Ofwat has published a paper setting out its approach to mergers under the revised special merger regime following the changes introduced as part of the Water Act 2014.

Introducing the paper, the water regulator explained that as each water company is a regional monopoly, it uses comparative information to ensure that customers are paying a fair price for their water, to identify good performance and to set incentives for companies to improve.

The need for comparative information is recognised through the special merger regime which examines whether water sector mergers could prejudice Ofwat’s ability to carry out its functions by impacting on its ability to make comparisons.

Ofwat said the development of the retail market for non-household customers in April 2017 together with the  proposals for upstream activities in Water 2020, would change its need for comparative information in “a dynamic way2 and its approach to mergers will also change as a result.

Following the introduction of changes set out in the Water Act 2014, the special merger regime will be amended to allow a process whereby a decision on a water merger can be achieved during the first stage (Phase 1) of a merger investigation rather than automatic referral to an in-depth (Phase 2) investigation.

Ofwat said this aims to reduce the disincentives for companies to merge and the level of regulatory uncertainty when a merger is proposed. One of Parliament’s objectives of the revised special merger regime is to allow for some mergers to proceed following a Phase 1 investigation as the automatic referral of all mergers to an in-depth Phase 2 investigation under the previous regime was viewed as a disincentive to potentially beneficial mergers.

The revised special merger regime requires the regulator to provide an opinion to the Competition and Markets Authority (CMA) during Phase 1 of a merger inquiry on the impact of a merger on Ofwat’s ability to make comparisons and relevant customer benefits; and whether undertakings in lieu (UILs) would remedy, mitigate or prevent the prejudicial effect on this.

Ofwat is also required to consult on and prepare a statement of methods, which sets out the criteria it will use to assess the impact on the ability to make comparisons and the weighting applied to those criteria.

When the relevant sections are in force, the Water Act 2014 introduces a revised Phase 1 process to the special mergers regime. In the revised Phase 1 process, in addition to the existing tests on applicability and turnover, the CMA can decide not to refer a qualifying water merger to a six month inquiry group-led investigation if the:

• merger is not likely to prejudice Ofwat’s ability to make comparisons;
• likely prejudice is outweighed by relevant customer benefits; or
• company has offered appropriate UILs of a reference which remedy, mitigate or prevent the prejudicial effect on its ability to make comparisons.

Without ability to make comparisons Ofwat would have been unable to set stretching cost and service targets

According to the regulator, without the ability to make comparisons between water companies it is likely that Ofwat would not have been able to set the same stretching cost and service targets which would have been a detriment to customers through higher bills or lower service quality.

Particular areas flagged up where comparisons have recently been made use of include:

• risk based assessment of company business plans and the categorisation of companies’ business plans, which introduced rivalry between companies to obtain enhanced status at the 2014 price review;
• wholesale and retail cost modelling in the 2014 price review where Ofwat used information on individual water company costs to develop cost models, cost benchmarks and cost allowances;
• outcome delivery incentives (ODIs) which were set at the 2014 price review where, for five cross-company ODIs Ofwat used comparisons across water companies to identify upper quartile performance and intervened to ensure that companies were only able to access financial rewards for genuinely stretching performance;
• service incentive mechanism (SIM) which uses qualitative and quantitative measures of customer satisfaction to financially reward or penalise companies based on their performance relative to the rest of the industry; and
• standards of board leadership, transparency and governance across companies highlighting best practice to encourage all companies to meet principles in this area.

The paper sets out the following high-level principles used by Ofwat to assessing mergers:

• Each merger will be considered on its merits, taking full account of its benefits.
• Any merger has the potential to prejudice Ofwat’s ability to make comparisons.
• A merger between companies whose scope of activities does not overlap is unlikely to prejudice the ability to make comparisons.
• A merger of a high performing company in terms of efficiency/service could prejudice the ability to set cross industry benchmarks.
• Each merger may permanently reduce the number of independent comparators in the monopoly parts of the value chain; and as a result the detriment to the comparative regime may increase for each successive merger.
• A merger could lead to the loss of a company which had important similarities to other companies, e.g.  operating in similar conditions facing similar issues.
• A merger could lead to the loss of a company which had important differences from other companies, which for example could reduce the scope of the development of best practice.
• It might be possible for Ofwat to amend its approach to offset, to an extent, the impact of the loss of a comparator.
• A merger has the potential to create customer benefits which could outweigh the prejudice to the ability to make comparisons, including price reductions, service improvements, greater choice and increased innovation.
• UILs may be appropriate to remedy, mitigate or prevent the prejudicial effect on the ability to make comparisons.

To provide the best opportunity of Ofwat recommending to the CMA that the merger is cleared at Phase 1, Ofwat says merger parties should develop their submission in line with its statement of methods and take account of a report commissioned into valuation methods by Europe Economics. Merger parties are also encouraged to discuss their proposed submission with Ofwat during the pre-notification phase of the process.

The paper says in assessing the impacts of a merger on Ofwat’s ability to make comparisons and the customer benefits, the greatest weight will be placed on merger party assessments which are "complete, robust, certain, clear, independently assured and which provide evidence of customer support."

Click here to download Ofwat’s approach to mergers and statement of methods

Click here to download Europe Economics paper Valuing the Impact of Mergers in the Water and Sewerage Sectors and Identifying Undertakings in Lieu.