Justin Taberham examines the prospects for the UK water sector.
Near daily media interest and criticism of water companies’ pollution performance has lately been often stimulated by public reporting or legal action against them. In addition, debt loadings for some companies are at unsustainably high levels and investors have had to inject further capital into companies. So it is hardly a surprise that there is significant pressure on the government to act and a wide-ranging discussion has begun on the future of the industry and what reform is required.
So how did we get to this point? Privatisation in 1989 seemed to make a pretty good start: the government assumed responsibility for the English water industry’s total debts amounting to £5bn and granted the water companies a further £1.5bn in what was denoted a “green dowry” of public funds. Ordinary people from beyond the usual share buyers were encouraged to buy shares with the slogan “You could be an H2Owner’ and the offer was hugely oversubscribed.
Since privatisation there has been a migration of the sector towards a model of private finance and a rise in Private Equity (PE), sovereign wealth fund and pension fund investors, which has become very common in the infrastructure sector globally.
This, though, changed pretty quickly. Since privatisation there has been a migration of the sector towards a model of private finance and a rise in Private Equity (PE), sovereign wealth fund and pension fund investors, which has become very common in the infrastructure sector globally.
As of 2021, only three privatised companies remain listed on the London Stock Exchange, three are delisted and the other nine are owned by Special Purpose Vehicle (SPV) companies. Currently, more than 70% of the sector is owned by overseas investors.
Allied with this migration is a growth in the complexity of company structures and a rapid change in the way that debt is utilised. Several companies from the early 2000s have used a structure called Whole Business Securitisation’ (WBS). This model can take advantage of the fact that a company with higher debt loadings can be allied with more “steady” credit ratings, given the secure future income stream from customers. The WBS model also allows for increased returns on investment.
In response, debt loadings within the sector have risen rapidly. (See box: English water company debt and investment)
Thames Water
- Thames Water has reserves of around £4.4bn.
- March 2023 Thames Water statement “As of 30 September 2022, the net debt figure (on a covenant basis) for Thames Water Utilities Limited was £14.3bn”.
- Its regulatory gearing is 80.6%, the highest in the sector.
Sector-wide
- There has been investment totalling around £190bn of capital expenditure by 2022: about double that of the period before privatisation.
- The value of water company assets has increased from £9bn to £85bn.
- Debt raised over the same period is about £57bn.
- Equity is just under £20bn.
- Average regulatory gearing as of March 2022 – 68.5%.
All figures from Ofwat, the water industry economic regulator, July 2023
The water sector’s economic regulator, Ofwat, has become increasingly responsive to risks of financialising within the sector. It introduced a process of financial resilience reporting in 2015 following the clarification in the Water Act 2014 of its resilience duty, which requires companies to report on financial measures.
However, there was an investor backlash against these regulatory measures which investors saw as a threat to the level of their returns. Four companies appealed Ofwat’s price determinations in 2019, where they decided a five-year “price structure” for each company for 2020-25. Appeals were held by the Competition and Markets Authority (CMA) and the resulting decision was, to a degree, in the favour of the companies. In their response to the decision, Ofwat voiced potentially a note of frustration: “We can have no confidence that these higher returns will translate into investment services for the benefit of consumers and the environment.”
Performance in recent years has seen trust in the water industry deteriorate. If it is to be rebuilt, we need to see profound, long-term change across the sector.
Allied to issues around debt loadings and financial models, water companies’ environmental performance has faced scrutiny. Environmental regulator, the Environment Agency (EA), publishes its annual Environmental Performance Assessment (EPA) of the water and sewerage companies operating in England. The 2022 report notes: “Performance in recent years has seen trust in the water industry deteriorate. If it is to be rebuilt, we need to see profound, long-term change across the sector… there are some deep-rooted problems which can only be solved by significant investment. Not just this year and next, but for some decades to come.”
However the current UK government does not seem to be coming to the support of its regulators. A 2021 letter from the chair of the EA stated: “Over the past few years, the drop in grant has forced us to reduce or stop work we used to fund, with real-world impacts (for example, on our ability to protect water quality) for which we and the government are now facing mounting criticism.’” More recently the government has sought to remove the nutrient-neutrality requirement on planning decisions undermining Natural England’s ability to reduce housing development pressure on water quality.
Earlier this year Thames Water almost went bust. So what happens if a water company goes bust?
Branston and Tomlinson suggest that if Thames Water were to fold, the government would use the Special Administration Regime (SAR) to take over the company, but would aim to pass ownership back into private hands as soon as possible. In normal administration processes for companies that have collapsed their assets are sold to repay debts as far as possible, but water company assets cannot be sold and it is likely that the current shareholders would expect government compensation to cover this.
Ofwat has noted that the special administration regime is designed “not to keep a company in business but rather to ensure that the provision of services to customers is maintained” – meaning investors “bear an appropriate level of risk in relation to the decisions that they make” and reducing the “risk to taxpayers that they will have to bear costs relating to a failed company”.
