Owning and buying privatised network utilities in the UK raises regulatory issues, yet there continues to be interest in investing in them. On 31 May 2012, the UK Competition Commission (“CC”) approved the acquisition by South Staffordshire plc, the holding company of South Staffordshire Water PLC (“South Staffordshire”), of Cambridge PLC (“Cambridge”). This is the first time that the CC has given its unconditional approval (without commitments or remedies) under the water special merger regime currently applied to water mergers in England and Wales. While the regulatory regimes for the energy and water sectors are similar, the water sector has some specific features. Historically, consolidation in the water industry has been challenging and mergers between the larger water companies have been prohibited or subject to conditions.
Regulatory framework for merger review of network utilities in England and Wales
Before reviewing the implications of the CC’s decision, it is useful to set in context the regulatory regime that governs utilities mergers in England and Wales.
EU merger control
All mergers, acquisitions, or the creation or change in control of a full-function joint venture meeting certain turnover thresholds must be notified to the European Commission for approval before their implementation under the EU Merger Regulation (139/2004/EC) (“EUMR”). The EUMR is designed to catch large scale transactions affecting the EU. Where a transaction is subject to notification and approval under the EUMR, this generally confers on the European Commission exclusive jurisdiction to review the competition aspects of the transaction within the 27 Member States of the EU.
Merger States may take appropriate measures to protect (non-competition-related) “legitimate interests,” even where the EUMR applies. The European Commission has recognised the UK’s legitimate interest in applying the special water regime as described below.
Even where a transaction is subject to the EUMR, the UK regulators may make amendments to the licences of the network utilities, subject to any licence modification process under the relevant legislation which itself allows appeals to the CC, provided that such modifications are necessary for regulatory considerations rather than competition law considerations.
UK merger control
Where the EUMR does not apply, mergers may be subject to national merger control in the individual relevant Member States. The UK currently has a voluntary merger control system in that there is no obligation to notify the UK competition authorities of a proposed or completed transaction, although in order to obtain legal certainty companies typically seek advance clearance for transactions raising competition issues. UK merger control applies where either: (a) the UK turnover of the enterprise being acquired exceeds £70 million; or (b) as a result of the merger a share of 25 per cent or more in the supply or consumption of goods or services in the UK, or a substantial part of the UK, is created or enhanced. This ‘general’ merger control regime applies across sectors including the utilities sector. The substantive test for assessment of a merger under the UK general merger control regime is competition-based (i.e., whether the merger gives rise or is likely to give rise to a substantial lessening of competition in the UK or a substantial part of the UK).
Water special merger regime
Mergers involving two or more water companies in England and Wales are subject to a special regime that was revised in 2004. The Office of Fair Trading (OFT) is under a duty to make a mandatory reference to the CC of anticipated or completed mergers between two water enterprises (water and water and sewerage companies appointed by the Water Services Regulation Authority (“Ofwat”)), unless:
the value of the turnover of the water enterprise being taken over does not exceed £10 million; or
the only water enterprises already owned by the acquirer each have turnover that does not exceed £10 million.
If these thresholds are exceeded, then the OFT must make a reference to the CC regardless of any competition issues. Owing to the low turnover tests, the practical effect of this regime is to require a reference to the CC in the case of an acquisition of any of the water or water and sewerage companies in England and Wales by a company that already has an interest in another such company in England and Wales. It is expected, however, that a lighter touch approach to water mergers may be adopted in the coming years following changes that have been proposed to the current water special merger regime (see “Regulatory context and future developments” below).
The sector regulators (Ofwat in the water sector and Office of Gas and Electricity Markets (“Ofgem”) in the electricity and gas sector) will consider a transaction within their remit and assess whether it raises regulatory issues, particularly where the merger reduces an ability to regulate the sector due to the reduction in the number of comparator companies for the setting of price controls and incentivising performance and efficiency. However, comparative competition in the regulation of the energy (electricity or gas) networks is not given the same statutory force as mergers under the water regime. While comparator considerations may be relevant to the setting of price controls, the question of whether energy mergers are approved under UK merger control is a competition based-assessment.
By contrast, in the water sector following a mandatory reference to the CC under the special water regime, the CC must consider whether:
a water merger has taken place or there are arrangements in progress that, if carried into effect, would result in a water merger; and
the water merger has or may be expected to prejudice the ability of Ofwat to carry out its functions under the Water Industry Act to make comparisons between different water enterprises.
If the CC finds that there is an adverse outcome in terms of the ability of Ofwat to make comparisons, then the CC must determine what action it should take to remedy this adverse outcome or whether it should recommend Ofwat to take remedial action.
