Merger mania in water world

THE SCENE is set for a series of battles that could herald the biggest carve-up of Southern England since the days of Alfred the Great.

Within a year, the patchwork of local fiefdoms that is the water industry in the South, an anomalous legacy of privatisation a decade and a half ago, is set to be swept away in a wave of takeovers pitching indigenous would-be regional overlords against hordes of foreign raiders.

The endgame could be a new geography of multi-billion pound super-companies whose increased size and scale could yet work in the favour of the consumer by cutting unnecessary costs to keep a lid on rising household bills.

On 2 December water regulator Ofwat, headed by Philip Fletcher, will issue its final decision on how much the country's 10 water and sewerage giants and 13 smaller, local-water-only companies can crank up residential prices.

The outlook for the consumer is not good. Having won the argument that they need substantially more cash to upgrade Victorian water systems and keep up with Brussels-enforced environmental rules, most companies will be raising their annual bills by more than 15%.

Anti-merger policies

THE average rise is set to be between £34 and £44 a year in the Thames and Southern regions and between £55 and £61 in the Wessex and South West regions - at a time of soaring electricity and gas bills, council tax and travel costs.

Ofwat's final determination will also sound the starting gun on what is expected to be a round of consolidation previously stalled by the anti-merger policies of successive regulators.

With business plans and funding in place for the next five years, rival companies will be sizing up the opposition and informing their bankers just how much they are prepared to pay for their rivals.

Until now, Ofwat has all but barred mergers, saying that it needs its near-two dozen separate, independent companies so it has enough 'comparators' to ensure it receives the best information on which to execute its economic regulation of the industry.

For its part, the industry believes Ofwat's claims are overblown, yet takeover strategies have been stymied by one important fact. The Department of Trade and Industry has hitherto had the right to veto mergers, and has used this in favour of Ofwat. But that has now changed.

The Enterprise Act has now been extended to the water industry, meaning that any decision on a merger will be solely in the hands of the Competition Commission. The Secretary of State loses the right of veto entirely, and as a result Ofwat's power of persuasion could be lessened.

Few insiders doubt that a takeover melee is about to break out as would-be consolidators race to the newly empowered Competition Commission to test the new regime. But why the certainty that consolidation is set to take place?

Like asking any English football supporter what the score was in 1966, every water executive up and down the country will tell you the what happened last time the Commission was asked to intervene. That was a resounding 4-1 result in favour of a takeover player - French giant Vivendi, now called Veolia, trying to buy Southern Water for £2.05bn. That defeat for Ofwat was only reversed when the Trade Secretary intervened to block the deal.

The argument is that if the original ruling by the Commission is the form line for potential mergers, we could be in for a free for all.

Veolia was initially given the green light by the Competition Commission in a signal that the commission was comfortable with a big water and sewerage company owning three other small water-only companies which it already controlled - the neighbouring Three Valleys, north and west of London, Folkestone & Dover and Tendring Hundred in Essex.

Big bucks to be made

THE takeover players are already planting and unfurling their standards and the City can sniff the possibility of making big bucks. Private equity houses are stalking the sector, and one has already made its move on South Staffordshire Water.

A stock market-quoted vehicle has even been formed to enter the game. Augean, backed by waste multi-millionaire David Williams' City investment house Marwyn and led by former Mid Kent Water boss Keith Tozzi, has already raised City funding to move forward its plans to buy water and waste companies.

'Our strategy is based on consolidation,' says Tozzi. 'There are benefits in putting two companies together and running them as one. Savings would be made in the elimination of duplicated headquarters, IT and financial systems or call centres. If the companies were geographically contiguous, there would be operational synergies.

'And in terms of capital investment programmes - the construction and maintenance of reservoirs or trunk mains - each company is doing the same and there would be far greater buying power if they could act together.'

He says his argument is particularly apposite in the South East, which has the lowest rainfall and the fastest-growing populations. The difference in the size of bills in different areas would suggest Tozzi has a point.

Customers of water-only companies Mid Kent, South East Water and Folkestone & Dover can pay up to 60% more, on average between £133 and £166 a year, than in neighbouring Southern Water, where the average bill is £106.

Breaching the dam

OFWAT remains implacable, however, saying that independent companies remain key to its job of getting the best deal in setting prices for consumers.

'Once they've gone, they've gone,' says head of regulatory finance Keith Mason, 'and our ability to do our job becomes much harder.'

The regulator further argues that it has yet to see evidence of the savings that could be achieved to ensure consumer prices will go down, the key quid pro quo before it supports any merger activity.

Water industry investors believe, however, that the dam of regulatory inflexibility is ready to be broken. Insiders say Malaysian-owned Wessex Water will move on Bristol Water, that German-owned Thames Water is sizing up Sutton and East Surrey and, notwithstanding other lurking predators, Severn Trent would like to go for South Staffs.

The market is already abuzz with talk of a mega-merger between Kelda (Yorkshire Water) and Northumbrian. If that were to happen, Northumbrian would be likely to have to sell Essex & Suffolk, probably to Anglian. Only last year, Anglian was being stalked by City money while Pennon has come under the heavyweight gaze of venture capital king Guy Hands.

One executive of an investment house with strategic stakes in a number of water companies is adamant. 'Expect Ofwat's stance to be tested post-2 December. Expect corporate activity,' he says. 'The big mergers, say Northumbrian and Kelda, may at the moment be a bridge too far but that does not mean the companies will not test it with the regulators. The big deals may be an issue for 2006 after the smaller deals are done next year.'