Vivendi Water UK PLC and First Aqua (JV Co) Limited: A report by the Competition Commission on the proposed merger

This report provides an interesting insight into the role and importance of comparative competition in the water industry of England and Wales.

The parties involved

Vivendi Water UK PLC (VWUK)

VWUK is a wholly owned subsidiary of Vivendi Environment (VE), which in turn is approximately 41% owned by Vivendi Universal, a French-based multi-national company with a variety of interests. VE describes itself as the world's largest provider of environmental services. It has four main businesses: water, energy, waste management and transportation.

VWUK currently has the following interests in regulated water enterprises in England & Wales:

• 100% of Three Valleys, the largest of the 13 Water only Companies (WoC)
• 99% of Tendering Hundred Water Services Ltd, a small WoC
• 74% of Folkstone & Dover Water Services Ltd (F&D), another small WoC
• 31.4% of South Staffordshire Group Plc, the fourth largest WoC by turnover

Southern Water Services Ltd (Southern)

Southern is one of 10 water and sewerage public limited companies (WaSC) in the UK, it provides sewerage services to some 4 million people in Kent, Sussex, Hampshire and the Isle of Wight. Its appointed area for the provision of water services also covers small areas of Surrey, Berkshire and Wiltshire. Several WoCs – principally F&D, Mid Kent Water, Portsmouth Water and South East Water – provide water services in parts of the area where Southern provides sewerage services.

In 2002 Southern's turnover from regulated activities was £424 million, of which £307.5 million (72.5%) came from sewerage services and £116.5 million (27.5%) from water services.

The merger transaction

In 2001 VWUK sought to acquire Southern from its owner Scottish Power. Due to VWUKs existing holding of water companies, the merger would have been subject to a Competition Commission inquiry. Scottish Power did not wish to become involved with the delay and uncertainty of such an inquiry.

Citicorp, which was advising VWUK on the acquisition, developed the idea that a financial consortium might be formed to acquire Southern without triggering a reference to the commission. They established a special purpose vehicle, named First Aqua (JV Co) Limited, to enter into an agreement with Scottish Power to buy Southern. Shortly after that agreement was completed, First Aqua (JV Co) Limited entered into a second agreement to sell Southern to VWUK.

The legal framework

Due to the size of VWUK and Southern's turnover, and because much of the turnover of the VE group arises in other EC countries, the acquisition has a 'community dimension' and falls within the ambit of the EC Merger Regulation (ECMR). The European Commission has exclusive competence to apply the provisions of the EMCR. On 23 August 2002 the European Commission cleared this merger.

Member States are not allowed to apply their national legislation on competition to mergers that fall within the ambit of the EMCR. However, in this case the Commission did recognise the legitimate interest of the UK government in examining the merger's implications for their regulatory regime under the Water Act 1991.

This Act provides that the UK Competition Commission, in considering whether a water merger may be expected to operate against the public interest "shall have regard to the desirability of giving effect to the principle that the Director General of Water Services' (DGWS) ability, in carrying out his functions…to make comparisons between different water enterprises should not be prejudiced". This ability is said to underpin the regime of 'comparative competition' in the water industry, in which the level of product market competition is very low.

The function of the DGWS

The DGWS uses comparisons for a variety of purposes in seeking to promote efficiency and high standards. He analyses data using econometric and other techniques to establish which companies are most efficient in order to set benchmarks for the others. The DGWS aims to set price limits which enable customers to receive the highest standard of service at the lowest possible price whilst enabling companies to earn an adequate return on capital.

He states that the success of the regime depends on there being diversity of ownership; the more companies there are under independent ownership, the greater the opportunity for the efficiency frontier to be advanced.

