Wa­ter com­pa­nies in­un­dated by del­uge of reg­u­la­tory pres­sures

Unloved by the Left and Right, and be­dev­illed by past ex­cesses, tighter reg­u­la­tion is forc­ing the in­dus­try into a fi­nan­cial strait­jacket, re­ports Jil­lian Am­brose

The Sunday Telegraph - Money & Business - - Front Page -

Wa­ter com­pa­nies are un­pop­u­lar and, as of­ten for­eignowned mo­nop­o­lies, make ready po­lit­i­cal tar­gets. Michael Gove is not a man to waste an op­por­tu­nity. Ahead of the in­dus­try reg­u­la­tor’s five-year review, which be­gins in earnest this week, the En­vi­ron­ment Min­is­ter made clear there are rougher waters ahead for the sec­tor.

Gove pub­licly named and shamed com­pa­nies, ac­cus­ing their bosses of “play­ing the sys­tem for the ben­e­fit of wealthy man­agers and own­ers” at the ex­pense of con­sumers and the en­vi­ron­ment.

But as Ofwat pre­pares to act on that man­date, it has be­come clear that in­creased reg­u­la­tory pres­sure threat­ens to drain bil­lions of pounds of in­vest­ment from in­ter­na­tional funds, at a time when the in­dus­try ar­gues it most needs the cash.

The mis­deeds of the wa­ter in­dus­try are many. Cat­a­strophic lev­els of pol­lu­tion and leak­age are com­mon­place, yet bills have been al­lowed to rise to pay for in­vestor div­i­dends and ex­ec­u­tive pay.

Just this sum­mer United Util­i­ties drew pub­lic anger after nar­rowly avoid­ing a hosepipe ban for seven mil­lion house­holds in the North West dur­ing one of Bri­tain’s worst heat­waves in decades.

Months be­fore, thou­sands of cus­tomers across the coun­try were left with­out any wa­ter at all after burst pipes and leak­ages, which emerged in the wake of the freez­ing tem­per­a­tures brought by the Beast from the East.

Thames Wa­ter was one of those com­pa­nies named and shamed by the reg­u­la­tor for fail­ing its cus­tomers. The coun­try’s largest sup­plier was al­ready bat­tling for re­demp­tion after years of crit­i­cism of pol­lu­tion fail­ures and fi­nan­cial en­gi­neer­ing at the be­hest of its for­mer owner, the Aus­tralian in­vest­ment bank Mac­quarie.

The “vam­pire kan­ga­roo” wrung £1.6bn in div­i­dends for it­self and its fel­low in­vestors over 10 years while the group paid very lit­tle tax. Thames was mean­while left sad­dled with over a bil­lion pounds of debt last year and fac­ing a record in­dus­try fine for dump­ing mil­lions of tons of sewage into rivers.

It claims to have re­formed, but the reser­voir of pub­lic re­sent­ment built up dur­ing the Mac­quarie years is prov­ing dif­fi­cult to drain.

Ofwat is poised to an­nounce a tougher new reg­u­la­tory regime stretching from 2020 to 2025. It will de­mand that wa­ter com­pa­nies in­crease in­vest­ment while cut­ting house­hold bills. There will be tougher penal­ties for missed tar­gets and a far higher bar to win more pric­ing free­dom.

On top of this the reg­u­la­tor is due to set out pro­pos­als that gov­ern how and when com­pa­nies can pay div­i­dends to their in­vestors, and how they man­age their debt.

Wa­ter com­pa­nies will re­spond on Monday with new busi­ness plans to match the new rules, but al­ready the blow has rip­pled out from the sec­tor to the City. In an­tic­i­pa­tion of the over­haul, credit rat­ing agency S&P Global cut its out­look on wa­ter com­pany debt from sta­ble to neg­a­tive.

“In our view, an ap­proach that re­lies on less-pre­dictable and harder-to­fore­cast in­come could de­crease the high sta­bil­ity of cash flows for reg­u­lated wa­ter util­i­ties – which is a key fac­tor in our as­sess­ment of Ofwat’s strong reg­u­la­tory regime from a credit per­spec­tive,” says the agency.

S&P says it un­der­stands Ofwat’s eco­nomic ra­tio­nale be­hind tight­en­ing the fi­nan­cial strait­jacket. The reg­u­la­tor is due to change its as­sump­tions on how much it costs wa­ter com­pa­nies to raise cap­i­tal for in­vest­ment. The fig­ure is key to the prices wa­ter com­pa­nies can charge con­sumers and is ex­pected to be cut to as low as 3.8pc, from 5.65pc cur­rently, against a back­drop of his­tor­i­cally low in­ter­est rates. A lower cost of cap­i­tal as­sump­tion should mean lower bills.

“How­ever, our view of Ofwat’s low-risk, credit-sup­port­ive reg­u­la­tory frame­work is also de­pen­dent on the main­te­nance of the fi­nan­cial at­trac­tive­ness of the sec­tor to in­vestors,” S&P says.

In­deed, Ofwat’s plans are al­ready tak­ing a toll on the at­trac­tive­ness of the UK wa­ter in­dus­try to in­vestors. The threat of fur­ther pain ahead comes at the worst pos­si­ble time for the sec­tor as it pre­pares to face an un­prece­dented in­vest­ment chal­lenge.

