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The proposed takeover of Wessex Water Plc by The Enron Corporation:
A consultation paper by the Director General of Water Services
On 24 July 1998, the Enron Corporation ("Enron") announced an offer to acquire all the issued share capital of Wessex Water plc, the holding company of Wessex Water Services Limited which is a licensed water and sewerage undertaker (the "Appointee").
Enron does not control any water enterprises. Therefore, the Secretary of State for Trade and Industry is not required to refer this offer to the Monopolies and Mergers Commission (MMC). However, because the assets of Wessex Water plc are valued at more than #70m, the Secretary of State may nevertheless refer the offer to the MMC.
The Director General of Fair Trading ("DGFT") will advise the Secretary of State whether to make that reference (or whether, instead of such a reference, it might be appropriate for the Secretary of State to seek from Enron binding undertakings, designed to remedy whatever adverse effects DGFT has identified). DGFT looks to the Director General of Water Services ("the Director") for advice on those aspects of the offer which will impact upon the Director''s ability to regulate the Appointee, or might impact upon his wider ability to regulate other licensed providers of water and sewerage services in England and Wales.
To assist him in preparing that advice, the Director invites the comments of interested persons about the issues noted below. However, those responding should feel free to deal with whatever other aspects of the case they believe to be important.
If the Secretary of State refers Enron''s offer to the MMC, it must consider whether the takeover is likely to have effects adverse to the public interest. If it so concludes, the Secretary of State may either prohibit the takeover, or seek remedies. If the MMC makes no adverse public interest finding, the offer may proceed.
If the offer were to be successful, the Director would need to decide whether the Appointee''s conditions of appointment as a water and a sewerage undertaker ought to be modified, in order to deal with regulatory issues arising from the takeover. Those which he has so far identified are set out in the section headed Regulatory Issues below.
The Director's role under the Water Industry Act 1991
The Director is required to carry out his role as economic regulator of the water and sewerage industries in England and Wales in the manner in which he considers best calculated to ensure that certain objectives are achieved. For example, he must seek to secure that the functions of water and sewerage undertakers are properly carried out and that the companies appointed for those purposes are able to finance their functions.
Subject to that, he must protect the interests of customers, for example over the price and standards of the services which they receive, by promoting efficiency on the part of the companies providing those services and by facilitating competition in their provision.
Competition in the market for ownership and control of licensed utilities is likely to be beneficial. It may stimulate existing owners and managers to strive for greater efficiency and better service to customers. At the same time, prospective owners may be encouraged to pursue their interests whenever they think that those currently in charge of the utilities are not taking full advantage of those opportunities.
Therefore, the Director accepts in principle that changes of ownership following takeovers may be beneficial. At the same time, because he is concerned that the functions of water and sewerage undertakers should be properly carried out, he wishes to be satisfied, in each particular case, that the prospective owner has the probity and operational and financial capacity to assume that role. This issue is of particular importance as Enron has no directly-relevant experience of the provision and financing of UK water and sewerage services. The Director will form an opinion of Enron''s standing in this context. He is interested to understand the views of others.
Regulatory Issues
The only previous example of a takeover like this one, from outside the water and sewerage industry, was that by ScottishPower plc for Southern Water plc. In that case, the successful offer created the possibility that ScottishPower plc would provide electricity as well as water and sewerage services i.e. would be a multi utility company. This consideration does not apply in the present case. However, the Director considers that the current offer does present similar issues to this and other previous mergers and invites comments on the proposed measures which are set out below.
Comparative information
One of the Director''s most important tools for the regulation of water and sewerage companies is the ability to make comparisons between them (comparative competition). When advising DGFT, the Director will assess whether Enron''s prospective ownership of Wessex Water plc might adversely affect his ability to make those comparisons.
