How to fix Britain’s water industry

The sale of the UK water industry in 1989 is the most controversial of all Margaret Thatcher’s privatisations. Critics argue that it has been little more than a rip off: the privatised companies have failed to eliminate leaks, been permitted to dump vast quantities of untreated sewage into our waterways and used clever financial engineering to boost rewards to shareholders. Indeed, a study published in 2018 argued that the cash flow from customers could have funded all investment undertaken, while borrowings merely went to rewarding shareholders.

Was it all a terrible mistake? Whether or not it was, what should be done now?

It is easy to argue that the answer to the first question has to be “yes”. Water is not just a local monopoly, it is also a vital necessity. This means the providers have enormous market power and are subject to no competition. That in turn makes tough regulation essential. But regulators are always likely to be outwitted, if not captured, by the profit-driven businesses they are trying to curb. Furthermore, given the nature of the business, the relevant risks are mainly borne by the customers rather than shareholders. If the companies fail to deliver, the former cannot go elsewhere. They can only complain and, if the answer is more investment, pay up. Beyond all this, water is an industry with profound externalities, notably those for the environment and health.

For all these reasons, it has long been assumed that profit-seeking enterprises are bound to be problematic in this sector: conflicts of interest are too great to be managed. Yet there is a counterargument that, in the UK case, seemed decisive. It is that Her Majesty’s Treasury in particular, and the government more broadly, is a hopeless trustee of such vital assets. It is obsessed with the liability side of its balance sheet and consistently ignores the assets. So, the water industry was chronically starved of investment. In this highly second-best world, privatisation would, it was argued, lead to higher investment and better performance in the industry.

Michael Roberts, former chief executive of Water UK, argued a few years back that “since privatisation, investment of nearly £160bn has seen strong, steady improvement, giving customers world-class drinking water. Leakage is down a third since the mid-1990s, two-thirds of beaches are classed as excellent, compared with less than a third 25 years ago.” This is not entirely wrong.

Yet over time improvements in performance tailed off and the scandals we see emerged. There was a failure to monitor what water utilities were doing, especially their dumping of sewage, and a corresponding failure to be demanding enough on needed investments. Moreover, Ofwat’s powers were inadequate: it could not impose changes on licences, block dividends or control salaries in any way. Now at least it can.

So, what is to be done? It would be possible to renationalise the businesses. I remain, however, sceptical over the government’s ability to run the sector any better (though Scottish Water is a public company accountable to the Scottish parliament). A second option is to keep independent companies, but change the structure of ownership from shareholder-owned companies. One such alternative is Welsh Water, which is funded solely by debt and charges. This model was controversial when created in 2001. Yet it has been a successful business with a good record on changes in charges to customers. But its superiority on other dimensions is less clear.

If the businesses remain independent, the key action must come from the remit and actions of regulators. It is clear that the current situation is unsustainable. There will have to be a great deal more investment. That in turn must ultimately be funded by charges (with tough controls on diversions to salaries and dividends). Crucial here will be the closest possible co-operation between environmental and financial regulators. Higher standards must be set, monitored and imposed, with fierce penalties on those who fail to meet them. Licences must be lost if necessary.

Last but not least, there is a discussion to be had over whether the framework needs to be transformed. Oxford’s Dieter Helm is particularly radical. He argues for “a water system that places fewer demands on drinking water supplies, where sewerage systems are used to handle sewage only, where sewage is not discharged into rivers, and where farming and flood defences take account of the wider natural capital”. The answer, he insists, is integrated regulation of river catchments.

Sometimes the best thing to do is to step back and ask how radically something needs to change. That is now the case for the water industry. Let us do so.

martin.wolf@ft.com

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