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On 7 March 2022 the Competition and Markets Authority (CMA) decided to clear Pennon’s acquisition of Bristol Water (case page), subject to certain conditions (‘undertakings in lieu of reference’, or UILs). 

Now that the dust has settled on the deal, what should water companies and infrastructure investors take from the CMA’s decision to accept the UILs offered by Pennon? Does this decision open the floodgates to other acquisitions of small water-only companies? And what does it mean for the consolidation of larger companies? 

A bumpy road at first

The CMA’s decision in March marked the end of its initial inquiry into the Pennon / Bristol Water deal (known as the ‘phase 1’ inquiry). Whilst the CMA ultimately cleared the deal without referring it for an in-depth, or ‘phase 2’, inquiry, it was not altogether a smooth ride for the merging parties: 

• In November 2021 the CMA found no concerns (under the Enterprise Act 2002) in relation to the merger’s impact on competition. 
• However, in December 2021 the CMA found (under the Water Industry Act 1991, as amended by the Water Act 2014) that the merger could have a significant negative impact on Ofwat’s ability to regulate the sector, leading to Pennon’s offer of undertakings. 

There are a number of insights from the December 2021 phase 1 decision that will be helpful to firms and investors mapping out their own deal strategies: 

• Ofwat’s role is paramount, as the CMA at phase 1 is required to seek its opinion and places significant weight on this, particularly given the strict timeline. Investors should seek to engage proactively with Ofwat prior to the final opinion being submitted to the CMA. It may even be more efficient for investors to consider engaging in pre-deal discussion with the regulator, so as to gauge the level of concern at a very early stage.
• The CMA assessment is dependent on case-specific factors, rather than a mechanistic ‘magic number’ of remaining water companies. For example, a merger involving a company that sits among Ofwat’s top performers and/or with important similarities to other companies is at higher risk of CMA scrutiny. While investors have limited information available about other companies’ cost drivers, Ofwat’s performance league tables can help gauge the relative positioning of the acquirer and the target, and the risk that the merger negatively affects industry cost and performance benchmarks.  
• The CMA did not place weight on the consumer research submitted by Pennon, due to severe methodological issues. Parties planning a deal often find it difficult to repurpose surveys taken in other contexts for the CMA process, and would do well to consult with the CMA. 
• The CMA dismissed ‘relevant’ customer benefits brought forward by Pennon, on the ground that they were not sufficiently evidenced and often unquantified. This is consistent with the traditionally very high bar set by the CMA at phase 1 to take account of countervailing factors. 

A proven path to deal clearance

Getting clearance at phase 1 is not without its challenges. As Pennon / Bristol Water demonstrates, even if the initial phase 1 decision is not unconditionally favourable, this does not necessarily mean the deal is derailed. The parties still have an opportunity to propose UILs that remedy the CMA’s concerns. The CMA’s decision on Pennon’s undertakings shone a light on the CMA’s current thinking around what it might consider to be acceptable UILs. This is welcome, given that in recent years the CMA has acquired a general reputation for being a much tougher enforcer of merger control across sectors.

• The presence of Ofwat as a sector regulator, with statutory powers and supervisory expertise  makes the CMA more open to ‘behavioural remedies’. The CMA will likely defer to Ofwat in terms of what constitutes an acceptable package, as it has a very short window of time to conclude this part of the process (just 5 days). Firms stand the best chance of success if they have pre-agreed their ‘red lines’ on UILs internally before notifying the deal to the CMA and consider as early as possible the strategic narrative and evidence base that will support a potential offer of UILs.
• It is not sufficient that the UILs address the potential harm to customers of both parties (for example, by sharing efficiencies, or removing the small company premium in the current price control). They should also protect the benchmarking quality for the whole industry, which is why the package offered by Pennon focused on maintaining separate reporting / forecasting, and separate wholesale water price controls. 
• The “accounting” separation required to support separate wholesale price controls may create additional internal complexity and erode some regulatory cost efficiencies. But it will also provide the business with a clearer picture of where it is performing well (or not), which more enlightened operators will see as a potential lever for future value generation. 
• Encouragingly for firms and investors, the undertakings do not require any material degree of operational separation. This should enable the parties to continue integrating the businesses and achieve the stated benefits of the merger.
• It will be interesting to see whether the undertakings will remain in place for the long term. If the performance between the two businesses converges significantly, driven by integration, sharing of best practices and setting common price control parameters (Output Delivery Incentives rates and Performance Commitments), the detriment on Ofwat’s benchmarking may diminish over time.

What are the prospects for further water mergers? 

The recent Pennon / Bristol Water decision signals that Ofwat and the CMA are open to consolidation. It remains to be seen if this will spark a dash for acquisitions of smaller water companies but, for those weighing up their options in the industry, there are some key takeaways: 

1. Each additional merger of water companies in England and Wales will face a greater hurdle, as the impact of the deal on various aspects of Ofwat’s benchmarking will be more pronounced. 
2. Firms and investors should be realistic as to the prospects of unconditional deal clearance, and be prepared from an early stage to offer undertakings. 
3. With a carefully thought-through strategy and robust evidence, it is possible to get the deal through at phase 1. The CMA and Ofwat seem prepared to accept a package of behavioural remedies that allows for a very significant degree of integration, so investors should not be unduly discouraged. 
4. The key to minimising friction in clearance is to embrace reasonable principles of accounting separation, share benefits with all customers and develop a constructive pre-deal engagement strategy with Ofwat. 
5. The specifics of the case will have a bearing on the approach. For example, a merger of two larger water and wastewater companies may call for a more creative approach to UILs, potentially involving the creation of the first ‘wastewater only’ company in England and Wales, alongside a ‘water only’ company.

The untrodden route to clearance

Merging water parties do have the option to press their case for unconditional deal clearance by progressing to an in-depth phase 2 investigation instead of offering undertakings at phase 1. At this point Ofwat’s role in the process changes significantly. Ofwat becomes an interested third party and the CMA is not obliged to place any weight on its opinion. In some ways the CMA’s role during the phase 2 process resembles the regulatory appeal model, where the CMA is asked to review Ofwat’s price determination and form its own conclusions. We have recently seen in the PR19 appeals that the CMA does not shy away from taking an independent stance and reaching different conclusions on important aspects of those price determinations. 

Testing the phase 2 process would open new strategic plays for the firms involved. Given the time and cost involved, it would take a brave party to explore such an untrodden route. Most likely, firms and investors will likely feel it is not worthwhile for the acquisition of a small water-only company, but this may be necessary to unlock the potential for consolidation among larger water and wastewater undertakers.