The perfect time for M&A?

Forthcoming changes to the UK water market regime, including a relaxation of the rules governing mergers and acquisitions, could make the sector more attractive to investors, says Satyen Dhana.

The UK water market has long been viewed as a sector where regime change may be appropriate. The Cave Review set the tone for the scope of potential action to bring about a more competitive UK water market. While the government has moved away from some of the more radical proposals set out in the review, recent regime developments have pushed the sector into a new era that could make it more attractive to water companies and investors.

First is the full opening of the non-household market from April 2017. While the reforms introduced by the Water Act 2014 do not go so far as to require formal separation of water companies’ retail and wholesale activities, they do change fundamentally the dynamics of the industry, because they will allow third-party suppliers to offer an alternative to non-household customers. To date, these customers have been, by and large, exclusively supplied by the incumbent water (and waste) supplier.

The new regime represents an opportunity for water companies to increase their customer base, which to date they have been unable to do. The uncoupling of the monopoly provision of water services to certain customers has already had an effect on the industry: a number of water companies are restructuring to take advantage of new opportunities in the market. They are seeking to exploit the regime to supply water services to customers outside their traditional markets.

Second, the Competition and Markets Authority (CMA) has consulted on its approach to water mergers under the revised special regime. The consultation closes on 15 October 2015.

The revised special regime, which is due to come into effect in November this year, will relax the rules for water mergers, allowing them to be cleared following a Phase 1 investigation, rather than automatically requiring a Phase 2 investigation. The new regime will also allow water mergers to be cleared with undertakings from the merging parties sufficient to address any regulatory concerns.

The CMA is currently conducting a Phase 2 investigation into the completed acquisition of Bournemouth Water by Pennon Group (the owner of South West Water). It recently provisionally cleared the merger. The CMA concluded that while having some adverse effect on Ofwat’s ability to make comparisons between different water companies, because it reduced the number of regulated water companies, this was not significant enough to prejudice Ofwat’s ability to carry out its statutory functions (the legal test applied by the CMA when reviewing water mergers in the UK).

The approach adopted by the CMA in its provisional findings echoes the reasoning applied by its predecessor, the Competition Commission, when it cleared the merger of South Staffordshire plc and Cambridge Water plc in 2012 – the first and so far only water merger to be unconditionally cleared in the UK.

Clearly, the UK water regime is changing.  It is beginning to take steps towards a structure similar to the current UK energy market or the water market in Scotland. It is difficult to predict whether opening up the non-household market will affect the returns of water companies and make them more or less attractive for M&A activity.

On the one hand, it is an opportunity – a water company could seek to gain a larger customer base – but on the other hand, it could also be a threat: existing monopoly provision is being chipped away at the edges.

 The suspicion is that its impact could be limited in the short term: it is unlikely that water companies will lose significant numbers of customers immediately when the “tap” is turned on to competition in 2017. The full effects of the regime change will take a number of years to be felt, particularly among the larger water and sewerage companies.

The changes to the special water merger regime may have a more immediate effect.

There is no doubt that the current water merger regime has limited consolidation. However, the changes to the regime will allow more speculative water mergers to be tested at Phase 1 and remedies offered without the need for a full Phase 2 review.

This could lead to larger water and sewerage companies looking for bolt-on acquisitions of smaller water companies, similar to South West and Bournemouth, or smaller water company mergers – which may have been stifled previously by the prospect of a lengthy and costly Phase 2 review, where the consolidation would give rise to only small, in cost terms, but important, efficiencies.

Companies, investors and others interested in exploring these opportunities should be looking closely at the changes and the interplay between the revised special regime for water mergers, the CMA’s approach to it and how the opening up of the non-household market affects their own investment models and appetite to transact in the UK water sector.

It could lead to a rush to close deals. The regime can take only so much consolidation – the merger test remains the same and there will be a point where the CMA decides that, regardless of regime, Ofwat’s ability to make comparisons is significantly affected: every consolidation reduces this ability by its very nature.

Satyen Dhana, competition partner, CMS