Water industry regulator Ofwat has today launched a new consultation on its proposed approach to mergers under new rules, which aim to reduce barriers to companies merging which provide benefits to customers.

Currently there are rules in place for water mergers which recognise the importance of Ofwat being able to compare information across companies to keep down prices and drive better service. Up to now, qualifying company mergers have been automatically referred to an in-depth Competition and Markets Authority (CMA) review.

The existing special merger regime applies when two or more water companies merge with each other – it does not apply to water supply licensees, but it will cover a retail business carried on by a water company when two or more water companies merge. Mergers between water supply licensees or between a water company and a water supply licensee) are covered by the general merger regime.

Where a water company merges with another business outside of the industry it is known as a change in ownership and these mergers are not subject to the special merger regime.

In the Government’s view the existing special merger regime acts as a disincentive to potential beneficial mergers between undertakers and creates uncertainty when a merger is proposed or has taken place. The Water Act 2014, when fully enacted, will make changes to the rules, giving Ofwat a greater role. Ofwat will provide an opinion to the CMA on:

• the impact of a merger on Ofwat’s ability to make comparisons and relevant customer benefits; and
• legal agreements with companies (undertakings in lieu) which would remedy, mitigate or prevent the prejudicial effect on Ofwat’s ability to make comparisons. 

This could result in there being no need for an in-depth CMA review.

Ofwat’s consultation sets out its principles and approach to assessing mergers, including how it will assess the impact on its ability to make comparisons.

Keith Mason – Senior Director of Finance and Networks at Ofwat said:

“We welcome the changes to the rules on water mergers in the Water Act 2014. Our increased role at an early stage in the process will provide greater certainty around potential mergers and reduce the burden on mergers which provide benefits to customers. Yet it still ensures that customers remain protected where this is not the case.”

Comparators used in PR14 and for Outcome Delivery Incentives

Water companies are regional monopolies, so comparisons between water companies have underpinned the way the sector has been regulated since privatisation. Ofwat makes use of comparisons both during the price review process, for example in setting price limits or service quality requirements, and between price reviews, for monitoring and enforcement and spreading best practice.

Comparative regulation has underpinned the way Ofwat has regulated the water and sewerage sector since privatisation it uses comparisons both during the price review process, for example in setting wholesale and retail price limits or service quality requirements, and between price reviews, for monitoring and enforcement and spreading best practice. The consultation paper says that making comparisons between companies is one of the key tools at Ofwat’s disposal and that comparative regulation provides a number of benefits, including:

• It can improve cost estimation as Ofwat is better able to assess the true costs of water companies by comparing costs across a number of independent firms operating in similar circumstances;
• It can provide an impartial view of the performance of water companies by allowing comparisons to be made across the sector;
• It helps overcome imperfect information, better allowing customers, investors, Ofwat and other stakeholders to assess the performance of companies;
• It provides a greater incentive for independent companies and their management to outperform their peers in the water sector;
• It provides greater incentives for innovation by facilitating a variety of different approaches to attempting to outperform price controls and other companies in the sector.

Specific areas where the regulator has recently made use of comparisons include:

• 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 we 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 where Ofwat highlighted and shared best practice to encourage all companies to meet its principles in this area.

Use of comparators likely to change

The paper says that Ofwat’s approach to regulation and  how it uses comparators is likely to change going forwards – including changes introduced during the 2015-20 period such as the introduction of non-household retail competition and the abstraction incentive mechanism.  

It also highlights some interesting pointers on the impact of abstraction reform on water resource management. The regulator is currently considering abstraction reform which may address the issue where some water undertakers have surplus water resources under their licences that they do not abstract. However, as the licence has been given and may be used in full if the company decided to, no further licences can be issued. The paper says this has an adverse effect on new entrants to the upstream markets as they have limited or no access to incumbent’s surplus water supplies. 

Ofwat principles for assessing mergers

Ofwat has now developed the following set of high level principles to guide its approach to 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 Ofwat’s ability to make comparisons.
• A merger of a high performing company in terms of efficiency/service could prejudice Ofwat’s 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, for example 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 Ofwat’s ability to make comparisons.
• Undertakings in lieu (UILs) may be appropriate to remedy, mitigate or prevent the prejudicial effect on Ofwat’s ability to make comparisons.

The consultation document says that assessment of the impact of a merger will be based on evidence provided by merger parties, taking into account Ofwat’s own analysis where appropriate. Ofwat’s criteria for assessing whether a merger would prejudice its ability to make comparisons include:

• the extent to which the merger involves overlaps in functions – if it does not Ofwat will take the view that there is no prejudice e.g. a water only company taking over sewerage functions would not prejudice the ability to make comparisons in these areas;
• the extent to which the merger would change benchmarks – Ofwat’s ability to make comparisons is likely to be more affected if it were to lose a high performing company as this could change cross-industry benchmarks and reduce the efficiency challenge for all companies;
• the number and quality of independent comparators that remain – for example, during the 2014 price review Ofwat developed robust cost models for water with 18 comparators, however, the models for wastewater proved more difficult to develop where there were only 10 comparators – meaning the regulator is likely to be more concerned with losing a wastewater comparator;
• whether there are alternative approaches available to Ofwat  to offset the loss of the comparator i.e. could Ofwat amend its regulatory approach to offset the loss?

Next steps

Ofwat is seeking responses on any part of the consultation document including its approach to mergers and draft statement of methods, in particular on:

• ts principles and approach to mergers;
• the proposed process for Phase 1 mergers under the new Phase 1 special merger regime; and
• the draft statement of methods.

Deadline for comments on the consultation proposals is 10 July 2015. Responses should  be e-mailed to This e-mail address is being protected from spambots. You need JavaScript enabled to view it or posted to: Mergers, Ofwat, Centre City Tower, 7 Hill Street, Birmingham B5 4UA.

Respondents who want to discuss any aspect of the consultation document should contact Tim Griffiths on 0121 644 7610 in the first instance.

Follwing the consultation, Ofwat will publish its final approach to assessing mergers in September.

Click here to download the consultation paper in full.