After years of lax oversight, Ofwat needs shareholders to invest more, but investors will only do that if consumer bills rise.
(Bloomberg) — Ofwat faces a difficult balancing act. The UK regulator must shore up the water companies — requiring billions from shareholders — without killing off investment in the water sector. It is a challenge that some believe will be beyond the organization whose chairman on Wednesday sought to reassure MPs by telling them it would take a “more muscular approach” to dealing with the turmoil facing the heavily indebted industry.
“We have the power to enforce compliance, to address any aspect of under-performance through either fines, withholding dividend payments if we think they are in breach of their obligations,” Iain Coucher told a hearing of the House of Commons Environment, Food and Rural Affairs Select Committee. “We didn’t have that power before — we do now.”
Created in 1989, when the water industry was privatized, Ofwat for years took a hands-off approach to the way the companies ran their businesses as long as bills stayed low and the water kept running. It allowed companies to pile up debt and underinvest for a decade from 2006. That lack of investment has been blamed for sewage flooding into the nation’s rivers and seas, and leaving leaky pipes in urgent need of repair. Since the crisis around Thames Water, which has debts of around £14 billion, exploded two weeks ago those decisions have been under the microscope.
Ofwat’s job now is to ensure firms can attract funds to rebuild water industry infrastructure while protecting customers. To do that, it needs businesses to improve their creditworthiness by convincing shareholders to inject equity and then borrow at affordable rates. It also needs household bills to rise allowing companies to cover future borrowing costs while paying shareholders a dividend.
Read more: Water Companies Need to Rebuild Trust Before Hiking Bills
Yet politicians are in no mood to defend a big rise in household bills to fund investment during a cost-of-living crisis, even if it would not fall due until 2025. A £100 average increase, which the Consumer Council for Water thinks is likely, would push 1.1 million households into water poverty — defined as when water bills cost more than 5% of income after housing costs — the consumer watchdog said.
“The regulator is caught in an impossible bind as its two objectives — to promote the interests of customers and to ensure that firms are able to finance their operations — are contradictory,” said Kate Bayliss, an economics research associate at the School of Oriental and African Studies. “Regulation is not simply a question of setting rules and then enforcing them. The actions of the regulator have a huge impact on the way the system works.”
Shareholders extracted £18 billion from the sector between 2006 and 2017, according to work by Bayliss and David Hall, a visiting professor at the University of Greenwich. Ofwat’s defense was that it had no authority over corporate structures until 2021, but it made no effort to stop the money flowing out of the companies either. Bills went up, and are likely to do so again to pay to stop the sewage overflows.
Ofwat’s challenge has never been greater. In October, the industry will open negotiations over the next five year investment program — which runs between 2025 and 2030 and will also determine household bills in that period. When the investment round was last negotiated Ofwat approved a figure of £51 billion over five years. According to Ofwat calculations that figure could rise by two-fifths.
“The quantum of money is huge,” Coucher told the House of Lords on July 4. “We are very concerned about the impact on bills.”
Capital Injection vs Consumer Bills
The scale of the challenge was highlighted by Thames Water, the UK’s biggest water utility serving 15 million people in London and the surrounding areas. Amid concerns its owners would refuse to provide the equity demanded by Ofwat, the government began talks about contingency plans for a last resort rescue involving a temporary nationalization. But on Monday, shareholders agreed to inject £750 million on top of £500 million pledged in 2022. The move was broadly welcomed by markets as a first step.
Against the existing £2 billion equity base, the recapitalization was substantial. But it has only bought Thames Water a little time. Ofwat wants another £2.5 billion between 2025 and 2030, nearly trebling the equity in less than a decade. Luke Hickmore, investment director at Abrdn Plc, which holds some of the Thames Water secured bonds, has urged Ofwat to “recognize where the industry is, and what it needs to do to attract more capital.”
The water company’s shareholders supported the plans on the condition that Ofwat ensures “an appropriate regulatory environment,” shorthand for big increases in bills to match the big investment. Discussions are ongoing but the industry wants a 40% rise over the 2025-30 regulatory period — roughly 25% on top of inflation.
The negotiations over the 2025-30 review are likely to be fraught. Whether Thames Water can secure £2.5 billion from shareholders will depend on the rate of return, which will be partly determined by what Ofwat decides on consumer bills. Without fresh equity, Thames Water won’t be able to raise the investment capital Ofwat wants and repairs will not be made.
Full-blown nationalization isn’t an option the government will consider, according to people familiar with the Treasury’s thinking. Special administration, under which the state takes temporary ownership before transferring the business to new shareholders, was considered for Thames Water but never realistically on the cards, the source added. Triggering it would threaten investment in the whole privatized water industry.
“The horse has bolted,” said Dieter Helm, economics professor at the University of Oxford and a former government adviser, responding to a question of what should be done with Ofwat. “If we want to invest more to deal with the problems we’ve got, we either have to save or we have to carry on being beggars for foreign investment.”
Ofwat has enhanced its investigation capabilities, Coucher told parliament, “we are empowering our people to be much, much more intrusive on companies’ performance.” But the regulator has tried to get tough before. Its 2015-20 review set a notional debt to regulatory capital target of 62.5% but it was not enforced. In 2019, its cap on shareholder returns was cut to the lowest level since privatization. The water companies appealed against the decision and won.
In 2021, the regulator finally got the tools to beat the industry into shape — primarily a block on dividends. It is now forcing companies to take action to meet a new 60% debt target. Also in 2021, Australia’s Macquarie injected £1 billion into Southern Water — diluting existing shareholders in the process. Last week, it said it would add another £550 million. Yorkshire Water has also announced a £500 million capital raise.
Rapid structural change is not easy, though, as Thames Water illustrates. Half the business is owned by Canada’s Ontario Municipal Employees Retirement System pension fund and the UK’s Universities Superannuation Scheme, neither of which have received a dividend since buying their stakes in 2017. Other investors, like British Columbia Investment Management Corp., Queensland Investment Corp. and the Dutch Stichting Pensioenfonds Zorg en Welzijn, enjoyed handsome returns in the decade before that.
Giving evidence in the House of Lords last week, David Black, Ofwat chief executive, hinted that investor divisions have become a problem for the Thames Water board. He raised the prospect of change. “Then there will be a discussion between the outgoing shareholders and the new shareholders as to the value of the existing Thames,” Black said. Southern saw shareholders massively diluted. “That is a potential option for raising funding for Thames Water, so I would not rule that out,” Black added.
USS appears to be on side with Thames Water. Chief Executive Bill Galvin last month said that “the long-term objective of repairing important UK infrastructure and paying pensions to our members are in strong alignment” with the right regulatory set-up. Omers did not comment.
The critical issue, though, remains the outcome of the 2025-30 investment negotiations. Will Ofwat secure political support for the increase in household bills required to deliver the investment needed? Or will Ofwat be forced to back down on investment to spare households further financial pain?
In testimony to the House of Lords on July 4, Coucher set out just how difficult a line it is to tread between the needs of customers, the environment and shareholders. “We know that we have to make this attractive — but not too attractive — for international and national investors, so that they get a rate of return that reflects the risk they are taking,” he said. “We know that this will need a significant amount of new money.”
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