Vivendi Water UK PLC and First Aqua (JVCo) Limited: A report on the proposed merger

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Summary

Introduction

We were asked to report on the proposed acquisition by Vivendi Water UK PLC (VWUK) of First Aqua (JVCo) Limited (JVCo) from First Aqua Holdings Limited (First Aqua): see Appendix 1.1 for our terms of reference. JVCo owns Southern Water Services Limited (Southern), a regulated provider of water and sewerage services in south-east England.

VWUK is the holding company of the UK water interests of Vivendi Environnement SA (VE), which in turn is 41 per cent owned by Vivendi Universal SA (Vivendi Universal). Vivendi Universal is a French-based multinational company with interests in the media and communications industries. VE is involved in the water, energy, waste management and transportation industries. Its group turnover in 2001 was £18 billion. VWUK owns three regulated water companies in England and Wales and has a 31.4 per cent holding in a fourth, South Staffordshire Group PLC (South Staffs Group).

First Aqua is a special purpose vehicle (SPV) created for the purpose of acquiring Southern from its previous owner, Scottish Power Plc (Scottish Power). It is owned by a consortium comprising Citicorp Banking Corporation (Citicorp) and a number of private equity investors.

The water industry

Under the Water Act 1989 the Water Authorities were converted into water and sewerage public limited companies (WaSCs) and privatized. The controls previously applied to the statutory water companies, which provided water services only, were removed: they are now known as water-only companies (WoCs). Following a number of mergers since privatization, the water industry in England and Wales now comprises 10 WaSCs and 13 WoCs. Under the Water Industry Act 1991 (the 1991 Act) the Secretary of State for Trade and Industry is obliged to refer to the Competition Commission (CC) proposed mergers of regulated water enterprises whose assets exceed £30 million.

The merger transaction

VWUK sought to acquire Southern in 2001 but Scottish Power did not wish to undergo the uncertainty of a CC inquiry. Citicorp, which was advising VWUK in relation to the possible acquisition of Southern, developed the idea that a financial consortium might be formed to acquire Southern without triggering a reference. As a result First Aqua was established and entered into an agreement with Scottish Power to buy Southern. Shortly after that agreement was completed, First Aqua entered into a second agreement to sell Southern to VWUK. This second agreement triggered the reference to us, on 23 May 2002, because of VWUK's existing holdings of water companies.

The second agreement provides for VWUK to acquire JVCo, and hence Southern, for £2,081 million. The financial and ownership structure envisaged is complex. [ Details omitted. See note on page iv. ] Two SPVs [ Details omitted. See note on page iv. ]. VWUK would own [%] per cent of the ordinary voting shares having provided [ % ] per cent of the total purchase consideration. The envisaged gearing level of the regulated business is [%] per cent and that of the holding company about [%] per cent.

The legal framework

Because of the parties' combined world and EC turnover, the proposed merger comes within the ambit of the EC Merger Regulation (ECMR). However, the European Commission has recognized in a Decision the legitimate interest of the UK in examining the merger's implications for the regulatory regime under the 1991 Act. The Decision reserves to the European Commission consideration of other matters. The European Commission cleared the merger under the ECMR on 23 August 2002.

Section 34(3)(a) of the 1991 Act provides that the CC, in considering whether a water merger may be expected to operate against the public interest, 'shall have regard to the desirability of giving effect to the principle that the [Director General of Water Services' (DGWS's)] ability, in carrying out his functions …, to make comparisons between different water enterprises should not be prejudiced'. This ability underpins the regime of 'comparative competition' in the water industry, in which the level of product market competition is very low.

The public interest

The DGWS uses comparisons for a variety of purposes in seeking to promote efficiency and high standards. He analyses data using econometric and other techniques to establish which companies are most efficient in order to set benchmarks for the others. Thus he aims to set price limits which enable prices to customers to be as low as possible consistent with enabling the companies to provide high standards of service while earning an adequate return on capital. He told us that the success of the regime depended on there being sufficient diversity of ownership: the more companies there were under independent ownership, the greater the opportunity for the efficiency frontier to be advanced. The DGWS submitted that the loss of Southern's independence would weaken the comparative system; there would be an additional, smaller detriment from the disappearance of Folkestone & Dover Water Services Limited (F&D), one of VWUK's existing WoCs, which he considered would be absorbed into Southern as a result of the merger.

There would be no loss of a comparator in sewerage, which accounts for nearly three-quarters of Southern's turnover, because VWUK has no sewerage interests at present. As regards water services, we agree that the merger would prejudice the DGWS's ability to make comparisons. This detriment stems from the loss of possible future gains in efficiency resulting from the loss of Southern as an independent comparator, as well as from the harm to the DGWS's econometric modelling. We consider that this detriment would be mitigated, though not nullified, if the DGWS were to use additional methods of comparison in his price reviews. We consider that there would also be a modest detriment as a result of the closer association of F&D with Southern, although we do not believe that the complete disappearance of F&D would be a necessary consequence of the merger. One of us, Chris Goodall, believes that the detriments caused by the merger are greater than perceived by the majority: see paragraph 1.15.

We have considered whether the financial structure which VWUK envisages for Southern would be prejudicial to the regulatory regime. Four of us believe that there is insufficient evidence to conclude that this is likely. In addition we believe that VWUK would be highly motivated to see that Southern performed well in both financial and service terms; and we note that the DGWS has evolved a range of licence conditions to protect regulated businesses from financial strains that might affect their owners. It would be important, however, for the DGWS to be vigilant in monitoring Southern's performance.

We have also considered the benefits which the parties claimed the merger would bring, to the extent that we are permitted to do so by the 1991 Act and the EC Decision. We find that they are not of 'substantially greater significance' for the public interest than the detriment which the merger would cause to the DGWS's ability to make comparisons between companies. Section 34(3)(b) of the 1991 Act therefore prevents us, in reaching our conclusion on the public interest, from having regard to the desirability of achieving those benefits.

We conclude that the proposed merger may be expected to operate against the public interest because it would prejudice the DGWS's ability to make comparisons between different water enterprises.

Remedies

In considering remedies we take account of the fact that VWUK recently sold its 25 per cent holding in Bristol Water, a substantial WoC, following discussions with the DGWS and in order to pave the way for the acquisition of Southern. We also have regard at this stage to the merger's potential benefits, notably for the management of water resources in Kent and East Sussex. The four of us believe, moreover, that the detriment we have identified is not great enough to justify prohibiting the merger or requiring VWUK to divest Three Valleys Water Plc (Three Valleys), the largest of its three WoCs. We also see objections to the idea, discussed between the DGWS and VWUK before the latter agreed to buy Southern, that Southern's water operations in Hampshire and the Isle of Wight should be established as a separate enterprise and sold off in order to create a new comparator. Instead we recommend that VWUK be required to divest its 31.4 per cent stake in South Staffs Group, thereby securing the independence of that company as a comparator.

Statement of dissent

The other member of the Group, Chris Goodall, considers that the detriment from the loss of Southern's independence is greater than the majority believes it to be. He also considers that F&D would disappear as a consequence of the merger, creating further prejudice to the DGWS's ability to make comparisons. Furthermore, he takes the view that the complex and [ % ] financial structure envisaged by VWUK is liable to prejudice the DGWS's ability to promote improved efficiency and quality of service. He believes that, since South Staffs Group already behaves as an independent comparator, and is regarded as such by the DGWS and by the company itself, the value of the remedy recommended by the majority is small and hypothetical. He believes that the sale of Three Valleys, in addition to the divestment of the stake in South Staffs Group, is the remedy that most closely matches the detriment to the public interest.

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