Lyonnaise des Eaux Sa and Northumbrian Water Group Plc: A report on the merger situation

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On 6 March 1995 Lyonnaise des Eaux SA (Lyonnaise) announced its intention to acquire Northumbrian Water Group PLC (Northumbrian Water Group) in order to merge their respective regulated water businesses in the North-East, North East Water plc (NEW) and Northumbrian Water Limited (Northumbrian) under a new Appointment from the Director General of Water Services (DGWS). This is the first proposed acquisition of a water and sewerage company (WaSC).

Because of the parties' combined world and EC turnover the proposed merger has a Community dimension. Nevertheless, in response to an application by the UK under Article 21(3) of the EC Merger Control Regulation (No 4064/89), the EC Commission recognized in a Decision of 29 March (see Appendix 1.2) the legitimate interest of the UK in examining the proposed merger's implications for the regulatory arrangements laid down in the Water Industry Act 1991 (the 1991 Act). The Decision reserves to the EC Commission consideration of other matters. Lyonnaise has not set the EC merger control procedures in motion by notifying the proposed concentration, as no formal bid has been made.

Lyonnaise is an international conglomerate with extensive water and construction interests. Its subsidiary, NEW, is a water-only company (WoC) supplying the northern part of the north-east region. Northumbrian is a WaSC supplying water mainly to the southern part of the region and sewerage services throughout the whole region. The map at Appendix 3.2 shows the respective areas of operation.

Under the reference made to us on 31 March 1995 (see Appendix 1.1), we have to decide whether arrangements are in progress which if carried into effect would result in the creation of a merger situation qualifying for investigation under the special provisions relating to water enterprise mergers in sections 32 to 34 of the 1991 Act. In the absence of offer terms from Lyonnaise we sought other evidence. We are satisfied that such arrangements are in progress and that the merger qualifies for investigation.

Sections 32 to 34 of the 1991 Act (see Appendix 1.3) make special provisions for the mandatory reference to the MMC of mergers between water enterprises. Section 34(3)(a) provides that the MMC `shall have regard to the desirability of giving effect to the principle that the Director's [DGWS's] ability, in carrying out his functions ..., to make comparisons between different water enterprises should not be prejudiced'. This ability underpins the regulatory arrangements which promote `comparative competition' in the water industry which is characterized by natural monopolies.

The DGWS gave evidence that the availability of a wide range of comparative information had been of great importance to his determination at the 1994 Periodic Review of a price cap for each water enterprise for the period to 1999/2000 and the following quinquennium. He also submitted that the use of comparators was a continuing and evolving process which would continue to play a fundamental role in the regulation of the water industry. In the DGWS's view, the loss of Northumbrian as a separate comparator would seriously prejudice his ability to make comparisons and weaken the effectiveness of the regulatory system.

We consider that Northumbrian has value to the DGWS for comparative purposes as a medium-sized enterprise with its water supply operation directly comparable to NEW's. In addition to that particular impact of this merger, we have assessed the contribution it makes to the cumulative weakening of the structure of regulation.

Our conclusion under section 34(3)(a) of the 1991 Act is that the loss of Northumbrian as a separate comparator would prejudice the DGWS's ability to make comparisons between different water enterprises. We conclude that, while the prejudice is not susceptible to precise quantification, it is clearly significant to his ability to maintain comparative competition.

We considered that the terms of the EC Decision meant that we could not take account of the potential implications of the merger for competition, employment or regional policy. In the terms of section 34(3)(b) of the 1991 Act the principal `other purpose' we were able to consider was the achievement of efficiency savings resulting from the merger. The long-standing co-operation between Northumbrian and NEW in respect of sources and treatment of water and billing means there is little scope for further rationalization. We conclude (under section 34(3)(b)(i)) that further material efficiency savings cannot be achieved in the absence of the merger.

We considered the operating cost savings that might arise from a merger. Northumbrian estimated £3.1 million a year: Lyonnaise estimated £11 million a year by 1999/2000. We conclude in the terms of section 34(3)(b)(ii) of the 1991 Act that the prospective savings are insufficient to be of `substantially greater significance in relation to the public interest' than the prejudice to the DGWS's ability to make comparisons between different water enterprises.

Within the framework of section 34(3) of the 1991 Act, and having regard to the terms of the EC Decision, we conclude that the acquisition of Northumbrian Water Group by Lyonnaise may be expected to operate against the public interest, with the particular adverse effect of prejudice to the DGWS's ability to make comparisons between companies.

We are required under section 72(2) of the Fair Trading Act 1973, which applies to this reference, to consider possible remedies. Our primary concern has been to secure the underlying objectives of the regulatory arrangements.

The DGWS submitted that the loss of a comparator could be remedied if Lyonnaise undertook to make such a substantial reduction in charges to customers that it would be forced to move towards the `efficiency frontier' for the industry and become an exemplary comparator.

We believe the operating cost savings forecast by Lyonnaise fall well short of what we would expect from the highly efficient comparator required to reinforce the regulatory structure.

We recommend that, if the merger is to proceed, action should be taken so that a single new Appointment is made for the merged enterprise which requires it to maintain or exceed current levels of customer service. We further recommend that this new Appointment should have the effect of securing substantial price reductions sufficient to compel the merged company to the forefront of efficiency in the industry. The DGWS is in this case best able to calculate what would be needed to achieve this outcome and advise the Secretary of State.

We recommend that the price reductions take effect from 1 April 1996. As well as immediately benefiting customers in the region, they will ensure that the advantage of creating the new comparator will inform the DGWS's analysis of average efficiency for the purposes of the next Periodic Review. By this means, customers throughout England and Wales will obtain an appropriate measure of redress for the weakening of the regulatory structure which protects their interests.

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