Wessex Water plc''s shares are listed on the London Stock Exchange (the "Stock Exchange"). If it is taken over by Enron, that listing will cease. The de-listing of Wessex Water plc''s shares would also disapply the Stock Exchange''s public disclosure rules and remove the Appointee''s performance from scrutiny by the public, City analysts and shareholders. It would reduce the Director''s ability to form a judgement about how the financial markets perceive Wessex Water plc and its operations, of which the Appointee''s activities are a major component. That in turn would remove the Director''s ability to compare the market''s ratings of Wessex Water plc with other listed owners of licensed water and sewerage utilities. It would also affect his ability to make judgements about an appropriate cost of capital for the water and sewerage industries.
It would also reduce to 5 (from the original 10) the number of listings of water and sewerage companies (excluding multi utilities). As listings are lost the value of those remaining become greater.
These detriments might be remedied in one of several ways. First, the Appointee could agree to licence modifications to publish financial information as if it were listed and subject to the rules of the Stock Exchange. Further Enron might agree to re-list its UK water interests on the Stock Exchange in the near future. It might alternatively list a class of equity, which would provide investors with a return related to the Appointee''s performance, as well as financial information for them and the Director. A further possibility is the listing of preference shares (or other financial instruments) in the Appointee''s holding company, which would provide some market information, albeit less than would a listing of equity.
Apart from this prospective loss of stock market information, the proposed merger would not involve the loss of a comparator for use in making regulatory judgements about efficiency and standards of services. However, if the proposed merger were to proceed, some functions might be combined within the enlarged group. This might affect the comparability of the regulated business with others. The proposed arrangements for access to information and ring fencing discussed below would help to secure continued comparability.
Financing of functions
Enron's offer for Wessex Water plc''s shares relies substantially on debt finance which will increase the gearing of the Enron group. Enron is already an international concern. Its exposure in other ventures in other parts of the world may mean that, if it suffered a sufficiently-severe reverse elsewhere, its response might impede or diminish the Appointee''s financial capacity. Anything, which could prejudice the financial viability of the Appointee would be of concern to the Director.
These concerns could be dealt with by licence modifications on ring-fencing, management and dividend policy, similar to those agreed in the ScottishPower plc takeover of Southern Water plc. There is also a case for requiring Enron to agree that the Appointee''s licence conditions should be modified to prohibit it from raising any finance for its core business on terms which include cross-default covenants. Otherwise, those covenants would enable the lender to treat events of default on loans to other parts of the Enron group as triggering the requirement to repay the Appointee's facilities.
The Appointee's ability to finance its functions might be further safeguarded by requiring Enron to agree that all loan facilities made available to The Appointee or the Appointee for the purposes of Appointee's core businesses should secure and retain investment grade credit ratings, or an equivalent. However, the Director considers that the licence modifications proposed in this paper would make it unnecessary to stipulate such a rating.
Ring-fencing of the Appointee''s core businesses and assets, including management resources
The Director is considering whether Enron's prospective ownership of Wessex Water plc (and therefore, its control of the Appointee) calls into question the adequacy of the ring-fencing arrangements around the Appointee''s core water and sewerage businesses. Ring fencing arrangements are necessary to enable effective regulation of the water utility in a wider group. The Director has compared this possibility with the situation which arose following recent takeovers of Public Electricity Suppliers by parent companies of water and sewerage utilities (and in Scottish Power''s takeover of Southern Water, the owner of Southern Water Services Ltd ).
He believes that if Enron''s offer were to be successful, the ring-fence around Appointee''s core business and assets ought to be strengthened by means similar to those employed in those earlier cases. For example:
- The Appointee's trading between the core businesses and other parts of the Enron''s group should be at arm''s length and be subject to market-testing. The Appointee''s Board should certify annually to the Director that the terms of all such contracts safeguard the Appointee''s ability to perform its core functions and achieve proper standards of service;
- The Appointee should be prohibited from offering financial support to other parts of the Enron group (whether by guarantee or loan or equivalent) without the Director''s consent. It should also be prohibited taking up loans, which contain cross-default covenants; and
- The Appointee should be required to obtain from Enron an undertaking that the latter would provide to the Appointee all information about other activities which the Appointee might be required to provide to the Director for the purposes of his supervision of the Appointee's core businesses and that Enron would ensure that no group company did anything which might result in the Appointee breaching any of its statutory or licence obligations as a water or a sewerage undertaker.
