Water industry regulator Ofwat has flagged up a possible net detriment to customers in England in the range £10 million to £106 million (present value to 2025) as a result of the merger of Bournemouth Water with South West Water.

The assessment forms part of Ofwat’s conclusions in its initial detailed and lengthy 137 page submission to the Competition and Markets Authority as part of the CMA's investigation into the acquisition by Pennon Group Plc of Bournemouth Water Investments Limited.

The Ofwat submission specifically addresses the questions related to the concept of “enhanced company”, small company premium and efficiencies or benefits associated with the merger. The document sets out the regulator’s assessment of prejudice and benefits that arise from the merger, together with an initial view on possible remedies.

In total, taking account of the monetised, quantitative and qualitative assessments and the level of certainty over the impacts and future regulation, in Ofwat’s view the merger will introduce detriment to its ability to make comparisons between different water enterprises. Ofwat’s overall assessment of plausible net detriment lies in the range £10 million to £106 million (present value to 2025) or £13 million to £119 million on the basis of a 30 year present value.

The regulator said it had not attempted to narrow the range or provide a point estimate due to the different approaches used in the analysis across each of the benchmarks.

Ofwat said the merger would result in the loss of Bournemouth Water as an independent comparator and would have a detrimental impact on its ability to make comparisons in a number of ways:

• Detriment to Ofwat’s SIM benchmark. Bournemouth Water has demonstrated upper quartile performance in the service incentive mechanism (SIM) over the three years 2011-12 to 2013-14. The SIM is the comparative mechanism that is used to measure customer service experience across the sector - the detriment could amount to around £10 million by 2025.
• Detriment to Ofwat’s wholesale cost benchmark - At the 2014 price review (PR14) Bournemouth Water was in the upper quartile of the 18 water companies Ofwat regulates in its benchmarking assessment of wholesale costs - the detriment could amount to £43 million by 2025.
• Detriment to Ofwat’s assessment of outcome delivery incentives – Bournemouth Water demonstrated upper quartile performance against each of the three comparative outcome delivery incentives for the water service that were applied at PR14. Ofwat considers that the loss of Bournemouth Water could result in it setting less stringent benchmarks in these areas - the detriment could amount to between £8 million and £66 million by 2025.
• Loss of precision. OFwat’s assessment of the wholesale cost models used at PR14 indicates that the loss of Bournemouth Water as an independent comparator would have resulted in a reduction in the precision that applies to its wholesale cost econometric models.  No value of detriment to the loss of precision of wholesale cost models is stated in monetary terms  - but the loss of precision to Ofwat’s models is assessed to be in the range 0.21% to 3.8%. The detriment is not linear and would increase in the future if subsequent mergers were to arise.
• Qualitative assessment – Ofwat has identified areas where Bournemouth Water has demonstrated attributes that make it a useful comparator which suggest a detriment over and above those identified on the quantitative assessment. These included the development of outcome delivery incentives in its original business plan at PR14 where it led the way in terms of the proportion of performance commitments that were subject to a financial incentive and its conservative financing structure. Importantly, Ofwat said it was one of only two companies to demonstrate the need for a small company uplift to its cost of capital.

Ofwat has concluded that, taking account of the impacts on benchmarks, precision of its econometric models and its qualitative assessment, the loss of Bournemouth Water introduces detriment to customers in England and Wales and prejudices its ability to make comparisons.

Ofwat has also carried out an initial quantification of the potential customer benefits that may arise from the merger. However, although the regulator has assessed that the merger could deliver synergy savings by 2020, some of would be passed to customers through the existing regulatory mechanisms in 2020-25, both estimates have been redacted.  A number of other figures have also been redacted. Ofwat has focussed its assessment of the potential benefits of the merger based on lower prices, improved quality or greater innovation.

The regulator said that the benefits arise only to the customers of South West Water and Bournemouth Water and do not outweigh the prejudice. However, while this means there is a need for a remedy in this instance, in Ofwat’s view the assessment of prejudice is not so great as to lead it to oppose the merger and the regulator has set out a range of potential remedies that could apply.

"Remedies should take account of wider detriment to customers"

Ofwat’s submission says that remedies are complicated because the net detriment that arises is to all customers in England and Wales whereas the relevant benefit is only to the customers of South West Water and Bournemouth Water, commenting:

“We anticipate that the merger parties will set out the synergy savings that could arise for customers. However, remedies that comprise a price reduction would only help customers in the Bournemouth and South West Water regions; our view is that remedies should take account of the wider detriment to customers.”

“We look to Pennon to set out its view of the potential remedies that could apply. We do not, at this stage, set out a firm view of the remedy that should apply as we would expect remedies to be discussed further during the process of this investigation.”

South West Water has separately carried out an assessment of prejudice and benefits arising from the merger and shared its emerging analysis with Ofwat in advance of the Phase 2 investigation.

The submission sets out the full spectrum of remedies that could be considered in the context of the merger as follows:

Behavioural

Possible remedies in this context include a commitment to licence amendments that allow Ofwat to regulate the sector more effectively in the future. For example, revealing information in different parts of the value chain that could be subject to different forms of regulation or competition in the future could be helpful to the way the regulation might evolve. This may increase the information that is available to allow Ofwat to regulate different parts of the value chain. This could include, for example, separating resources from treatment and networks or separating water and wastewater businesses. Remedies which may include separate management or separate accounting arrangements could also be beneficial.

Customers of South West Water do not currently benefit from the full suite of ring-fencing licence conditions which provide protection to customers to ensure that a company has sufficient financial and managerial resources to carry out its functions as a water company. Ofwat expects that following the merger South West Water will adopt the full suite of conditions to provide adequate protections to customer.

 Structural

Ofwat does not consider that full divestiture of either South West Water or Bournemouth Water by Pennon would be an appropriate remedy on the basis of disproportionality and relevant customer benefits foregone. However, in the event that Pennon was to offer partial divestiture of its activities to create a new independent comparator, this could be considered as a possible remedy.

Price reductions

In Ofwat’s view  price reductions are an appropriate remedy only where accompanied by an undertaking that confirms it will be passed back to customers,  together with an undertaking from the merger parties confirming when the price reductions will be made and the value of the price reductions.

Click here to download Ofwat's submission in full