South Staffordshire/Cambridge Water
South Staffordshire supplies drinking water to 514,433 homes and 29,418 business customers in an area of 1,490 square km. Cambridge supplies drinking water to 117,677 homes and 9,796 business customers in an area of 1,173 square km in the city of Cambridge. The two operators are non-contiguous. The transaction was a mandatory water merger reference on the basis that the turnover of both companies exceeds £10 million. On 5 January 2012, the OFT made a mandatory reference to the CC.
Following its review, the CC concluded that overall, the merger may not be expected to prejudice the ability of Ofwat in carrying out its regulatory functions to make comparisons between different water enterprises. A number of aspects of the CC’s decision are worth comment:
Assessment of merger: The CC assumed that the licences of South Staffordshire and Cambridge would be merged. Consequently, the companies would produce one business plan and be subject to one price control across their two operational areas in the future. The CC carried out some sensitivity analysis to reflect the potential merger of the licences of the water company Veolia. Taking account of pending Ofwat reforms and government proposals for reform of the water industry, the CC decided that an appropriate time framework against which to assess the impact of the merger was the period to 2020.
Impact on comparators: The CC’s analysis showed that the merger would be likely to have two opposing effects on Ofwat’s models of opex efficiency. First, it could be expected to result in a loss of precision as a result of the reduced number of observations available to Ofwat. Second, the merged group would be likely to have a greater probability of becoming a benchmark with other small companies. The CC considered that this effect could potentially have a positive effect by leading to stricter targets for other companies. The CC noted that, to the extent that Ofwat will rely less on econometric methods going forward, any detriment associated with the merger would be reduced. The CC also found that the merger may have only a small adverse impact on the precision of Ofwat’s cost-base assessment, which could be offset by the potential benefits of the merger in assisting Ofwat to set capex efficiency targets. The CC also noted that South Staffordshire’s management had achieved high Asset Management Assessment at the last price review.
Impact of the merger on Ofwat’s ability to incentivise service quality. Across all measures of service quality, the evidence suggested that on average both companies perform better than the industry. The CC considered it likely that what it described as Cambridge’s “distinctive” approach would be lost as a result of the merger. The CC therefore found that the loss of Cambridge could be expected to have a detrimental effect on Ofwat’s use of league tables to incentivise service quality.
Impact of the merger on Ofwat’s ability to use comparisons to promote best practice. The CC found that Ofwat’s role in spreading best practice and innovation was relatively narrow. It concluded that the impact of the merger on Ofwat’s ability to identify and spread best practice and innovation would not be significant.
The CC noted that the arguments in this case are finely balanced and some issues were difficult to assess. However, it did not find that the overall impact of the merger on Ofwat’s use of comparators could be expected to be sufficiently adverse to amount to prejudice. As the two operations are non-contiguous, the CC considered that despite the common ownership, a degree of managerial and operational independence would continue. It also attached some weight to the fact that post-merger there would still remain 18 independently-managed water companies, including some that would be as likely as Cambridge to present an alternative small company perspective. The CC noted, however, that the merged entity will be able to achieve efficiency savings if it is allowed to operate under a single licence.
Regulatory context and future developments
This is the second water merger considered by the CC under the current water special merger regime. On 1 May 2007, the CC published its final report on the acquisition of Macquarie Luxembourg Sarl, the owner of South East Water Limited, by Hastings Diversified Utilities Fund and Utilities Trust of Australia, the joint owners of Mid Kent Water Limited. As distinct from the South Staffordshire/Cambridge case, the CC concluded that the merger may be expected to prejudice, albeit to a limited extent, the ability of Ofwat to make comparisons between water enterprises. It concluded that both water companies would be required to make a one-off price reduction to their customers totalling £4 million and that, in the next price control review, Ofwat should take into account the annual savings in opex expected to result from the merger.
Regulation of the water sector is subject to ongoing and significant change. This unconditional clearance may contribute to the agenda for future developments. The Water Bill represents a major reform of the regulatory regime, that could facilitate further consolidation in the sector. On 17 May 2012, the Department for Environment, Food and Rural Affairs (“Defra”) issued a call for evidence on the proposed reform. In it, Defra sought views and evidence on proposals to increase the threshold at which mergers are automatically referred by the OFT to the CC from the current level of £10 million. Defra expressed particular interest in opinions concerning (a) whether the water special merger regime remains relevant; (b) whether the turnover threshold should be increased to £70 million (as under the ‘general’ UK merger control regime); (c) whether there are alternatives to setting a turnover or other threshold; and (d) the likely benefits and costs of increasing the threshold. The response period closed on 28 June 2012.
Developments on the new legislation should be closely monitored by water companies, investors, financiers, and other interested parties seeking to enter and expand in the water sector.
A version of this article was published in Water Briefing.