Pennon Group and Bournemouth Water A report on the completed acquisition by Pennon Group plc of Bournemouth Water Investments Limited 5 November 2015 © Crown copyright 2015 You may reuse this information (not including logos) free of charge in any format or medium, under the terms of the Open Government Licence. To view this licence, visit www.nationalarchives.gov.uk/doc/open-government- licence/ or write to the Information Policy Team, The National Archives, Kew, London TW9 4DU, or email: [email protected]. Website: www.gov.uk/cma Members of the Competition and Markets Authority who conducted this inquiry Simon Polito (Chair of the Group) Sarah Chambers Andrew Popham Jayne Scott Chief Executive of the Competition and Markets Authority Alex Chisholm The Competition and Markets Authority has excluded from this published version of the report information which the Inquiry Group considers should be excluded having regard to the three considerations set out in section 244 of the Enterprise Act 2002 (specified information: considerations relevant to disclosure). The omissions are indicated by []. Contents Page Summary .................................................................................................................... 3 Findings .................................................................................................................... 16 1. The reference ..................................................................................................... 16 2. Industry background ........................................................................................... 16 3. Water regulation and key bodies......................................................................... 21 Regulatory framework and approach .................................................................. 21 Wholesale price controls ............................................................................... 22 Retail price controls ....................................................................................... 24 Wholesale quality of service: outcome delivery incentives ............................ 25 Retail quality of service: Service incentive mechanism ................................. 26 Planned regulatory reforms ................................................................................. 27 Key regulatory and industry bodies ..................................................................... 29 Ofwat ............................................................................................................. 29 Drinking Water Inspectorate .......................................................................... 31 Environment Agency ..................................................................................... 31 Consumer Council for Water ......................................................................... 32 Customer challenge groups ........................................................................... 32 Competition and Markets Authority ................................................................ 33 4. The merger parties .............................................................................................. 33 Pennon ............................................................................................................... 33 SWW ................................................................................................................... 33 Bournemouth Water Limited ............................................................................... 35 5. The merger ......................................................................................................... 37 The transaction ................................................................................................... 37 The rationale ....................................................................................................... 37 Jurisdiction .......................................................................................................... 37 6. Assessment of the impacts of the merger on Ofwat’s ability to make comparisons 39 Ofwat’s approach to assessing the merger ......................................................... 39 CMA’s approach to assessing the merger .......................................................... 40 Wholesale price controls ..................................................................................... 45 How Ofwat uses comparators in wholesale price controls ............................. 45 How a merger might result in adverse impacts .............................................. 45 How a merger might result in adverse impacts: precision effect .................... 47 Pennon’s submissions on the precision effect ............................................... 48 Ofwat’s submissions on the precision effect .................................................. 48 CMA’s analytical approach to the precision effect ......................................... 49 CMA analysis of the precision effect .............................................................. 52 How a merger might result in adverse impacts: benchmarking effect ............ 67 Pennon’s submissions on the benchmark effect............................................ 68 Ofwat’s submissions on the benchmark effect............................................... 70 CMA’s analytical approach to the benchmark effect ...................................... 71 CMA analysis of the benchmark effect .......................................................... 75 Conclusion on wholesale price controls ......................................................... 78 Retail price controls ............................................................................................ 80 How Ofwat uses comparators in retail price controls ..................................... 80 How a merger might result in adverse impacts .............................................. 81 Pennon’s submissions on retail price controls ............................................... 82 1 Ofwat’s submissions on retail price controls .................................................. 83 CMA’s analytical approach to retail price controls ......................................... 83 CMA analysis of retail price controls .............................................................. 85 Conclusion on retail price controls ................................................................. 86 Monitoring and incentivising service quality: outcome delivery incentives .......... 87 How Ofwat uses comparators in monitoring and incentivising service quality through ODIs ................................................................................................ 87 How a merger might result in adverse impacts .............................................. 87 Pennon’s submissions on ODIs ..................................................................... 90 Ofwat’s submissions on ODIs ........................................................................ 90 CMA’s analytical approach to ODIs ............................................................... 91 CMA analysis of ODIs ................................................................................... 95 Conclusions on ODIs ................................................................................... 101 Monitoring and incentivising service quality: service incentive mechanism ...... 103 How Ofwat uses comparators in monitoring and incentivising service quality through the SIM .......................................................................................... 103 How a merger might result in adverse impacts ............................................ 103 Pennon’s submissions on the SIM ............................................................... 103 Ofwat’s submissions on the SIM .................................................................. 104 CMA’s analytical approach to the SIM ......................................................... 105 CMA analysis of the SIM ............................................................................. 107 Conclusion on the SIM ................................................................................ 108 Spreading of best practice ................................................................................ 108 How Ofwat uses comparators in spreading best practice ............................ 108 How a merger might result in adverse impacts ............................................ 109 Ofwat’s submissions on spreading of best practice ..................................... 109 Pennon’s submissions on spreading of best practice .................................. 113 CMA analysis of spreading best practice ..................................................... 114 Conclusion on spreading best practice ........................................................ 115 7. Conclusions on prejudice .................................................................................. 116 Appendices A. Terms of reference and conduct of inquiry B. Current regulatory approach C. Ofwat’s use of comparators and planned reforms D. Impact on the precision of Ofwat’s wholesale cost models E. Impact of the merger on Ofwat’s wholesale benchmarks F. Setting household retail prices G. Outcome delivery incentives H. Monitoring and incentivising service quality: service incentive mechanism Glossary 2 Summary 1. On 8 June 2015 the Competition and Markets Authority (CMA) referred the completed acquisition by Pennon Group plc (Pennon)