1. Business retail reform

1.1 Work continues apace on preparations for market opening in April 2017.  Recent Ofwat publications on the topic include –

1.1.1 a consultation (now closed) on protection of non-household customers through the use of deemed contracts;

1.1.2 a consultation (now closed) on proposals for the introduction of interim supply arrangements where a water or sewerage supply licensee ceases to supply its customers;

1.1.3 a consultation (now closed) on reviewing the non-household retail price controls introduced for AMP6 in readiness for market opening;

1.1.4 a consultation (now closed) on the proposed introduction of a customer protection code of practice, which will include a requirement that relevant information is readily available in a standard format to non-household customers, to properly inform a decision to switch supplier;

1.1.5 a consultation (closing date 5 February 2016) on licence modifications, specifically proposals to remove the in-area trading ban and to introduce a new condition on market readiness.  Ofwat intends to remove the in-area trading ban in April 2016 - this will enable retailers to offer national water contracts to large users ahead of market opening (currently only Business Stream can do so).  To reinforce existing safeguards against unfair conduct, Ofwat will require companies to update their Condition R compliance codes.  The new market readiness condition will be couched in general terms, to avoid any need to modify it.  It will require companies to prepare data, develop and test systems and processes, and develop market assurance and readiness plans.  The condition will cease to have effect on market opening.

2. Household retail reform

2.1 In November 2015 HM Treasury published “A better deal: boosting competition to bring down bills for families and firms”.  The paper refers to numerous sectors and areas of customer service including access to broadband, ability to unlock mobile phones, pricing for dentistry, sales of school uniforms, and retail competition for household water customers.

2.2 The paper makes two statements in respect of creating competition for domestic water customers –

2.2.1 Ofwat will provide a cost/benefit analysis by summer 2016 of extending retail competition to household water customers;

2.2.2 government will work with water companies to “begin the transition to retail competition” before the end of the current Parliament (i.e. by no later than May 2020).

2.3 Two aspects of this announcement have caused surprise; firstly the timing, ahead of non-household retail market opening, and secondly that the second limb of the announcement appears to pre-judge the outcome of Ofwat’s CBA.

2.4 Market analysts were quick to state that fluctuations in customer numbers will increase cash flow volatility and therefore perceived risk, unless revenue losses can be off-set by cost savings. 

3. Economic regulation of the water sector

3.1 A report by the National Audit Office in October 2015, “The economic regulation of the water sector”, received widespread media attention.  The coverage focussed on one aspect, namely that during AMP5 water companies benefitted from substantial windfall gains arising from low borowing costs, higher than expected inflation and low taxation. 

3.2 What was not so widely reported were the numerous commendations of the sector and its regulatory regime.  These included, “The regulatory framework has contributed to major improvements in water quality since privatisation”, “Customer bills have stabilised…”, “Ofwat’s approach to price regulation has encouraged companies to improve efficiency, resulting in lower customer bills”. 

3.3 In conclusion the report states that the sector’s price cap regime does not balance risks appropriately between companies and customers and so does not yet achieve the value for money that it should.  This will have reinforced Ofwat’s intention to move away from RPI in favour of the generally lower CPI in future price reviews.

4. Water merger control

4.1 On 13 November 2015, the Competition and Markets Authority (“CMA”) published its final guidance with regard to the special water merger regime, as amended by the Water Act 2014 (the “Guidance”). The Guidance outlines the processes and methodology that the CMA will employ when considering water and sewerage mergers going forward.

4.2 The Water Act 2014 removes the need for most water mergers to be automatically referred for in-depth assessment in a phase 2 investigation, and now allows the CMA the power to clear a merger at phase 1 including, where appropriate, through acceptance of undertakings in lieu of a phase 2 investigation. Ofwat is given a statutory role in phase 1 investigations and is required to provide its opinions to the CMA on the impact of a merger on Ofwat’s ability to make comparisons and on relevant customer benefits that may flow from the merger.

4.3  The Guidance

4.3.1 Although the Guidance remains largely unchanged from the draft provided for consultation in September 2015, there have been some useful clarifications around the process and procedure for the CMA’s consideration of undertakings in lieu of a reference for a phase 2 investigation (“UILs”), and around the approach the CMA may adopt in considering the impact of a merger on Ofwat’s ability to make comparisons between water companies (which is an essential part of Ofwat’s approach to price regulation).

