• UFACEX UK Holdings plc, a subsidiary of Union Electrica Fenosa S.A., announced on 14 December 1999 that it had acquired share capital in Cambridge Water plc and intended to acquire the outstanding share capital. The Board of Cambridge Water plc supports the offer, which is valued at £54.2million.
• Union Electrica Fenosa S. A., based in Madrid, generates and distributes electricity in Spain. It has investments in telecoms, professional services, and international investments. The company operates in 30 countries worldwide.
• The Competition Commission is not required to examine this proposed takeover as UFACEX UK Holdings plc does not currently operate any water enterprises in England and Wales. Nor do the provisions under the Fair Trading Act (1973) apply as the assets of Cambridge Water plc are below the threshold of £70million and Union Electrica Fenosa has no overlapping activities in the UK.
• The Director General of Water Services has a duty to ensure the company can finance its functions. He also has a duty to promote economy and efficiency.
• Competition in the ownership and control of regulated water and sewerage companies is beneficial as it stimulates existing suppliers to become more efficient. The Director believes Union Electrica Fenosa's experience in delivering utility services in competitive markets will have a positive impact as the company can develop the water supply business as the industry opens up to competition.
• The Director is satisfied that there will be no deterioration to the quality of services provided to Cambridge Water plc's customers. The company's Licence will need to be tightened, as for previous mergers. The Director will expect Union Electrica Fenosa to accept a similar package of Licence amendments.
• The Director needs to be assured of the probity and operational and financial capacity of Union Electrica Fenosa to ensure the activities of Cambridge Water plc continue to be properly carried out. He will make enquiries about the suitability of Union Electrica Fenosa with regulators in markets where the company operates.
• The Director has consulted Eastern Customer Service Committee, the customers' representative, to seek its view of the proposed takeover.
• Further information is provided in The proposed takeover of Cambridge Water plc by UFACEX UK Holdings plc: An information note by the Director General of Water Services. Any comments on this should be provided to Keith Mason at keith.mason@ofwat.gsi.gov.uk

On 14 December 1999, UFACEX UK Holdings plc ("UFACEX UK") announced that it had acquired 48.3% of the ordinary share capital and 60.1% of the non-voting ordinary share capital of Cambridge Water plc, together with a recommended cash offer to acquire the outstanding ordinary and non-voting ordinary share capital of the company. Cambridge Water plc ("Cambridge") is a licensed water undertaker ("Appointee") regulated by the Director General of Water Services ("the Director"). The offer values Cambridge at £54.2 million and is fully supported by the Board of Cambridge. As well as the water supply business Cambridge operates in the gas supply business and markets the supply of electricity.

UFACEX UK is a wholly-owned subsidiary of UFACEX which in turn is a wholly-owned subsidiary of the Spanish-based company Union Electrica Fenosa S.A. ("Union Fenosa"). UFACEX carries out Union Fenosa's international activities and UFACEX UK has been specifically formed for the purpose of acquiring Cambridge. Union Fenosa is based in Madrid and is listed on the Madrid Stock Exchange having a market capitalisation of approximately £3.3bn, compared to a market capitalisation, for example, for the Anglian Water Group of approximately £1.6bn. Its principal activities are the generation and distribution of electricity for the Spanish market. In addition it has investments in telecommunications, professional services and other industrial markets in Spain. Internationally it has activities in over 30 countries worldwide.

For the year ended 31 December 1998, the Union Fenosa group reported turnover of £1.2bn and profit before tax of £133m. This compares to a turnover for the Anglian Water Group of £830m and profit before tax of £258m for the financial year 1998-99.

Union Fenosa does not currently control any water enterprises in the UK and hence the Secretary of State for Trade and Industry is not required to refer this offer to the Competition Commission. There are provisions under the Fair Trading Act (1973) whereby the Secretary of State for Trade and Industry may nevertheless consider whether a reference is appropriate. These do not apply in this case, however, as the gross value of the assets of Cambridge is less than £70m and Union Fenosa does not carry out any overlapping activities in the UK. The EC Merger Regulation does not apply because of the small size of Cambridge.

Nevertheless there are issues concerning competition and regulation arising from the offer which have to be considered by the Director. The Director must decide whether Cambridge's conditions of appointment as a water undertaker need to be modified to deal with these issues.

2. Competition issues

The Director has a number of duties set out under the Water Industry Act (1991). He must seek to secure that the functions of the water and sewerage undertakers are properly carried out and that the companies appointed for those purposes are able to finance their functions. He must also protect the interests of customers, for example over the price and standards of the services they receive. He can achieve this by promoting efficiency on the part of the companies providing those services and by both developing competition in their provision and minimising anti-competitive behaviour in the water industry. The Director's powers in relation to competition will be strengthened by the Competition Act 1998.

In principal the Director is of the view that competition in the market for ownership and control of licensed utilities is beneficial. This is because it may stimulate existing owners to be more efficient in the service they provide as well as encouraging prospective owners to take advantage of opportunities which are not being fully exploited by the existing ownership. The Director believes that the financial strength of Union Fenosa and its experience in delivering competitive utility services could have a positive impact by encouraging Cambridge to develop its water supply business as the water sector continues to open up to competition over the coming years.

As Union Fenosa is a new entrant to the UK water industry, the Director will need to be satisfied that it is `fit and proper' to control a water undertaker. He will consider whether it has a track record of managing similar businesses and the probity of its management. Although Union Fenosa has experience in providing utility services (mainly electricity) in international markets it has no UK experience. The Director will be approaching the appropriate regulators in the principal markets where Union Fenosa operates to satisfy himself that it is competent to take on the responsibilities of owning a water company in the UK.

