Water industry executives and investors have been digesting last month's Competition Commission report on the merger of South East Water (SEW) and Mid Kent Water (MKW). The transaction is the first merger of water companies to have been reviewed since 2002. It is also the first time the Commission has looked at a water merger under the Enterprise Act 2002, meaning that this is the first case in which it has had the power to make the final decision and to impose remedies. In light of the high levels of corporate activity that have recently taken place in the water industry (and with speculation of future deals rife), the transaction has been eagerly anticipated as something of a test case for future deals.

In the UK, water mergers are subject to a special merger control regime (contained in the Water Industry Act 1991) that is intended to protect Ofwat's ability to make comparisons between water companies. Having the ability to compare the performances of water companies forms a cornerstone of Ofwat's regulatory activities, in particular with regard to regulating prices. Price regulation is a necessary part of Ofwat's function given that water companies operate in local monopolies, largely immune from competition for the supply of water (and sewerage) services to customers in their licensed area. Prices are capped by Ofwat on a five-yearly basis, in light of its assessment of the income needed by each water company to meet its minimum service obligations and to earn a reasonable return for investors. Making comparisons between water companies forms an important element in setting the price cap.

The Commission's investigation was triggered by the acquisition of SEW by two unit trusts managed by Hastings Funds Management. That transaction had the effect of bringing SEW and MKW under common ownership and control since the Hastings funds already owned MKW. The transaction therefore met the statutory definition of a water merger and triggered a mandatory reference to the Commission.

In its report, dated 1 May, 2007, the Commission concluded that the merger could be expected to prejudice Ofwat's ability to make comparisons between water companies. In particular, the merger would reduce the precision of the econometric models from which Ofwat estimates technical efficiency targets and this could be expected to result in Ofwat setting higher price caps at future periodic reviews. The merger would also have some adverse impact on Ofwat's ability to make qualitative comparisons and on its ability to make cost-base comparisons. However, the Commission concluded that the extent of the prejudice was likely to be "limited".

In finding that the transaction would cause prejudice, the Commission's approach can be regarded as somewhat cautious. SEW and MKW are both relatively small water companies and, even following the merger, there would in principle remain a total of 21 (reduced from 22) comparators available to Ofwat. Further, neither SEW nor MKW is a benchmark company, meaning that neither company is sufficiently well-performing for the regulator to use it as a benchmark for assessing the relative under-performance of other companies. Nevertheless, the Commission concluded that the transaction could be expected to prejudice Ofwat's ability to make comparisons between water companies.

Having concluded that the transaction would cause prejudice to Ofwat, the Commission considered whether that prejudice could be overcome through remedies. In this regard, two factors weighed in favour of the parties: first, the limited scope of the prejudice; second, the customer benefits (in the form of cost savings) that could be expected to arise from the merger. Indeed, the Commission concluded that the transaction would realise customer benefits that were substantially more important than the limited prejudice to Ofwat.

The Commission therefore accepted as a remedy a price reduction by the parties. While it noted that a price reduction would not overcome the prejudice to Ofwat, it considered that a price reduction would mitigate the adverse effects of the merger by offsetting the higher prices that might have been expected to result from the prejudice caused by the merger. It considered that any price reduction should take the form of a one-off lump sum (set at £4m, which was broadly in the middle of the range of customer detriment that was expected to arise from the merger) payable in advance of the next five-yearly periodic review, plus a requirement that Ofwat reflect Hastings' expected operating expenditure savings when it sets prices at the next review.

So what signals does the Commission's decision send to those interested in further water industry consolidation? One clear message is that any future consolidation is likely to be regarded as causing prejudice to Ofwat. It follows that the focus will in any future cases be on whether the 'price' (i.e. in terms of remedies) for being able to do the deal is worth paying. In this regard, the Commission's acceptance of a price reduction has been viewed positively by the industry. However, much will depend on the degree to which a transaction will cause prejudice to Ofwat and the extent to which customer benefits can be demonstrated. In cases where the scope of prejudice is greater or where the expected benefits are smaller, the Commission is likely to reflect this in the remedy – if it considers a price reduction to be insufficient, its comments in this case suggest that it may regard divestment of the acquired business (or blocking the transaction) as the only effective remedy.

Simon Barnes is a senior associate in Lovells' competition and European practice.