4.3.2 A water merger may give rise to some prejudicial effects on Ofwat’s ability to make comparisons between water companies. However it may be possible for these prejudicial effects to be remedied, mitigated or prevented through undertakings given by the parties. The phase 1 decision is in effect a decision on whether such prejudicial effects can be expected from a merger.

4.3.3 The CMA has redrafted part of the Guidance in an effort to make it clearer to prospective merger parties that they are able to discuss UILs with the CMA’s case team, or offer UILs, at any time during phase 1, and indeed the CMA strongly recommends early discussion where UILs may be appropriate to address any likely prejudicial effects. As is the case under the general merger regime, however, UILs will only be considered formally once a phase 1 decision has been made.

4.3.4 The CMA has also amended the Guidance to give itself more flexibility in relation to its analytical and methodological approach to the statutory question it is asked to address. It has, for example, removed a section of the guidance which could have been read as requiring the CMA to undertake, as part of its analysis, an assessment of the impact of a merger based on a static approach (where account is taken of the regulatory framework used in the previous price control review and the relative performance rankings of the merger parties in that review) as well as an assessment based on a forward looking approach (where account is taken of information relevant to how merger parties may perform in future price determinations). The deletion of this section no doubt follows from the Pennon/Bournemouth water merger[1] in which the CMA placed greater weight on the forward looking approach, on the basis that it is this approach which analyses the impact of the merger on Ofwat’s ability to make comparisons between water companies at future price reviews. The CMA’s approach is covered in detail in Section 4 and states that whilst the Guidance highlights the types of factors that the CMA will consider in its investigation, that does not prevent the CMA from adjusting its approach to take account of any future developments in Ofwat’s regulatory approach and how it uses comparators.

4.4 Statement of intent

4.4.1 The CMA and Ofwat have also published a statement of intent alongside this guidance, which sets out the general principles which will apply to the working arrangements between the CMA and Ofwat.

4.4.2 This statement of intent sets out the role that Ofwat will play in providing an opinion to the CMA on water and sewerage mergers at phase 1. Whilst an opinion given by Ofwat will not be binding on the CMA, the CMA will give it significant weight when making decisions which may impact upon Ofwat’s ability to make comparisons in the water and sewerage market. An opinion by Ofwat will also help the CMA to form decisions with regard to the extent of any potential prejudice and whether this might be outweighed by relevant customer benefits arising from the merger (and, if not, whether any UILs offered by the parties are likely to be effective in remedying, mitigating or preventing that prejudice from arising).

4.4.3 The statement of intent also addresses the forms of cooperation at the various stages of the merger investigation, including the pre-notification period, assessment period and meetings with the merger parties.

4.5 Water Mergers (Miscellaneous Amendments) Regulations 2015

4.5.1 The Water Mergers (Miscellaneous Amendments) Regulations 2015 (the “Regulations”) came into force on 18 December 2015. They apply the current statutory provisions and timescales for assessing general mergers under the Enterprise Act 2002 to all water mergers reviewed by the CMA. Designed to improve the speed, quality and robustness of the CMA’s assessments, the Regulations introduce an initial 40 working day timescale for a decision to be issued at phase 1, followed by five working days for the merging parties to offer UILs, where appropriate, and a total of 10 working days following the decision for the CMA to consider such UILs.

4.6 Comment

4.6.1 The Water Act 2014 amends the special water regime to allow the CMA to decide not to make a phase 2 reference in certain circumstances. This power will be subject to obtaining an opinion from Ofwat on whether the merger will prejudice its ability to make comparisons between water companies, and whether such prejudice is outweighed by the relevant customer benefits (such as lower prices or higher quality goods or services) produced by the merger.

4.6.2 There are no formal time limits on pre-notification discussions and, under the Guidance, parties to a potential merger are strongly encouraged to discuss the proposed transaction with both the CMA and Ofwat at this stage, as it will allow the parties to discuss any UILs that could prevent or mitigate any prejudice to Ofwat’s ability to make comparisons in the market. This is especially important in instances where parties to a potential merger believe that there may be concerns with regard to the impact of the transaction on Ofwat’s ability to fulfil its regulatory functions.