SUMMARY OF SEVERN TRENT PLC AND SOUTH WEST WATER PLC: A REPORT ON THE PROPOSED MERGER

On 21 March 1996 Severn Trent Plc (ST) announced its intention to make a bid for South West Water Plc (SWW). ST and SWW own regulated water and sewerage businesses, respectively Severn Trent Water Ltd (STW) and South West Water Services Ltd (SWWS).

STW is one of the largest of the ten water and sewerage companies (WaSCs) in terms both of turnover and area covered. It provides water and sewerage services in an extensive region of central England and Wales. 8.3 million customers obtain their sewerage services from the company, while water services are provided to 7.2 million customers. A water-only company (WoC) supplies the remaining 1.1 million. SWWS supplies water and sewerage services to around 1.5 million customers, principally in Devon and Cornwall.

Under the reference made to us on 21 May 1996 (Appendix 1.1), we are required to decide whether arrangements are in progress which if carried into effect would result in the creation of a merger of two or more water enterprises which is required by section 32 of the Water Industry Act 1991 (WIA) to be the subject of a reference. We are satisfied that arrangements for such a merger are in progress.

Sections 32 to 34 of the WIA (Appendix 1.2) make special provisions for references to the MMC of such mergers. Section 34(3)(a) provides that in determining whether such a merger operates against the public interest the MMC `shall have regard to the desirability of giving effect to the principle that the Director's [Director General of Water Services-DGWS's] ability, in carrying out his functions ..., to make comparisons between different water enterprises should not be prejudiced'. The system of comparative competition by which the water industry is regulated depends upon the DGWS's ability to make such comparisons.

The availability of a wide range of comparative information about companies' costs and levels of service is important to the DGWS in enabling him both to set prices at each Periodic Review and, between Reviews, to secure higher standards of performance and customer service. The uses which the DGWS makes of comparisons between companies has been developing as the industry has evolved since privatization.

ST argued that as it intended to maintain STW and SWWS as two separate WaSCs following the merger, with two separate managements and separate appointments, SWWS would remain as valuable as it had previously been for comparative purposes. We reject that argument. Companies which are not independently owned are not adequate substitutes, as comparators, for independently-owned and -managed companies since differences of management style and management priorities may well be significant factors in determining performance. ST's own proposals emphasized the degree of integration which it envisaged for SWWS and STW following the merger. ST would moreover dictate overall direction and strategy. SWWS would in our view to all intents and purposes be lost as a comparator.

We consider that this proposed merger, involving as it would for the first time the loss to the comparator system of one of the ten WaSCs, is of a different order to any that have previously taken place in the industry. We consider that SWWS is of substantial value to the DGWS for comparative purposes. This is particularly the case on the sewerage side, where the DGWS already has difficulties in making robust comparisons of operating efficiency with only ten comparators. The loss of SWWS as a comparator would weaken the comparative system across the range of uses to which comparisons are put. We do not, however, think that this loss can be reliably quantified.

Our conclusion under section 34(3)(a) of the WIA is that the loss of SWWS as a comparator would seriously prejudice the DGWS's ability to make comparisons between different water enterprises.

We considered the cost savings, namely some 30 million of annual cost savings by the year 2001, and other benefits that ST claimed for the merger. SWW considered that annual cost savings of at most 10 million a year were possible, all from head office savings. We conclude in the terms of section 34(3)(b)(ii) of the WIA that the prospective savings and other benefits to be expected from the merger are insufficient to be of `substantially greater significance in relation to the public interest' than the principle that the DGWS's ability to make comparisons between different water enterprises should not be prejudiced.

We conclude that the acquisition of SWW by ST 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 different water enterprises.

We are required under section 72(2) of the Fair Trading Act 1973 (FTA), which applies to this reference, to consider what action should be taken to remedy or prevent that adverse effect.

The DGWS told us that any remedy for the loss of SWWS to ST would have to involve a package of measures, which should include an undertaking by ST to make immediate, very substantial reductions in charges to all customers of the merged enterprise, in order to force it beyond the current `efficiency frontier' for the industry and to become an exemplary comparator. In practice, however, he was unable to envisage any realistic remedy for the detriment that would result from the proposed merger. ST itself did not consider that the level of price reductions cited by the DGWS was feasible and believed that any such reductions should apply only to SWWS's customers. We are not convinced that ST would be able to make efficiency savings sufficient to enable such reductions to be made.

We take the view that in respect of this proposed merger no remedy, even in the shape of very significant price reductions aimed at forcing the merged enterprise beyond the current efficiency frontier, would be sufficient to compensate for the loss of SWWS as a comparator. The loss of SWWS as an independent WaSC, providing sewerage as well as water comparisons to the DGWS, would be substantial and would weaken the comparative system permanently. Benefits to customers in the shape of lower prices and better service which might be secured as a condition of the merger would, however, be transitory, as the dynamics of the comparative system caused other companies to equal and exceed them over time. We accordingly take the view that no remedy is adequate in this case.

We therefore recommend that the merger be prohibited.

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