Management of the Appointee's water and sewerage undertakings
Wessex Water plc's acquisition by the Enron group should not compromise the effective management of Wessex Water Services Ltd. In response to previous consultation papers issued by the Director on mergers of utilities, concern was expressed about the loss of managerial effectiveness as a result of the merger.
Furthermore, the Director needs to know where key decisions are taken and to have a close relationship with the Board who will be taking those decisions. This in turn raises the question of where the licence is held. The Director considers that the licence should be held where the key decisions are taken and if the licence holder is a subsidiary company, it should be able to demonstrate an adequate degree of independence and that its Directors have clear responsibilities for regulatory matters.
In previous mergers, the Director agreed licence amendments which strengthened management independence of the water utility as follows:-
- The appointee should be required to conduct its core businesses as if it was substantially the sole business undertaken and it was a separate public limited company;
- The composition of the Board should be such that it could act independently of the parent, and the Directors should act exclusively in the interests of the water utility if conflicts of interest arose and that they should not vote on contracts where they have interests by virtue of other Directorships;
- The appointee''s dividend payments should not exceed amounts which would, in the Director''s opinion, preserve its ability to continue to discharge its water and sewerage utility functions and to finance them; and
- The appointee should be required to obtain from its ultimate parent company an undertaking to ensure that the appointee's Board contains at least two non-executive directors of standing and having relevant experience in the recognition and protection of customers' interests. In addition, in Wessex Water's case, if the licence is not held by the key decision-taking body, then it may be necessary for there to be a formal protocol between the Appointee and this body. This protocol would, inter alia, set out the formal roles of each board in order to secure the appropriate degree of independence and responsibility of the utility.
Access to information
The Director has powers to require information from regulated companies about their regulated activities. He needs to secure continued access to sufficient high quality information to allow him to carry out his duties.
The task of obtaining information on the water utility could be made more difficult by the merger. Licence amendments will be necessary, as in the case of earlier mergers, to ensure sufficient access to information from any company within the enlarged group. This involves information both on present performance and on that needed for future reviews of price limits.
The need for licence modifications
The Director considers that the measures which he has suggested ought to be achieved by modification of the Appointee''s conditions of appointment as a water and a sewerage undertaker.
Prices and service standards
Customers will look to the Director to ensure that the Appointee''s core businesses continue to provide requisite standards of service at appropriate prices. Irrespective of the ownership of Wessex Water plc, the Appointee will continue to have the obligations imposed upon it in primary legislation (especially the Water Industry Act 1991) and the conditions of its Appointments as a water and a sewerage undertaker. The Director will continue to regulate the Appointee under those provisions. The Appointee''s existing price limits allow it to improve its service to customers. Customers should be able to assume that a change of ownership makes no difference. The Director will exercise his powers to that end, both in relation to existing commitments and those which follow from the Periodic Review of price limits which will take effect on 1 April 2000.
The Director's proposed actions pending the Secretary of State''s decision whether to refer Enron''s offer to the MMC
The Director will formulate his advice to the DGFT. To meet the latter''s timetable for advising the Secretary of State, responses to this consultation should be made by Wednesday 5 August 1998.
The Director will also discuss with Enron the issues noted above. He will seek from Enron appropriate commitments about his proposals for the modification of Appointee''s licence, to deal with his concerns, as noted earlier in this paper. He will reflect the outcome of those discussions in his advice to the DGFT.
Those responding to this consultation should write to David Rees, Corporate Finance Advisor, Office of Water Services, Centre City Tower, 7 Hill Street, Birmingham B5 4UA (Fax 0121 625 3609). Each response will be placed in Ofwat''s Library for public inspection, unless it is clearly marked "in confidence".
A copy should also be sent to Ms Olwyn Parsons at the Office of Fair Trading, Field House, 15-25 Bream''s Buildings, London EC4A 1PR.
David Rees
Corporate Finance Advisor
Office of Water Services
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