Merger and other competition law wrangles will increase under water’s new regulatory framework. Sam Williams says water firms need to set a firm course on how much risk they are willing to swallow for commercial advantage
The substantial regulatory reform currently being implemented in water has important implications for the nature of competition law issues that are likely to arise in future. In particular, there will be increased incentives for merger activity, while the introduction of separate retail and wholesale price controls (if coupled with the emergence of competition in the contestable retail market) are likely to give rise to a number of vertical related issues.
In terms of mergers, the industry is currently subject to a special regime which requires that if the acquiring or acquired party has a turnover of more than £10 million a year, there is an automatic referral to the Competition Commission. The government has said this “disincentivises mergers and reduces the scope for water companies to be taken over by more efficient competitors or gain from efficiencies of scale”.
Consequently, Clause 12 of the draft Water Bill allows the Office of Fair Trading (OFT) to choose not to refer a merger in circumstances where: the merger is unlikely to proceed; it is not likely to prejudice Ofwat’s ability to regulate; or although Ofwat’s ability to regulate may be prejudiced, the benefits to customers (such as lower prices or improved services) outweigh the costs. Clause 12 further allows the OFT to accept undertakings in lieu of a referral to the Competition Commission from the merging parties. These would be designed to mitigate the impact on Ofwat’s ability to regulate – for example, undertakings such as continuing with separate price limits, or committing to divestments.
Clause 13 addresses the annual turnover threshold for referrals. It places a new duty on the OFT to keep the threshold under review and to advise the secretary of state as to what the appropriate level should be. In this context, it should be noted the Water White Paper mooted a threshold of £70 million, which if implemented could allow a number of small and medium-sized water-only companies to merge without mandated referral.
Irrespective of whether the threshold is increased, the changes set out in the Bill collectively serve to increase the prospects of mergers in the sector, particularly given that reliance on comparative benchmarking is likely to decline under Ofwat’s future regulatory model. However, as set out in Ofwat’s evidence to the Competition Commission regarding the Cambridge Water/South Staffordshire acquisition, the regulator is likely to remain concerned about mergers involving the larger water and sewerage companies.
From an economics perspective, the liberalisation of the contestable retail market (in which only transitory regulatory safeguards will be retained) could also affect merger incentives. In particular, if there is entry by other large utility retail service providers (say from the energy sector) there may be increased pressure for incumbent water and sewerage suppliers to realise economies of scale in their retail businesses. This would be consistent with the experience of the energy market, where there has been significant consolidation at the retail level post-liberalisation.
However, under the draft Water Bill incumbents are not able to divest themselves of their retail businesses in their own supply area (and must establish separate limited companies to apply for licences to compete in other areas). Given this, retail competition could create additional commercial incentives for full scale mergers between incumbent companies, because that would be one way of accessing retail scale economies (although merger incentives are likely to be largely wholesale driven, given the importance of capital programmes and the associated financing costs to the integrated suppliers). From a regulator’s perspective, this raises a conundrum: to fully realise the benefits of retail competition, fewer wholesalers might be required.
In addition to an increased prospect of mergers, regulatory reform will likely bring an increase in the number and scope of vertical related competition issues for Ofwat and the competition authorities to consider.
With regard to pricing in the contestable retail market, concerns regarding “excessiveness” are unlikely, given that Ofwat intends to deploy default tariffs to act as a form of transitional safeguard. However, a more active retail market may bring with it risks of predatory margin-squeezing by incumbents (unduly lowering their retail prices relative to wholesale prices and retail costs), to resist competitive pressures from rival firms. This raises a number of well-trodden, but nonetheless important, conceptual and practical questions.
For example, in considering whether – as is typically the case – it is the incumbent’s costs (under the equally efficient operator test) or the entrant’s that form the relevant benchmark, one might need to consider whether the entrant’s retail costs are more readily identifiable and reliable compared with those of the integrated incumbent supplier, whose retail costs can be identified only through detailed cost allocation analysis, which is inherently subjective. This is particularly relevant, given that Ofwat’s July consultation on retail controls acknowledged the existing uncertainties regarding cost allocations. One might also consider the extent to which the incumbent’s retail costs are themselves a legacy of its historic dominant position in retail and wholesale markets and reflect previous decisions regarding whether to adopt wholesale or retail-led commercial strategies.
In addition to matters relating to pricing, Ofwat will be keen to ensure the wider “terms and conditions” of access to wholesale services are non-discriminatory. Here a key issue is likely to be the extent to which Ofwat focuses on specific practices and terms, rather than the likely effects of practices on competition in the round. On a matter of practicality, there is also the question as to which institution is likely to be responsible for Competition Act investigations. The draft Water Bill leaves open the possibility that Ofwat might have discretion to choose what casework it takes on.
The above issues are not only pertinent to the regulator, they are of great importance to the companies themselves as they seek to develop new commercial strategies in a changed regulatory landscape. There will be far greater scope for companies to determine for themselves the extent of regulatory risk they consider to be appropriate (given the inherent uncertainties in competition law). While there may be no right or wrong answer, a strong regulatory strategy will be one that takes explicit account of risk and balances this against the potential benefits of more aggressive commercial approaches.
Sam Williams is a director of economics consultancy Economic Insight
This article first appeared in Utility Week’s print edition of 19th October 2012.
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