Changing tides

Investing in the water sector has always been highly attractive for infrastructure funds and investors because of the steady and stable rates of return that can be yielded from water assets. The hallmarks of the water sector make investing in it a relatively safe bet. Desirable characteristics include low operating costs and the potential for efficiency gains.

Since the start of the privatisation process in 1989, the UK water sector has attracted an array of global funds seeking to capitalise on those 'safe bet' conditions.  At present the water sector in England and Wales comprises 18 regional monopoly companies – 10 water and sewerage companies (WASC) and eight main water only companies (WOC) – and six small water companies.

Despite the attractiveness of investing in the UK water market, the UK merger control regime, with its heightened competition scrutiny, has always been a significant roadblock for mergers between water companies (both WASCs and WOCs). This is because effectively all but the smallest deals are automatically referred for an in-depth Phase Two merger investigation before the Competition and Markets Authority (CMA), irrespective of their substantive impact on competition in the traditional sense.  

This is illustrated by statistics which show that, of the nine mergers cleared in the last ten years, all but two were financial deals. This does not include the most recent industry deal between Bournemouth Water and South West Water which was referred to the CMA for a Phase Two investigation on 8 June 2015. 

But things look set to change for the first time since privatisation, as legislative amendments to the water merger regime are due to come into force when Section 14 of the Water Act 2014 fully takes effect and Ofwat moves away from comparative regulation. These changes could open up the UK water sector for significant M&A activity in the near future.

THE SPECIAL MERGER REGIME

UK water companies are regional monopolies and, in order to protect customers, water mergers have been subject to a special merger regime since the Water Industry Act 1991. Compared with the “normal” merger regime which regulates only those mergers which “substantially lessen competition”, water mergers have since 1991 been automatically referred for a Phase Two merger investigation before the CMA.

In practical terms, for a Phase One merger investigation, the CMA has up to 40 working days to conduct the investigation following receipt of the merger notice. But, for a Phase Two merger investigation, the CMA can take up to six months to investigate. 

However, the special water merger regime will change once Section 14 is fully brought into force some time during 2015 to 2017. Section 14 gives the CMA a degree of discretion when considering whether a Phase Two investigation is necessary for a particular qualifying merger, displacing the current mandatory process.

To date, water mergers have been assessed by reference to the economic performance of comparative companies in the industry. This comparative competition relies on there being an ample number of independent water companies to allow the regulator to compare relative performance of water companies when forming regulatory settlements and efficiency targets. But Ofwat admits that the benefits of comparative competition have lessened over time.  

In the future, the CMA must carry out a new balancing exercise to see whether the harm of having fewer comparators can be counteracted by customer benefits likely to flow from the water-to-water merger. One of Parliament's aims in creating this new regime was specifically to reduce the number of mergers referred for Phase Two investigation because those investigations were seen as a disincentive to potentially beneficial mergers. 

COMPARATIVE REGULATION

The benefit of a proposed merger for customers will be a key consideration for merger clearance. Ofwat uses comparative information to ensure that customers are paying a fair price for water, to identify good performance and set incentives for improvement in customer services. The new merger regime will continue to take into account whether a merger will prejudice Ofwat's ability to use comparators.  

But Jonson Cox, Ofwat's chairman, stated the watchdog was open to new ideas on how to reshape the water sector at a meeting of the Policy Exchange on 11 March 2015. Cox stated that comparative regulation had been useful, but going forward Ofwat no longer endorsed retaining an arguably excessive number of independent comparator operators as the primary means of gauging competition and efficiency in the water and sewerage sector. 

Under the new regime, in most cases Ofwat will have to provide the CMA with an opinion based on a statement of methods. Ofwat will have to consider if a proposed merger would prejudice its ability to make comparisons and, if so, whether that harm would be outweighed by customer benefits resulting from the merger. That opinion will also contain Ofwat's balanced view on whether the merger should be referred to Phase Two. It is expected that fewer water-to-water mergers will have to endure an independent investigation under the new regime.

In an effort to make their approach to future mergers and statement of methods more responsive to the market, Ofwat launched a consultation in May this year inviting views of stakeholders on the watchdog's current approach. Ofwat is due to publish its final approach to mergers and statement of methods in September 2015 following the consultation.

WATER DEAL-MAKING

The outlook for investment and structural change in the water sector is positive, especially in the wake of Price Review 2014 (PR14). PR14 provides certainty in relation to price controls for the period 2015 to 2020 and clarity on the outcomes that specific companies have to deliver in the period and in anticipation of the forthcoming merger regime and market liberalisation plans.

The May 2013 sale of South Staffordshire Water and Cambridge Water by Alinda Capital Partners to Kohlberg Kravis Roberts for an undisclosed fee demonstrates how water and sewerage assets are still appealing additions to any diversified investment portfolio. As noted above, the CMA has started a Phase Two investigation in relation to the April 2015 sale of Bournemouth Water to Pennon Group plc (owners of South West Water).

That deal shows how certain existing market players are interested in expanding their water portfolios.

Listed companies are a rarity in the sector, with the majority of water and sewerage companies in the private ownership of infrastructure funds. The last great wave of water acquisitions by funds occurred in the early to mid-2000s. This means there will be funds with existing water assets that will be considering divesting in the coming years, especially for strategic reasons and in order to satisfy shareholders' return on equity.

In April 2015, Citi announced it is looking to sell its 30 per cent share in Yorkshire Water's parent company, Kelda Water. Citi had acquired its interest in 2008 as part of a £3.0 billion (€4.2 billion; $4.8 billion) takeover which it led alongside GIC, Singapore's sovereign wealth fund. It is possible that such sales will act as a tailwind for the next wave of water deals.