Competition Commission clears Mid Kent / South East Water

Competition Commission report (97 pages, PDF, plus several appendices) on the merger of Mid Kent Water and South East Water (both under the ownership of Australian investment funds managed by Hastings). The Competition Commission allowed the merger despite the adverse effect on Ofwat's ability to make comparisons between water enterprises (which is the test under the water merger control rules).

Ofwat's preferred remedy of a partial divestment was rejected:

8.35 We conclude that partial divestiture is not likely to be an effective remedy option. In any event, Hastings told us that, if required to implement partial divestiture, it would [redacted].

A prohibition of the merger was rejected because it would prevent cost savings of “at least £3.1 million a year” (8.143), and the Commission decided that these savings should be given priority over the protection of Ofwat's ability to make comparisons:

8.147 The prejudice that we have identified is limited. Taking account of that prejudice, and the relevant customer benefits that we have identified, our judgement was that the benefits we have identified are substantially more important than the prejudice. We therefore consider that we may have regard to the effect of any remedial action on any relevant customer benefits. We have assessed the impact of each of the effective remedy options on relevant customer benefits in paragraphs 8.151 and 8.152.

The finding that the prejudice is “limited” or a “small adverse impact” appears to be based on bootstrap models of the effect of the merger on the standard deviation of parameter estimates in Ofwat's econometric models, combined with an assumption that Ofwat would reduce the effective catch-up rate to give the benefit of the doubt of the additional uncertainty to companies, without changing its other assumptions about expenditure reductions.

The Commission chose a price reduction remedy, expressed as follows:

8.96 In summary, we conclude that a price reduction remedy could be designed which would effectively mitigate the adverse effects of the merger by means of: (a) a one-off lump sum transfer of £4 million made by MKW and SEW to MKW and SEW's customers through the billing system in respect of bills for 2008/09; and (b) a requirement on SEW and MKW to accept a price control determination in 2009 based on savings in operating expenditure of £3.1 million a year as compared with current operating expenditure costs and projections.

The figure of £4 million appears to have been volunteered by the companies' owner. The report does not explain how it is related to expected efficiency savings net of the effect of Ofwat's rolling incentive schemes. The figure of £3.1 million is what the Commission “thought that Ofwat should be able to factor ... into its 2009 price determination without jeopardizing SEW's or MKW's ability to finance their functions” (8.88).

The undertakings or orders giving effect to this remedy have yet to be published on the inquiry home page. It remains unclear how the obligation fits with the fact that price control determinations are expressed a package with no opportunity to pick and choose between components.

The report does not appear to challenge the companies' owner's view that it is entitled to a minimum level of dividend from its investment in the England and Wales water industry:

8.72 Hastings expressed concern about the way in which any price reduction remedy would interact with the price control process. In its view, any price reduction would need to be funded by efficiency savings achieved by the merged company. [redacted] It said that there was no option for Hastings to make any price reduction transfer itself given that, as a listed fund with a share price driven by dividend yields, there was no option for it to fund any price reduction that would result in a significantly lower dividend.

For further information or advice please contact Franck Latrémolière.

Filed under Competition Commission, Merger control, Price controls, Water.

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