Issues affecting the public interest

In considering whether the merger may be expected to operate against the public interest, the Commission considered, the extent of the prejudice, which the merger might cause to the ability of the DGWS to make comparisons between different water enterprises. Such prejudice might be thought to result from Southern becoming part of VWUK and hence no longer an independently controlled water company. In addressing this issue, the Commission considered the following factors:

• The expectation that Southern would continue to operate under a separate appointment from the DGWS and to generate information for use in his comparisons between water enterprises;
• The ring-fencing provisions which are currently included in Southern's operating licence, and any additional provisions of that nature which might be introduced into the licence;
• Whether it is appropriate to take into account the management style of the acquiring party, particularly insofar as it affects the degree of operational freedom afforded to the managers of its subsidiaries;
• The presence and role of minority investors in the ownership structure envisaged in the sale and purchase agreement;
• The fact that the DGWS used Southern as the benchmark company for water service operating expenditure when he set price controls for the industry in England and Wales in the 1999 Periodic Review, and that in 2000/01 it continued to be assessed as the most efficient company in this respect;
• Whether it would be appropriate, if the sale and purchase agreement were completed, for Southern to be used as a benchmark in the future.

The Commission also took account of the extent to which the DGWS might use methods of arriving at regulatory decisions and judgments, which were alternative or additional to his existing methods, such that any prejudicial effect might be mitigated.

The Commission also considered whether any other detriments might result from the merger, namely:

• Whether the disappearance of F&D Water Services Ltd as a separately licensed water undertaking would be a consequence of the merger, and if so whether this would be prejudicial to the DGWS's ability to compare different water enterprises; and
• Whether the financial and ownership structure envisaged under the sale and purchase agreement might have an adverse effect on the regulatory regime e.g. by increasing costs or by prejudicing the company's ability in some circumstances to finance its functions.

The Commission considered whether they should be influenced by the proposition that successive mergers between water companies are increasingly prejudicial to the DGWS's ability to make comparisons. In addressing this issue they had regard to the European Commission's statement that "the minimum number of independent water companies should not be set higher than necessary to ensure the effective operation of the regulatory regime".

On this point VWUK tried to argue that, before the Commission could conclude that the merger was against the public interest, it would have to demonstrate that, the Office of Water Services (OFWAT), currently had the minimum number of comparators required to operate this regime. The Commission did not accept such a literal interpretation of the European Commissions statement. They said that the impact of loss of a comparator is not simply a question of the number of comparators but is a matter of degree; it depends upon the nature and quality of the comparator in question and the relevant circumstances at the time. They dismissed the proceeding argument that the number of independent comparators had risen by 2 in the past year.

Finally the Commission took into account whether the merger could be expected to lead to benefits for the public interest, for example:

• By enabling an improvement in the management of water resources as a result of the bringing under common ownership of F&D and Southern;
• By enabling Southern and VWUK to benefit from a reciprocal transfer of expertise and best practice in respect of both water and sewerage operations;
• By enabling cost savings to be made which could be passed on to customers in the form of price reductions;
• By enabling improved standards of customer service to be achieved; and
• By improving the environmental performance of Southern's sewerage operations.

In assessing any such benefits, the Commission had to consider:

• The extent to which it is open to them to take account of these benefits, consistent with s.34(3)(b) of the 1991 Act;
• Whether the benefits could be obtained in other ways than through the merger;
• Whether the benefits could be achieved in a manner that does not conflict with the principle that the DGWS's ability to make comparisons between different water enterprises should not be prejudiced;
• Whether the benefits are of substantially greater significance in relation to the public interest than any prejudice caused to the DGWS's ability to make comparisons.

Previous water merger inquiries

1995- Lyonnaise/Northumbrian

The legal framework was the same as in the present case. The Commission concluded that the merger would be against the public interest because the prejudice it would cause to the DGWS's ability to make comparisons between water enterprises was not offset by the benefits it would bring. They recommended that the Bid should be allowed only if substantial price reductions were agreed, sufficient to move the merged company to the forefront of efficiency. The Secretary of State permitted the merger on the basis that prices to water customers of the merging companies would be reduced by 15% over the following 6 years.

