Take a punt?

The Competition Commission's unconditional clearance of the South Staffs/Cambridge Water merger should give water investors confidence to consider consolidating acquisitions, say David Aitman, James Aitken and Satyen Dhana.

Since privatisation, the water industry in England and Wales has been synonymous with strongly performing companies, backed by consistent regulation. This has made it an attractive industry for investment. Continued merger and acquisition (M&A) activity in the water sector is in stark contrast to the cautious M&A landscape in other sectors – a recent example being CKI’s acquisition of Northumbrian Water in 2011.

However, true consolidation in the industry – water companies buying other water companies – has been very limited. There have been only two such transactions since 2000. This is due, in large part, to a restrictive water merger regime that requires all non-trivial transactions to be referred, automatically, to the Competition Commission for a six-month inquiry.

However, reform is afoot (see box). And against the background of reform, the Competition Commission has just cleared South Staffordshire plc’s acquisition of Cambridge Water unconditionally. This is the first time a water-water merger has been cleared without “remedies” such as divestments or customer payments.

The deal is the first water-water merger in five years. The two companies are relatively small water-only companies with non-contiguous supply areas. The most recent previous water merger, Mid-Kent Water and South East Water in 2007, also involved water-only companies, but in neighbouring areas.

The Cambridge transaction was automatically referred to the Competition Commission under the current rules (although interestingly it would not have been automatically referred if the current reform proposals had already passed into law). A key issue for the commission is whether a merger might risk the loss of high-performing companies, which Ofwat can use to inform industry comparisons. In particular, if either of the merging companies might have the potential to be used as industry “benchmarks” in the future, the “price” – in terms of conditions – for any clearance could be significant.

In the 2007 Mid Kent/South East case, the Competition Commission decided that neither company was likely to provide a useful benchmark in any realistic timeframe. It nonetheless required, as a condition for approval, that the merged group immediately cut its prices and that adjustments should be made to future price limit calculations.

Against that background, it might have appeared that the South Staffordshire/Cambridge deal faced a high regulatory hurdle. Both companies are regarded as high performers, with South Staffordshire, in particular, consistently ranked in Band A in Ofwat’s efficiency rankings. But in the event, the commission decided “on balance” to clear the merger without conditions.

While any future merger will be fact-specific, water firms and investors are likely to be asking themselves what can be gleaned from this decision for potential future deals. There appear to be three key lessons.

· Regardless of the size of any deal, the Competition Commission will scrutinise all water mergers. It has a long list of areas where potential detriment may arise, and will focus particularly on whether the merger will damage Ofwat’s ability to use its comparative, econometric, models at future price controls.

· Evidence will be crucial. South Staffordshire was able to produce, at an early stage, important economic and qualitative analysis that demonstrated potential benefits (rather than detriments) to Ofwat’s regulation directly arising from the merger. This analysis was scrutinised closely by the commission and was largely accepted. This evidence – its early availability and its robustness – was vital to the companies winning clearance.

· Notwithstanding the conclusions of the Cave Review, Ofwat is likely to remain sceptical of mergers and to advocate that remedies be imposed in each case. In South Staffordshire’s case, Ofwat maintained its traditional approach that all water mergers create a detriment to its regime, which requires a remedy. Showing corresponding benefits is therefore vital. Perhaps surprisingly, Ofwat told the Competition Commission that potential adverse effects on its “qualitative comparisons” will be even more significant under its new Future Price Limits approach than in the past and the commission accepted this.

So, are the merger reform proposals and the Competition Commission’s latest decision the first indicators of a shift in favour of consolidation in the water industry? The sector is currently going through an important period of regulatory change generally and there is a clear indication from the government that the current merger regime may need reform to allow more consolidation. A draft Water Bill is expected before Parliament’s summer recess.

It is too soon to predict definitively the impact of these developments, including how any new procedures will be operated by the Competition and Markets Authority when it is established. But the decision in South Staffordshire Water/Cambridge Water shows that an unconditional clearance is a real possibility in some cases, even under the current rules. For the first time since privatisation, water companies and investors alike may be able to realistically consider potential consolidating acquisitions, and the resulting efficiency savings that these may create.

David Aitman and James Aitken are partners and Satyen Dhana a senior associate at Freshfields Bruckhaus Deringer, which acted for South Staffordshire in its acquisition of Cambridge Water. Luis Correia, Alan Horncastle and Giordano Colarullo from Oxera acted as expert economic advisers to South Staffordshire Water

Reform in the making

The Cave Review in 2009 recognised that the current water merger regime inhibits consolidation and the efficiencies that could be expected to result. It therefore called for significant reform, including setting a threshold for automatic Competition Commission referral to cover only water companies with turnover above £70 million.

In response, the Department for Environment, Food and Rural Affairs is currently consulting on a “call for evidence” on proposals to reform the rules, which closes next week (28 June 2012). A key proposal on which the government is seeking views would abolish the current mandatory reference of water mergers to the Competition Commission for transactions above a certain size (whether the £70 million threshold is appropriate is also being consulted on). Transactions below the threshold would still be subject to an initial screening review (currently by the Office of Fair Trading, but would be replaced by the new Competition and Markets Authority under separate proposals to reform competition regimes).

If taken forward, future water mergers may be able to avoid any Competition Commission reference, possibly by offering so-called “undertakings in lieu” at a preliminary stage. This could greatly simplify the timing and process for future transactions.

This article first appeared in Utility Week’s print edition of 22 June 2012.

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