Until now, the UK water sector has been subject to a strict merger control regime, under which all transactions involving mergers between UK water companies (other than those involving a minority stake which was not sufficient to give any control for these purposes) were subject to an automatic in-depth phase II review by the UK competition authorities lasting several months.  The only exception was where the turnover of either the target water business, or the acquirer's water business, did not exceed £10 million – a small mergers threshold which is now too low to be relevant for most water company transactions. 

This contrasts with the position under the general merger control rules whereby only a minority of transactions – those potentially giving rise to a substantial loss of competition – are referred for a full phase II investigation.  It has arguably reduced M&A activity in the sector and acted as an obstacle to industry consolidation.

Furthermore, initiation of the phase II reference to the Competition Commission (replaced as of this April by the Competition and Markets Authority ("CMA")) rested on something of a hair trigger in that it had to be made where "it is or may be the case that … arrangements are in progress which, if carried into effect, will result in a [water] merger", and so parties ran the risk of being tipped into a phase II investigation even at an early stage of deal planning.

Once referred, water mergers are assessed by reference to a test aimed at preserving so-called comparative competition, whereby the water regulator OFWAT's ability to regulate is protected through the maintenance of a sufficient number of independent water companies from which it can derive information in order to make robust performance comparisons and thereby set stringent price caps, efficiency targets and service standards.  The questions asked under this test are whether the merger would prejudice the ability of OFWAT to make comparisons between UK water companies -- and also whether the merger would give rise to (offsetting) relevant customer benefits in the form of lower prices or better service.

The reasons for this special regime go back to the historic position of UK water companies as a series of regional monopolies not subject to market competition and so in need of strong regulation in order to deliver the best service to customers.

Reflecting these constraints, there have been only two water mergers reviewed under the current version of the legal regime that has been in force for the last decade.  In South East Water / Mid Kent Water (2006) there was an adverse finding because of the loss of comparator (a neighbouring company) and the parties were required to give significant price cuts to customers to remedy this.  More recently, in South Staffordshire / Cambridge Water (2012), the merger was allowed, although the authorities stated that the decision was finely balanced.

However, in recent years, as perhaps acknowledged in the slightly more permissive approach in South Staffordshire / Cambridge Water, there has been increasing pressure for legislative reform to relax the special regime for water mergers.  More sophisticated regulation and the gradual introduction of market competition in various areas of the water supply chain have strengthened the case for giving less weight to the maintenance of the current number of independent water companies (several of which are relatively small) for comparator purposes. 

The new rules

Under the new Water Act 2014, published last week, further exceptions to the requirement for a phase II review of water mergers have been introduced in order to allow a lighter-touch approach.  The CMA has the discretion not to initiate a phase II reference where:

  • In the case of prospective mergers, the arrangements are not sufficiently advanced or not sufficiently likely to proceed (this addresses the hair trigger problem of a phase II reference being triggered prematurely at the deal planning stage); or
  • The merger is unlikely to prejudice OFWAT's ability to make comparisons between water companies in order to regulate; or
  • Although the merger is likely to prejudice OFWAT's ability to make comparisons between water companies, that prejudice is outweighed by relevant customer benefits.

For the latter two situations, the CMA must obtain an opinion from OFWAT on those questions and consider it before coming to a decision, and OFWAT is obliged to make its assessment using the approach set out in a published statement of methods, which must indicate the criteria and their relevant weighting which it will apply.  This should improve predictability for potential acquirers and investors about the likelihood of transaction being subject to a phase II review.

Further flexibility in dealing with water mergers is introduced by giving the CMA the ability to accept undertakings as an alternative to a phase II reference (eg a price cut for customers).

In addition, the CMA is required to review and advise the Government from time to time on whether the £10 million turnover threshold should be changed.  The Government has considered but decided against increasing it to £70 million in introducing the new Act, but this provides the possibility for the issue to be revisited in due course in order to make the small mergers exception applicable to a broader group of water companies.

Promoting the introduction of more market competition, the new Water Act also introduces new types of licences for market entrants to wholesale and retail water and sewerage services using incumbent water companies' networks. 

Implications

These reforms, while not a radical change to the special regime for UK water mergers, nevertheless potentially open the way to more M&A activity in the sector by reducing the deterrent of a lengthy and burdensome phase II merger control investigation being triggered in almost all cases.  The changes could increase industry buyer activity, alongside financial investor interest, in water company targets. 

Although essentially procedural, they are also indicative of a trend, taking account of other developments in the industry, which places less weight in preserving the current number of independent comparator companies.

While the assessment of any particular water merger will turn on the identity of the companies involved and the details of the proposal, at a more general level all of this suggests that there will be greater scope to obtain merger control approval of water mergers, particularly those involving the smaller water-only companies where there may be efficiencies giving rise to relevant customer benefits.

With greater separation of activities and competition in a number of areas, there is also the possibility of cross-company restructuring and consolidation at particular levels of the supply chain as an alternative to the acquisition of entire water companies in their current vertically integrated form. 

Reflecting the current climate, it is interesting to note the recent comments of OFWAT's Chief Executive, Cathryn Ross, at the regulator's annual City briefing last month, which touch on these issues: "We also recognise that changes to industry structure may be appropriate. I don’t have an industry blueprint that I’m working to, but I would be surprised if 18 vertically integrated water companies were the most appropriate structure. And I want to say clearly that we are open to conversations about changes to that structure."