractively and moderately presented. In a sentence, Mr Wilmot-Smith QC submits that to arrive at a true figure for “additional costs” it is necessary to apply to the hypothetical Perry Oaks operation current environmental standards as they apply to the Scheme from time to time. Otherwise, he says, like is not being compared to like. However as against that, it is to be noted there are matters from the factual matrix that Thames Water is entitled to rely on and which tend the other way. It submits that the sale of the Perry Oaks site to Heathrow occurred in order to accommodate Heathrow’s wish to build a new terminal, and that the provisions of the Agreement relating to additional costs are part of the price which Heathrow was prepared to pay in order to induce Thames Water to sell the site. It was quite content with the site. Although Mr Wilmot-Smith took issue with Mr McCaughran’s description of the monetary sum of £3 million payable in respect of the sale as “nominal”, to put this figure into perspective, the sale encompassed 250 acres of land immediately adjacent to the airport—the land was clearly of immense value to Heathrow. As a commercial matter, what compensated Thames Water for the deal was reimbursement for the cost of building new plant to replace Perry Oaks, together with the additional cost of running it over an extended period of time. Mr McCaughran also drew attention to the fact that the Perry Oaks operation was inherently low tech because of the extent of land available for lagooning, whereas the new arrangements were always going to require a more technological approach to make up for the smaller sites. So it is not in fact, he suggests, as simple as comparing like with like.

Mr Wilmot-Smith QC warned against “allowing the tail of machinery to wag the dog of purpose”. On the other hand, the order of 11 November 2008 is that the trial shall be of the issue identified in the parties’ agreed List of Issues. I have set this out above. The issue identified is essentially one of machinery. It recites the common ground between the parties that the matter to be determined by the expert is the bases set out in sub-paragraphs (a) and (b) of Clause 7.3.2.1. It further recited the common ground that the expert is to make a final, once and for all, determination. As regards the putative Perry Oaks operation, the question is whether Heathrow is correct to say that “his determination may provide for the detailed manner or mode of operation of the Site (in accordance with the bases of operation he determines) to be agreed or determined on an annual or other periodic basis to take account of future events, such as changes in regulation or legislation”. I agree with Mr McCaughran QC that the distinction which Heathrow seeks to draw between basis of operation and mode of operation is the central plank supporting its case. Indeed this was not disputed, Heathrow asserting in its argument that the materiality of the distinction is illustrated by the example of the new pasteuriser that I have described above.

The effect of clause 7.3.2.1 is that “in order to calculate the amount of such additional costs to be paid” by Heathrow, the expert may be required to determine the basis “upon which … the sewage treatment works for the Site would have been operated as from 1989 until 2040 on the assumption that this Agreement … had not been entered into”. In agreement with Thames Water, I can see no ground in this or any other of the clause 7.3.2 wording to distinguish between the hypothetical basis of operation of the Perry Oaks site during the relevant period and the hypothetical mode of operation during the same period. The distinction is absent from the contractual language of clause 7.3.2, and finds no support elsewhere in the contract. I further agree that in practice, such a distinction is likely to be an illusory one.

Thames Water makes further points which I think support its case on construction. First, it says that although Heathrow accepts that the expert’s determination is to be a final, once and for all, determination, the effect of its arguments is that matters may be left open for subsequent review, determination or re-determination. I agree that in practical terms, this undermines the finality of the expert determination.

Second, it says that if matters are to be left over for subsequent determination, by what mechanism would such determination take place? Here it is relevant to consider clause 10 of the Agreement which contains provisions concerning disputes. By clause 10.2, a dispute as to the “rights and liabilities of any of the parties or to the terms and conditions to be embodied in any deed or document appertaining” to the Agreement is be referred to a solicitor agreed upon by the parties, or in default of agreement by the President of the Law Society. By clause 10.3, a dispute relating to “demolition, building or construction works, the content of the Scheme or the value of any interest in property” is to be referred to an expert of a specialisation and identity agreed upon by the parties and, in default of agreement, to be appointed by the President of the Chartered Institute of Arbitrators. By clause 10.4, a dispute relating to “methods of accounting or otherwise to matters usually and properly within the knowledge of a chartered accountant” is to be referred to a chartered accountant, who in default of agreement is to be appointed by the President of the Institute of Chartered Accountants.

As Thames Water submit, correctly in my view, if it had been intended that the impact of changes in legislation and the like on the hypothetical bases of operating the site at Perry Oaks was to be left open for periodic review, the expert best qualified to determine such an issue would be the expert appointed under clause 7.3.2.1. This person is someone “with knowledge and experience of the sewage disposal industry and of a process which is the same or similar to that to be adopted by the Scheme and of a process which is the same or similar to that now adopted at the [Perry Oaks] Site”. The clause provides that “such expert shall be appointed (in the absence of agreement) on the application of [Heathrow] or [Thames Water] by … the President for the time being of the Institute of Water Engineers”. None of the dispute resolution provisions of clause 10 is particularly apt to provide a substitute for such a person. However, it is accepted by Heathrow that the appointed expert must make a “final, once and for all determination” and that, as Thames Water submits, means that the expert would have no jurisdiction to determine further matters periodically (even if the prospective time span made that practical). It did not appear to me that Heathrow had any very convincing answer to this point, merely submitting that it cannot be right for a rush to finality to defeat the purpose of clause 7.3.2 by causing some future events to be left out account altogether. I accept therefore that the fact that the contract provides no mechanism to resolve future disputes of the kind contemplated by Heathrow supports Thames Water’s case that it was never intended that such disputes be left open in the first place.

In the result, I consider that Thames Water’s construction of the contract is the correct one. As Mr McCaughran QC submitted, once the bases are determined by the independent expert, the parties can agree the resultant costs, with reference to a chartered accountant under clause 10.4 in the event of dispute. Mr Wilmot-Smith QC suggested in oral argument that the expert determination may provide for the basis of operation to take account of future events. For present purposes, and in view of the formulation of the issues in the list of issues, I comment only that it is ultimately a matter for the expert to decide on the right approach. Whatever approach is adopted, there will in any event be a final, once and for all, determination. I would add that I consider this to be a commercially reasonable outcome, minimising the possibility of continuing disputes between the parties over the course of the thirty year life span of this contract.

I am most grateful to both parties for their assistance, and will hear them as to any further matters arising.