On top of reg­u­la­tory pres­sure, wa­ter com­pa­nies could find the nuts and bolts of their trade trick­ier too. Ris­ing pop­u­la­tion num­bers are putting strain on in­fra­struc­ture, much of which was de­vel­oped in the Vic­to­rian era. Cli­mate change and more ex­treme weather are mean­while rip­ping through the en­vi­ron­men­tal rule book.

“Con­cep­tu­ally, none of this is new,” Michael Roberts, the chief ex­ec­u­tive of the in­dus­try lobby Wa­ter UK, told a par­lia­men­tary re­cep­tion. “What is dif­fer­ent, though, is the scal­ing up needed in fu­ture. The sec­ond is the need to strengthen the cur­rent tools avail­able to wa­ter com­pa­nies to step up to the next level.”

Part of of­fi­cial­dom sym­pa­thises. Ear­lier this year the Na­tional In­fra­struc­ture Com­mis­sion (NIC) warned that Eng­land’s wa­ter net­work is al­ready un­der strain. A fifth of the coun­try’s sup­ply – or 3,000m litres – is lost each day to wa­ter leak­ages, and over the past two decades the amount fam­i­lies con­sume each day has re­duced by only 10 litres per per­son, per day.

As a re­sult, over the next 30 years there is a one in four chance that large num­bers of house­holds will have wa­ter sup­plies cut off for an ex­tended pe­riod be­cause of se­vere drought.

Sir John Ar­mitt, the NIC’S boss, has called for a twin-track in­vest­ment drive to cre­ate a na­tional wa­ter net­work and build new wa­ter sup­ply in­fra­struc­ture. His agenda un­der­lines the im­por­tance of in­vest­ment, and the po­ten­tial im­pli­ca­tions for the pub­lic fi­nances if re­na­tion­al­i­sa­tion oc­curs.

Wa­ter UK has ar­gued against calls for the sec­tor to be re­na­tion­alised. The in­dus­try lobby points to a string of pri­vati­sa­tion-era achieve­ments. Since the Nineties, £150bn of in­vest­ment has poured into the sec­tor, there has been al­most zero wa­ter bill growth in real terms and cus­tomers are five times less likely to suf­fer a sup­ply dis­rup­tion and eight times less likely to face sewer flood­ing.

Th­ese fig­ures have failed to calm the sec­tor’s crit­ics on both the Right and Left of pol­i­tics, how­ever, and in­vestors have no­ticed.

“Na­tion­al­i­sa­tion stalks the imag­i­na­tion of many in­vestors, but reg­u­la­tory thumb-screw­ing is real,” ac­cord­ing to one.

City sources say dam­age has al­ready been done re­gard­less of Ofwat’s next step. In­fra­struc­ture in­vestors rel­ish low-risk op­por­tu­ni­ties and are pa­tient enough to make the wait for re­turns worth­while.

But un­cer­tainty is a deal-breaker. Ofwat’s crack­down on div­i­dends is a case in point. So too is the Labour party pledge to bring the sec­tor back un­der pub­lic con­trol.

“Ev­ery­one ac­cepts that reg­u­la­tion needs to evolve over time, but it’s the sur­prises that are a prob­lem,” says an­other. “We could be just one snap-elec­tion away from a Labour-led na­tion­al­i­sa­tion plan.”

This is par­tic­u­larly con­cern­ing for in­ter­na­tional funds that are al­ready wary about the cur­rency-risk fac­ing ster­ling as Brexit trudges ahead.

“In the past, you’d be hard-pressed to find an in­ter­na­tional fund turn­ing down the UK on the ba­sis of ‘po­lit­i­cal risk’ but this is ex­actly what we are see­ing at the mo­ment,” he adds.

The funds that have in­vested in the sec­tor over the last year are typ­i­cally rais­ing money within the UK. True in­ter­na­tional in­vest­ment is very thin on the ground.

Al­ready the drought is tak­ing its toll. York­shire Wa­ter’s in­vestors have strug­gled for over a year to sell off a com­bined £4bn stake in the com­pany. In July last year it emerged that two of its in­vestors – Deutsche As­set Man­age­ment and the pri­vate equity fund Cor­sair Cap­i­tal – were hop­ing to sell their stakes ahead of the reg­u­la­tory crunch talks, which to­gether amount to a ma­jor­ity of 55pc.

In the past, wa­ter in­dus­try as­set sales would be hotly com­pet­i­tive as in­fra­struc­ture-hun­gry funds vied for the chance to clinch a sta­ble source of long-term re­turns.

“The mood mu­sic has been bad on this for a while,” says one City source.

Ac­cord­ing to those fa­mil­iar with the process the sale has been a “to­tal fail­ure”. The pair plan to reignite the process in a new bid­ding round next month, but the sale is un­likely to close un­til the po­lit­i­cal fog clears.

‘Na­tion­al­i­sa­tion stalks the imag­i­na­tion of many in­vestors, but reg­u­la­tory thumb-screw­ing is real’

The heat­wave has brought fires to the Pen­nines, right, and drought to the Lakes, be­low right, and with them a moun­tain of prob­lems for the util­i­ties to deal with

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