3. Regulatory issues

3.1 Comparative information

Effective regulation of the UK water industry continues to rely on the Director's ability to compare companies. It is the Director's view that apart from the prospective loss of stock market information (discussed below) this proposed merger would not involve the loss of a comparator for use in making regulatory judgements. However, for Cambridge to continue to be effective as an independent comparator the Director would need to ensure that the regulated water business is adequately ring fenced.

In the case of other mergers involving small water companies, the Director has secured licence amendments to provide him with access to information about the performance and costs of the regulated water business and also to secure the financial separation and independent management of that business. More recently, as part of the Periodic Review, he amended the licences of those smaller water companies which are part of larger groups in order to strengthen the ring fence. The Director considers that these licence amendments are appropriate for Cambridge. Similar licence modifications were also required to achieve these objectives in the only other instance where a non-UK business acquired a water company. (Azurix Europe plc's acquisition of Wessex Water in 1998).

The Director will expect Union Fenosa, if they become the new owners of the Appointee, to agree to these licence modifications.

The loss of a London Stock Exchange ("LSE") listing is an issue because the Director no longer has access to how the financial markets perceive Cambridge. However due to the low frequency of trading and the concentration of share ownership together with the small size of Cambridge, the Director does not consider the detriment to be as significant as in previous cases, for example with the Azurix/Wessex merger.

4. Proposed licence modifications

The proposed licence modifications seek to address five main areas of concern.

4.1 Financial ring-fencing

The UFACEX UK offer is cash based but is unlikely to impact significantly on the gearing of Union Fenosa. However the group is an international concern and the Director will need to ensure that the financial viability of the Appointee is protected from the Group's exposure to risk in other markets such that the Appointee can continue to finance its functions and implement its capital programmes. This can be dealt with by licence modifications on financial ring- fencing and dividend policy similar to those agreed in the take-over of other small water companies.

The proposed licence modifications would:

• prevent the giving of loans or guarantees to associated companies and further secure the financial position of the regulated business by preventing it raising finance on terms which include cross-default covenants related to other potentially more risky parts of the Union Fenosa Group; and
• ensure that Cambridge's dividend payments do not exceed amounts which would, in the Director's opinion, preserve its ability to continue to discharge its water utility functions and to finance them.

Cambridge will be incorporated into a much larger group, and, therefore, it will be necessary to strengthen the existing ring-fence around other aspects of the Appointee's core water business and assets, as well as ensuring the financial viability of the Appointee. This is required to ensure that the Appointee continues fully to meet its obligations as a water undertaker. The proposed licence modifications would:

• require that trading between the regulated business and other parts of the Union Fenosa group is at arm's length and subject to market testing;
• require the Board of the regulated business to certify annually to the Director that the terms of all such contracts safeguard Cambridge's ability to perform its core functions and achieve proper standards of service; and
• prohibit the transfer of assets to associated companies without the Director's consent.

In previous mergers, concerns have been expressed about the potential for less effective management of the regulated business following the merger.

The Director requires the licence holder to be the effective decision taker as regards the regulated business and that its management should be able to demonstrate an adequate degree of independence and have clear responsibility for regulatory matters. In this case, the Director would expect the licence to remain with Cambridge and this to be the key decision taking body. To address concerns about management of the regulated business, he would expect licence modifications to be agreed to strengthen the management independence of Cambridge as follows:

• Cambridge should be required to conduct its core business 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 Board of Cambridge should contain at least three independent non-executive directors of standing with relevant experience who shall collectively have connections and knowledge of the area in which Cambridge serves and an understanding of the interests of Cambridge's customers and how these can be respected and protected;
• the Director should be notified without delay of any change to composition of the Board or responsibilities of Board members; and
• Cambridge should adhere to the corporate governance principles as contained in the Principles of Good Governance and the Code of Best Practice as required by the listing rules of the LSE.

4.4 Stock Exchange listing and corporate control

The merger would result in an additional loss of a listing on the LSE and the loss of market information. However in this case the Director is of the view that the detriment is minimal and would not seek a remedy for this as has been the case with larger mergers. However he would seek a licence modification to ensure that Cambridge publishes its annual results as if it were still listed on the LSE and that these results and the accounts of the company should be subject to public discussion in a manner similar to a conventional AGM. As a minimum he would expect Union Fenosa to commit to hold at least one annual customer meeting to provide an opportunity for customers to question Cambridge and Union Fenosa management following the publication of Cambridge's annual report.

4.5 Access to Information

The Director has powers to require information from regulated companies about their regulated activities. The ability to carry out his duties depends on continued access to high quality information. The merger could make this more difficult and therefore licence amendments would be necessary to ensure sufficient access to information from any company within the Union Fenosa Group. This involves information both on present performance and that needed for future reviews of price limits.

5. Affect on customers of the proposals

The Director will expect Union Fenosa, if they become the new owners of the Appointee, to agree to the proposed licence modifications. If that is the case, then the Director is satisfied that there will be no deterioration in the quality of service provided to Cambridge's customers. Union Fenosa appreciate the need for adequate ring fencing for Cambridge and for independent local representation on Cambridge's Board and are willing to discuss appropriate licence modifications. The obligations imposed by the Water Industry Act and the licence issued under it would continue to apply and the Director believes that the proposed takeover should not adversely affect customers in any way.

Any comments on the proposed take-over and on the proposed licence amendments in particular should be sent to;

Keith Mason
Head of Regulatory Accounts
Office of Water Services
Centre City Tower
7 Hill Street
Birmingham
B5 4AU

or at

keith.mason@ofwat.gsi.gov.uk

by Friday 31 December 1999.