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The proposed takeover of Hyder Plc by St David Capital Plc:
A joint consultation paper by the Directors General of Ofwat and Ofgem
Introduction
1. On 18 April 2000, the Boards of St David Capital plc ("St David Capital") and Hyder plc ("Hyder") jointly announced that they have agreed the terms of a recommended cash offer to acquire the whole of the issued ordinary share capital of Hyder.
2. Hyder is a multi-utility company; it is the holding company of both Dwr Cymru Cyfyngedig ("Dwr Cymru") and South Wales Electricity plc ("Swalec"), companies which are regulated by the Director General of Water Services ("DGWS") and the Director General of Gas and Electricity Markets ("DGGEM") respectively. The Directors are issuing a joint consultation paper on the regulatory issues involved.
3. Hyder is believed to be the largest private sector employer in Wales. In 1996 Hyder purchased Swalec, the South Wales Electricity Company, this was followed by a more recent sale of the electricity retail supply business to British Energy.
Statutory position on mergers
4. The offer by St David Capital gives rise to a merger situation under the Fair Trading Act 1973, whereby the Secretary of State for Trade and Industry may refer a proposed merger or acquisition to the Competition Commission ("the Commission"). It is the responsibility of the Director General of Fair Trading ("DGFT") to advise the Secretary of State as to whether a merger or acquisition should be referred to the Commission (or whether instead of such a reference, it might be appropriate for the Secretary of State to seek binding undertakings from the new owners to remedy any adverse effects the DGFT has identified). Where a merger proposal involves a regulated business the DGFT will seek advice from the relevant Regulator (or Regulators as in this case), before advising the Secretary of State, on aspects of the proposal which would impact on their ability to regulate the licence holders.
5. If the Secretary of State refers St David Capital''s offer to the Commission, it must consider whether the take-over is likely to have effects adverse to the public interest. If the Commission so concludes, the Secretary of State may either prohibit the take-over, or seek remedies. If the Commission makes no adverse public finding, the offer may proceed.
6. This paper sets out the key issues on which the Directors will need to advise the DGFT. To assist them in preparing that advice, the Directors invite the comments of interested parties about those issues. However, those responding should feel free to deal with whatever other aspects of the proposals they believe to be important.
7. If the offer were to proceed, the regulators would need to consider what modifications might be required to the licences held by Dwr Cymru and Swalec, in order to deal with the regulatory issues arising from the take-over. Any proposed licence modifications are set out in this paper.
Details of the proposed acquisition and parties involved
8. St David Capital is a company established by the Principal Finance Group ("PFG"), a division of Nomura International plc ("Nomura"), for the purpose of making the offer for Hyder. PFG have stated that they will finance the acquisition and provide financial and strategic guidance to the operational development of Hyder. PFG was established in 1994 and has a record of acquiring and developing businesses in the UK and US; it has been involved in similar transactions for example involving Angel Trains Contracts Ltd, a rolling stock leasing company, and the sale of housing stock by the Ministry of Defence. Nomura is a European subsidiary of Nomura Securities Co Ltd, a Japanese investment bank.
9. Dwr Cymru is a water and sewerage undertaker covering an area of around 21,000 square kilometres and serving the majority of Wales with approximately 2.9 million customers. Swalec has around 0.9 million customers connected to its distribution network. The area covered by its distribution network is approximately 12,000 square kilometres, incorporating all of South Wales. Swalec is the smallest regional electricity distributor in England and Wales but has a relatively long and capital intensive network, primarily due to the geography of the area.
Duties of the Regulators
10. The duties of the DGWS are set out in the Water Industry Act 1991 and Water Industry Act 1999 ("Water Acts") and for DGGEM, in respect of the electricity industry, in the Electricity Act 1989 ("Electricity Act"). Their duties are not identical but are similar as far as the regulatory issues raised by the proposed merger are concerned.
11. The Directors'' duties, as stated in the relevant sections of their respective legislation, are to ensure that companies properly carry out their functions and that they can finance the proper provision of those services. They also have duties to protect customers. The Directors have further duties to promote efficiency and economy by the regulated businesses and to promote the efficient use of utility services by consumers. They also have duties towards the development of competition in the provision of utility services and in minimising anti-competitive behaviour in their respective industries. These powers have been recently strengthened by the Competition Act (1998).
12. An important aspect of competition is in the market for ownership and control of licensed utilities. Competition in ownership may stimulate existing owners to be more efficient in the service provided as well as encouraging prospective owners to take advantage of opportunities that may not have been fully exploited by the existing ownership.
