Recently Ofwat issued a consultation on its approach to future mergers in the water industry and on its draft statement of methods for assessing mergers, consistent with its new obligations following the Water Act 2014.Read on for an overview of the consultation and likley effect of the new regime.
The current special merger regime
Currently if two water companies, one of which has a turnover over £10 million, want to merge, the merger is automatically referred to a phase 2 Competition and Markets Authority (CMA) investigation, which takes around 6 months and is costly. This 'special merger regime' has been said to put the industry off mergers in the past. Since privatisation, there have been ten water merger references, of which three were prohibited. The latest one, the eleventh, is Pennon Group (South West Water's owner)'s acquisition of Bournemouth Water, which was referred for a mandatory phase 2 investigation on 8 June 2015.
The special merger regime is needed because the water industry is largely made up of a series of regional monopolies. In the absence of direct competition between companies, Ofwat regulates companies closely, to drive companies to achieve the best outcome for consumers. But to do this effectively, Ofwat uses comparators to benchmark companies against each other, identify what an efficient company can achieve and drive others to meet best practice. If two companies merge, then some key comparators may be lost, hence the need to check that Ofwat's ability to do its job is not prejudiced.
The new merger regime under the Water Act 2014
The Water Act 2014 is intended to make mergers easier, when it comes fully into force. Mergers will not automatically be referred for a full phase 2 investigation. Instead there will be an assessment by the CMA at phase 1 first. This assessment will be informed by advice from Ofwat as to whether:
- the merger is likely to prejudice Ofwat's ability to make comparisons between water enterprises; and if so
- the prejudice is outweighed by relevant customer benefits (which would not have happened without the merger)
- any undertakings in lieu (UILs) from the companies in question remedy, mitigate or prevent the prejudicial effect on Ofwat's ability to make comparisons
If the CMA, taking into account Ofwat's opinion, decides that there are no issues, or that any issues can be satisfactorily resolved, a phase 2 reference can be avoided.
Ofwat's draft statement of methods for assessing mergers
In anticipation of the new regime and as required by the Water Act 2014, Ofwat has produced a consultation draft of its statement of methods that sets out the criteria Ofwat uses to assess the impact of a proposed merger on its ability to make comparisons and the weighting applied to those criteria. It is also consulting generally on its proposed approach to mergers under the new Water Act 2014 regime. The consultation is open until 10 July 2015 and Ofwat will publish its final approach to mergers and statement of methods in September 2015.
From the draft, Ofwat is indicating that any merger between water companies has the potential to prejudice Ofwat's ability to make comparisons, although this is unlikely where the scope of services offered by the two water companies does not overlap. Consequently, the bar for finding potential prejudice may be relatively low. By contrast, experience from recent healthcare mergers in particular shows that the bar for demonstrating relevant customer benefits which are merger specific is high and difficult to meet. This is prefigured in Ofwat's consultation which states that it will require compelling evidence on customer benefits to recommend that these outweigh prejudice to its ability to make comparisons and will be mindful of the likelihood that such benefits may be short lived. Similarly, experience from the general merger regime suggests that undertakings at phase 1 need to be relatively simple and clear cut – although interestingly, the Ofwat consultation suggests that behavioural undertakings, such as maintaining separate administration, management or accounting regimes, could in principle be an acceptable undertaking to remedy potential prejudice.
Likely effect of the new regime
Defra's Water for Life White Paper, which formed the policy basis for the Water Act 2014, stated that mergers can be a strong driver for improving the efficiency of companies, leading to improved service and lower costs that can be passed on to customers, and the current regime reduced the likelihood of potential mergers between water companies and the scope for them to be taken over by more efficient operators and any resulting benefits. More recently, Ofwat has indicated that it would willingly and open-mindedly review consolidation in the industry.
However, a careful review of Ofwat's consultation suggest that full mergers between water and sewerage undertakings will still require a phase 2 review. The reforms are likely to be more beneficial at the fringes, to take an example from the consultation, where a water only company acquires sewerage interests, so there is no overlap in services and therefore no likely prejudice to Ofwat's ability to make comparisons. In any event, the invitation to engage early and resolve issues in informal consultation with Ofwat is welcome and constructive.
We are likely to see some of the principles set out in Ofwat's consultation in action in the near future, as the CMA reviews the Pennon/Bournemouth Sembcorp transaction.
It is worth emphasising (as the consultation observes) that there are transactions in the sector which will fall outside the special merger regime altogether – between water licensees, or water licensees and water companies. As the industry adjusts to retail market reform over the next few years, it may well be that consolidation of one form or another takes place in that arena, to be assessed under the general merger regime as appropriate.