MD136

TO MANAGING DIRECTORS OF ALL

WATER AND SEWERAGE COMPANIES

AND WATER ONLY COMPANIES

6 July 1998

THE TREATMENT OF MERGER SAVINGS AT THE PERIODIC REVIEW

I set out my views on the methodology for the 1999 Periodic Review in "Setting price limits for water and sewage services: The framework and business planning process for the 1999 Periodic Review" in February 1998. Since the 1994 Periodic Review there have been a number of mergers in the industry: both water-water mergers and those which created multi-utilities. I wish to ensure that all companies are treated consistently and am now writing to invite your considered views on proposals for the treatment of merger efficiency savings, intended to maintain incentives for out-performance.

Mergers – implications for all companies

The February framework paper states that I will be setting efficiency targets for each company for the five years of new price limits. These will be based on separate but linked assessments of the scope for both operating and capital efficiencies in the manner set out in "Assessing the scope for future improvements in water company efficiency: A technical paper".

The consultation paper, "The proposed framework and approach to the 1999 Periodic Review: A consultation paper", published in June last year, explained that in assessing past efficiencies, relative efficiency rankings and the scope for future efficiency, I propose to treat multi-utilities in the same way as other companies. In particular, in setting both industry-wide and company-specific efficiency targets I propose to take account of the scope for economies of scale and synergy savings that multi-utilities may have.

For the Periodic Review, actual costs will be used for the comparative efficiency analysis. All cost savings, however achieved, will be taken into account. This will ensure that all savings whether arising from mergers or other management actions will play a part in influencing our reasonable expectations about future efficiency improvements for the industry as a whole, and for individual companies.

The key question in considering merged companies at the Periodic Review will be whether the merger has produced savings over and above those which other companies have achieved by other means. This will be determined by considering whether the merged company has become a leading comparator as assessed by the comparative efficiency analysis. If it has not, it is difficult to see how customers may benefit financially from the merger.

Water-water mergers – implications for merged companies

For mergers between two water (and sewerage) undertakers, price cuts have generally formed part of a package of measures designed to ameliorate the loss of a comparator to the regulatory regime. Such cuts are designed to stimulate efficiency through lower costs, and to produce a better comparator as assessed using the comparative efficiency analysis.

For those companies which, following such a merger, have become a leading comparator, price limits will be set as for other companies. No further action is needed, since the merger price cuts have delivered what was intended.

For those companies which have not become a leading comparator by the time of the Review, it will be necessary to ensure that the particular pressure created by the agreed price cuts survives the Periodic Review. If necessary, I intend to adjust the costs of such companies so that the expected reductions in costs resulting from the agreed price cut are taken into account. In practice, this may best be done by comparing i) the aggregated pre-merger costs of the merged companies net of the agreed phased revenue reductions with ii) target costs for the merged group derived from our comparative efficiency analysis. If this suggests that, in order to preserve the trend of costs implied by the merger agreement, the company needs to be encouraged to move more quickly towards the efficiency frontier, its efficiency targets will be adjusted accordingly.

To preserve incentives, it is important not to act retrospectively by removing achieved merger benefits as well as enforcing beyond the Periodic Review price cuts which have been agreed and delivered before it. By using pre-merger costs and the agreed phasing of price cuts in i), I believe that companies are protected from such double jeopardy.

Other mergers – implications for merged companies

As in the case of water-water mergers, the critical question for other mergers is whether the merged company's customers benefit from efficiency gains greater than those achieved by other companies which have adopted different forms of corporate development. Additionally, if the merged company has become a leading comparator then the whole industry will be stimulated to improve.

In an incentive based framework, it would be appropriate for the methodology to encourage behaviour which results in a merged company becoming a leading comparator. This may be achieved by allowing such a company to continue to profit from some of the savings it has achieved by virtue of the merger. One practical way of doing this would be to allow the company to retain a proportion of the marginal efficiency improvement over the second best comparator. Some of the improvement, however, may have been due to factors other than the merger and consequently would not warrant special treatment. Your views are invited on how much of this difference should be retained and for how long as well as on how it may be quantified.

For water companies that have made acquisitions, there can, therefore, be no deterministic link between the acquisition costs and expenditure to achieve synergy savings and the price limits that I set. It would create perverse incentives to reward a company merely because it has chosen a merger with another utility as a means of securing savings, if that company has achieved less by way of efficiency gains than other companies that have followed more effective strategies.

Hence, I propose to treat those merged companies which have not moved to the forefront of efficiency in the same way as all other (non-merged) companies. Shareholders in such companies will nevertheless benefit from all savings from the merger up to the Periodic Review and savings achieved outside the utility.

Your comments on these proposals are invited by Friday, 31 July 1998.

I C R BYATT