Issues for consideration
13. The offer involves a take-over of two UK regulated businesses by a financial institution that has no current involvement in either regulatory regime or track record of management of a regulated utility either in the UK or abroad. This is the first example of the acquisition of a multi utility by such a company, but there have been a number of take-overs by parties with no prior involvement in the particular markets of either water and electricity companies. For example in water, Azurix Europe plc''s ("Azurix") acquisition of Wessex Water plc ("Wessex") in 1998 and in the electricity sector there have been a number of take-overs by US companies.
Competition issues
Change in ownership
14. As highlighted above, competition in the market for ownership and control of licensed utilities is likely to be beneficial. However both Regulators will need to be satisfied that Nomura, as prospective owner of SWALEC and Dwr Cymru, is a suitable company and has the operational and financial capacity to assume this role.
15. In particular, over the next five years, Dwr Cymru must deliver, within existing price limits, a capital programme for its water and sewerage businesses worth in excess of #1 billion. The DGWS is keen to ensure that under this new ownership Dwr Cymru will remain capable of delivering, in an efficient manner, this capital programme. He looks for commitment from the new owners that the take-over will not prejudice completion of the investment programme and that Dwr Cymru will continue to have available to it sufficient financial resources and facilities to carry out the programme along with its other regulated activities.
16. Swalec will be expected to continue to seek further improvements in efficiency and quality of supply in its electricity distribution business and DGGEM will wish to be satisfied that the merger will not in anyway prejudice Swalec''s ability to deliver these improvements. In the 1999 review of electricity distribution price controls, Swalec was identified as having below average levels of system performance.
17. The Directors will form an opinion on Nomura''s and St David Capital''s standing in this context and are interested to understand the views of others. In particular, the Directors will wish to understand fully the financing arrangements to be put in place to enable St David Capital to implement its offer (including the means by which capital providers expect to recover their investment and provide any additional financial support that either utility might expect in the future to require). The Directors will wish to be satisfied that the existing provisions of Swalec''s and Dwr Cymru''s respective licences, together with the further modifications proposed in this paper, may be expected to be sufficiently robust to withstand any pressures that arise as a result of the proposed change of ownership.
Market competition
18. The Directors have duties towards the development of competition between licence holders. The Competition Act 1998 has opened the prospect of increased market competition. In the water industry in particular, this is being developed through shared networks (also known within the industry as common carriage). The Directors believe that the change in ownership for Hyder should not negatively impact either on the opportunities for common carriage or on the development of competition in electricity distribution.
19. Because Nomura has no existing activities in the electricity market the DGGEM has no concerns relating to vertical integration.
Comparative information
20. Both Directors attach considerable importance to their ability to use comparative information from different companies to assist in the regulation of their respective industries. Apart from the prospective loss of stock market information (discussed below), this proposal would not result in the loss of a comparator for making regulatory judgements.
21. Following Dwr Cymru''s acquisition of Swalec in 1996 the DGGEM lost its stock market information. However, the shares for the combined company, Hyder, continued to be listed on the London Stock Exchange which provided the Directors with market information, albeit for the multi- utility. In addition listed preference shares were issued by Dwr Cymru. If the bid is successful Hyder''s ordinary share listing will cease. This would reduce scrutiny of Hyder plc''s performance by the public, City analysts and shareholders. It would reduce the Directors'' ability to form judgements about how the financial markets perceive Hyder plc and its operations, of which Swalec and Dwr Cymru''s activities are major components.
22. To address the concerns raised by the current proposal, the DGWS (as was required when Azurix took over Wessex) would expect licence amendments to remedy such a loss of information as follows:
* A condition requiring Dwr Cymru to maintain the listing of a financial instrument (bond or preference shares) on the London Stock Exchange;
* A condition requiring Dwr Cymru to publish information about its interim and final results, as is required by the listing rules for a company with ordinary shares listed on the London Stock Exchange. This condition would also require that the results and the accounts of the company should be subject to public discussion in a manner similar to a conventional Annual General Meeting.
23. DGGEM shares these concerns. In connection with a number of more recent mergers involving listed companies holding public electricity suppliers (PES) licences, the Secretary of State has obtained assurances from the companies concerned designed to ensure that there is no loss of publicly available financial information relating to the relevant licensees. Ofgem is presently reviewing its requirements for publication of regulatory accounting and other financial information. It will be appropriate to propose any modifications to Swalec''s licence relating to the publication of financial information once this review has been completed.
