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
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