Water has a private equity, not a private ownership, issue

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In 1989, on the eve of privatisation, the European Commission took legal action against the UK government for its failure to meet standards on drinking water. 

The fracas did not disrupt the flotation of regional water authorities in England and Wales, which were given more time to reach standards they should have met in 1985. The logic of privatisation — as laid out in the regulator’s “book of numbers” — was that the private sector would deliver crucial investment long ignored by the government.

And it did, to some extent. Capital investment rose by 85 per cent in the decade following privatisation; we no longer worry about our drinking water; leakage has fallen by a third since the mid-1990s.

Yet the structure put in place then has failed. The huge investment the system again needs, given population growth and a changing climate, is in doubt.

It is worth prising apart some failures. One relates to the financial resilience of water companies, given the risk that Thames Water with its £14bn in debts will require state help and that Yorkshire Water has raised £500mn from its private equity and sovereign wealth fund shareholders. This is largely a private equity, not a private ownership, issue. 

The three listed companies in the sector, Severn Trent, United Utilities and South West Water (via Pennon Group), alongside Dwr Cymru, the not-for-profit Welsh water company, have the lowest regulatory gearing levels, broadly in line with the “notionally efficient” level set by Ofwat, which has drifted up over time. 

Figures for gearing levels from Martin Young at Investec show a sudden leap at Thames after its acquisition by Australian “vampire kangaroo” Macquarie in 2006, which “hollowed out” the group in its 11 years of ownership, in the words of recently departed boss Sarah Bentley. Gearing jumped at Southern Water around the time Royal Bank of Scotland (in its own irresponsible heyday) took control in 2003. Yet the regulator didn’t seem troubled by questions of resilience until 2014.

“The regulatory structure set up in 1989 worked relatively well until the entry of much more aggressive private equity firms, who worked within the rules to increase debt and extract substantial returns to shareholders in a way that hadn’t been envisaged,” said Kate Bayliss, an infrastructure expert at Soas, University of London.

This is not to excuse or overlook the severe operational failings of listed water companies. No one has a clean sheet on environmental problems like leakage and sewage overflows — including Dwr Cymru or publicly owned Scottish Water. South West has had a particularly poor pollution record; United’s sewage pumping is behind the recent bathing ban on Blackpool beach.

Ofwat, dancing to the political mood of the times, prioritised keeping bills low over investing in crumbling and increasingly overwhelmed infrastructure. Today’s bill payers will be asked to pay up for that failure, just as some investors must stump up for the cynical extraction of dividends by owners past. Only one of these groups, however, had a choice on getting involved.

Some companies, however, may be making a better start at tackling problems. The three companies whose business plans were fast-tracked by the regulator in 2019 — a sign they had set appropriately stretching targets, for example on improvements — were the listed groups Severn, United and South West. Water companies underspent their regulatory investment allowance in 2020-22, except two: Severn and United.

Nearly 90 per cent of the extra investment approved under the 2021 green economic recovery programme for England’s water industry came from the three listed companies. The companies that will bring forward most investment spending, through a separate initiative, to shore up ailing infrastructure are United and South West.

Less overburdened balance sheets have more flexibility to respond to public anger and regulatory demands. And dismissing all providers of long-term private capital isn’t helpful, given the immense investment needs ahead, in water but in energy too.

But nor is treating all investors alike, to the maddening extent that Macquarie was welcomed back as an owner of struggling Southern Water, four and half years after it sold out of Thames. 

There are no easy answers, given the need to balance attracting huge investment with tougher operational and financial regulation. But considering who shows themselves to be a responsible owner, and the apparent restraining influence of the public equity markets, seems a decent place to start.

helen.thomas@ft.com
@helentbiz