Financial issues and ring-fencing of the regulated businesses
24. Nomura, which is providing the finance for the purchase of Hyder through its PFG division, is an international bank. Its exposure in other ventures in other parts of the world may mean that, if it suffered financial constraints elsewhere, its response might impede or diminish the financial capacity of the regulated businesses. Anything that could prejudice the financial viability of Dwr Cymru or Swalec would be of concern to the Directors.
25. For Dwr Cymru these concerns are partially dealt with by the existing licence conditions dealing with ring fencing, management and dividend policy that were agreed at the time Dwr Cymru acquired Swalec to create Hyder plc in 1996. The intention was to enable the DGWS to effectively regulate the water utility within the wider group.
26. Similarly, at the time of the take-over of Swalec, the DGES required modifications to its PES licence in order to introduce a number of provisions, collectively known as the financial ring-fence, designed to ensure that Swalec remained able to finance the conduct of its authorised activities by protecting it from pressures that might arise elsewhere in the Hyder group. The ring-fence provisions were also designed to ensure that the regulator continued to have access to information he may require for the discharge of his functions. Hyder was required to give certain undertakings in support of these protections. If the merger proceeds, Nomura and St David Capital will be required to give similar undertakings.
27. However the DGWS believes there is a case for further strengthening the ring-fencing provisions of Dwr Cymru''s licence and he would expect to make modifications to prohibit it from raising any finance for its core business on terms which include cross-default covenants. Such covenants enable the lender to treat events of default on loans to other businesses within the Nomura group as triggering the requirement to repay Dwr Cymru''s facilities. Similar conditions to strengthen the financial ring fence were imposed on all public electricity suppliers (PESs), including Swalec, by the Director General of Electricity Supply in 1997 following the report of the then Monopolies and Mergers Commission on the PacifiCorp/The Energy Group merger reference.
28. Additionally following its take-over by Azurix, Wessex''s licence was modified to include a condition requiring its new owners to agree that all loan facilities made available to Wessex should secure and retain investment grade ratings, or an equivalent. There are analogous clauses in the licences held by public electricity suppliers. It may be appropriate to include this in Dwr Cymru''s licence.
29. In connection with its group restructuring, initiated in 1998, whereby substantially all the utility operations and service activities of both Swalec and Dwr Cymru are being transferred to other group companies, Ofwat and Ofgem have required Hyder to enter into a number of undertakings designed to ensure that the respective utility licensees retain full operational control over their networks and utility functions. These undertakings are analogous to those Ofgem has recently required to be given by TXU Europe and EdF International in connection with the outsourcing by Eastern Electricity and London Electricity of substantially all their network operations to a joint venture company. It will be important to ensure that Nomura and St David Capital enter into similar undertakings if the merger proceeds.
Management of appointed businesses
30. It is important that Hyder plc''s acquisition by St David Capital should not compromise the effective management of Dwr Cymru and Swalec.
31. The DGWS considers that the licence for a water and sewerage undertaker should be held where the key decisions are taken. If the licence holder is a subsidiary company it should be able to demonstrate an adequate degree of independence and its Directors should have clear responsibilities for regulatory matters. While most of these concerns are dealt with by existing licence conditions that strengthen the management independence of Dwr Cymru, the DGWS considers that additional modifications should be made. This is to reflect the current best practice in terms of the licence modifications that have recently been included in other water companies licences. The additional modifications are:
* Increase the minimum number of independent non-executive directors on the Dwr Cymru Board from two to three; and
* Require Dwr Cymru to comply with any Principles of Good Governance and Code of Best Practice as may be incorporated into or approved for the purposes of the Listing Rules of the London Stock Exchange.
Comments Invited
32. The Directors would welcome comments on the paper by 5pm on Tuesday 9 May 2000, in order to meet the timetable set by the Office of Fair Trading. Response can be sent by letter, fax or e-mail to either of the addresses below.
Ms Rachel Graham
Office of Gas and Electricity Markets
Stockley House
130 Wilton Road
London
SW1V LQ1 | Emma Cochrane
Office of Water Services
Centre City Tower
7 Hill Street
Birmingham
B5 4UA |
33. These comments will be placed in the libraries at Ofgem and Ofwat, unless they are marked as confidential. Any comments should also be copied to Pat Fraser at the Office of Fair Trading, Field House, 15-25 Bream''s Buildings, London EC4A 1PR.
I C R Byatt
Director General of Water Services | C McCarthy
Director General of Gas and Electricity Markets |
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