But in reality the government could be forced to step in with funding to ensure that another company is willing to take over the failed company. The most recent example of a SAR process was the takeover of Bulb by Octopus Energy in 2021/22. In this scenario, the government stepped in with funding to ensure that Octopus Energy was willing to take over Bulb’s customers. However, following the National Audit Office Investigation into the takeover, there is an expectation on the government that it will recover all taxpayer funding.
So could anything change with a new government? The upcoming UK election – in January 2025 at the latest – is more than likely to result in a Labour government given current polling. This is already bringing deep analysis of what Labour will and won’t do when in power, but none of the options for the sector are without risk and complexity.
In May 2023, there was speculation in the Financial Times that a Labour government would merge most of the EA, with Ofwat and the water quality watchdog, the Drinking Water Inspectorate, to create a new oversight body. The party indicated it would also create a separate flooding agency.
There are a number of options for structural approach which a Labour government could consider:
- keep everything as is with water companies being fully privatised but tighten up regulation;
- nationalise into a publicly-owned utility along the lines of Scottish Water; or
- form a single purpose, not-for-profit company in England with no shareholders, along the lines of Welsh Water.
Keep it the same
This option is the simplest option. But it is becoming increasingly clear that this option has challenges with companies facing high debt loadings so increased regulation may just make their collapse more likely. Furthermore, pushing for increased investment in measures to deal with poor environmental performance will increase bills in the midst of a cost of living crisis.
The cost of solving one key issue within the water sector – the sewage spills into water bodies from Combined Sewer Overflows (CSOs) – has been suggested by the industry as £100bn (Environmental Audit Committee, 2021). The scale of likely investment across the sector which may be required is very significant. In addition, all policies and scenarios assessed would carry a significant cost in carbon emissions.
Nationalise, Scottish-Water style
Scottish Water is a public company accountable to Scottish Ministers and Scottish Parliament, partly funded by long-term loans from the Scottish government.
If the water sector was taken into public hands, this is a potential model for that. However, debt would have to be taken on by government.
The BBC has noted, however: “The publicly-owned provider is investing at only 40% of the rate that will be required to tackle the backlog of work from old pipes and the future challenge of climate change.” The reason for this lack of funding is that the requested degree of funding to support the required programmes was not agreed by the regulator, under what was noted as “political pressure”.
Single purpose not for profit
Welsh Water is owned by a public-interest company, Glas Cymru. It is a not for profit with a single purpose, with a government debt guarantee which helps keep the costs of servicing the debt down and it is financed in the capital markets. It has no shareholders and 62 trustees. Its decisions are made in the interests of wider society and any profits are reinvested or passed to customers in lower bills. There is considerable evidence that this option ensures funding is focused on the social purpose of the company.
My view is that the Welsh option is the best, but not necessarily the easiest, option for the future structure of the UK sector. Welsh Water has been shown to have a successful social company structure, with good environmental performance over the past 20 years as well as a clear focus and the development of programmes of work which directly tackle the changing priorities that other shareholder-owned companies have generally been unable to develop. It can also access capital markets, unlike the Scottish Water model.
One consideration is whether you could divert funds that currently are invested as “shareholders” in companies to “debt holders” in a not-for-profit. In addition, a sector with not-for-profit utilities might be very attractive to ESG investors.
There is the question, however, of how to migrate to this model. Do you transform any water company that goes bankrupt into a not-for-profit company rather than allow private investors to secure the company? This would mirror the happenings in 2001 when Dwr Cymru Welsh Water was formed after Hyder was broken up.
That might create a hybrid sector of private companies, not for profits and public companies, but we have that anyway with Welsh Water and Scottish Water. One consideration is whether you could divert funds that currently are invested as “shareholders” in companies to “debt holders” in a not-for-profit. In addition, a sector with not-for-profit utilities might be very attractive to ESG investors.
Whatever model the water sector sits in, considerable challenges will remain for the sector. Technical and delivery goalposts have moved over the past 20 years. There has been a change in focus and investment needs away from point source pollution control towards ecological water quality, catchment approaches, nature-based stormwater management, emerging contaminants, more complex chemical and organic pollutants, and climate change implications. And these required approaches have not been sufficiently funded.
Many commentators argue that privatisation has brought little benefit to the sector in the longer term. Professor David Hall of the University of Greenwich noted in 2022 that companies have invested “no net additional shareholder funds (equity) since privatisation” meaning that “money has been taken out, not put in”. Professor of Economics and Public Policy at King’s College London, Jonathan Portes, and a former senior civil servant, notes “I worked on the privatisation of England’s water in 1989. It was an organised rip-off.’
The question is whether the current industry model really is fit for purpose to deliver the significant investment programmes which are needed to respond to its critical challenges. An increasing number of sector experts would argue that change is needed, but would a future Labour government make that a priority?