1996- Competing bids by Seven Trent PLC & Wessex Water for South West Water PLC

In both cases the loss of South West as a comparator would be seriously prejudicial to the DGWS's ability to make comparisons of companies performance in their sewerage operations. He already had difficulty in making robust comparisons of operating efficiency with only 10 comparators. Benefits to customers were considered transitory, whereas harm to the regulatory regime would be permanent. The Commission recommended that both mergers be prohibited. The Secretary of State accepted this.

2000- Joint bid by VWUK and SAUR for Mid Kent

VWUK and SAUR planned to divide Mid Kent and merge the two parts with their own WoCs. The Commission considered that the loss of Mid Kent as an independent comparator would cause substantial prejudice to the DGWS's ability to make comparisons. It saw no appropriate remedies and recommended that the merger be prohibited. The Secretary of State agreed.

The Competition Commissions conclusions

• There would be no loss of a comparator in sewerage, which accounts for nearly three-quarters of Southern's turnover, because VWUK has no other sewerage interests in the UK.
• As regards water services, the merger would prejudice the DGWS's ability to make comparisons. This detriment stems from the loss of possible future gains in efficiency resulting from the loss of Southern as an independent comparator, as well as from the harm to the DGWS's econometric modelling. This detriment would be mitigated, though not nullified, if the DGWS were to use additional methods of comparison in his price reviews, similar to those currently used in the sewerage industry.
• The complete disappearance of F&D would not be a necessary consequence of the merger. There would however, be a 'modest' detriment as a result of the closer association of F&D with Southern. Its data would be 'tainted' thus reducing its statistical value. (The Commission did point out that F&D is however only a very small company and it is not currently independent).
• A majority of four commissioners believed that there was insufficient evidence to conclude that the financial structure which VWUK envisages for Southern would be prejudicial to the regulatory regime.
• VWUK would be highly motivated to see that Southern performed well in both financial and service terms; the DGWS has evolved a range of licence conditions to protect regulated businesses from financial strains that might affect their owners. It would be important, however, for the DGWS to be vigilant in monitoring Southern's performance.
• The benefits that the parties claimed the merger would bring are not of 'substantially greater significance' for the public interest than the detriment that the merger would cause to the DGWS's ability to make comparisons between companies. Section 34(3)(b) of the 1991 Act prevented them from having regard to the desirability of achieving those benefits.

In conclusion, the proposed merger might be expected to operate against the public interest because it would prejudice the DGWS's ability to make comparisons between different water enterprises. However, four of the commissioners permitted the merger to go ahead, subject to a number of remedies.

Remedies

When considering appropriate remedies the commission took into account:

• The fact that VWUK sold its 25 % holding in Bristol Water in order to pave the way for the acquisition; and
• The merger's potential benefits for the management of water resources in Kent and East Sussex.

A majority of four believed, that the perceived detriment is not great enough to justify prohibiting the merger or requiring VWUK to divest Three Valleys Water Plc, the largest of its three WoCs. Further they saw objections to the idea that Southern's water operations in Hampshire and the Isle of Wight should be established as a separate enterprise and sold off in order to create a new comparator. Instead they recommend that VWUK be required to divest its 31.4% stake in South Staffs Group within 6mths of completing the acquisition, thereby securing the independence of that company as a comparator.

Statement of dissent

One member of the group believed the detriment from the loss of Southern's independence to be greater than the majority considered. He thinks that F&D would disappear as a consequence of the merger. He also believes that, since South Staffs Group already behaves as an independent comparator, and is regarded as such by the DGWS and by the company itself, the value of the remedy recommended by the majority is small and hypothetical. As such, he states that the sale of Three Valleys, in addition to the divestment of the stake in South Staffs Group, is the remedy that most closely matches the detriment to the public interest.

For further information please contact Richard Temple at richard.temple@cms-cmck.com or on +44 (0)20 7367 3738.