The seeds of destruction were sown by the 1989 privatisation. The government sold water entities in England and Wales for a meagre £6.1 billion. In the absence of parallel water and sewage pipes, competition isn’t possible and companies have captive customers.
The industry has adopted the classic private equity business model. Its key elements are high prices, low investment and financial engineering to extract high returns. Instead of shareholders making long-term investment through equity, the business model uses debt because interest payments qualify for tax relief—effectively a public subsidy. This reduces the cost of capital and increases returns to shareholders but also increases vulnerability to interest rate hikes.
Minimum Investment, Maximum Profits
Since 1989, water charges have increased by 40 percent in real terms. Companies seem to have a profit margin of 38 percent, a very high percentage for a no-competition, low-risk business whose raw material virtually falls out of thin air.
Some 2.4 billion litres of water are lost every day to leaks due to poor infrastructure. Despite the population growing by nearly 10 million, no new reservoirs have been built. Water companies are required to provide clean water but have actually increased contamination by dumping sewage into rivers. Unplugged leaks and sewage dumping increase profits, dividends and performance-related executive pay.
A report from the House of Lords estimated that the industry needs between £240 billion and £260 billion of new investment by 2050, compared to £56 billion suggested by the government. However, the industry has been focused on cash extraction. It has paid out £72 billion in dividends since privatisation and is expected to pay another £15 billion by 2030. It has debts of around £60 billion. Of each £1 paid to the industry, 38p is earmarked as profit. Out of this 20p services debt, 15p is taken by dividends and 3p for things such as tax.
The focus on investment and efficiency has been low. The industry assumed that it could carry on borrowing at low-cost forever. Household bills are inflated to cover the cost of borrowing, which would not be necessary if the regulator, the Water Services Regulation Authority (Ofwat), had insisted on prudent practices.
There is the usual story of regulatory capture or at least cognitive alignment. Around two-thirds of England’s biggest water companies employ key executives who previously worked at Ofwat. Six of England’s nine water and sewerage companies have hired directors of corporate strategy or heads of regulation who previously worked at Ofwat.
For years, red flags have been publicly raised about financial engineering at water companies. In 2018, Ofwat suggested that ‘gearing’ or the debt-ratio at water companies should not exceed 60 percent (there is a complex calculation), but companies have resisted that.
Years of regulatory indulgence have been given visibility by the crisis at Thames Water. Thames loses around 630 million litres of water a day in leaks and routinely dumps tons of raw sewage in rivers. Since 2010, it has been sanctioned 92 times for failures and has been fined £163 million. Over the last three years, the salary of its recently resigned chief executive doubled.
Since privatisation, it has paid £7.2 billion in dividends and has debts of £14.3 billion secured against £17.9 billion of regulated operating assets. In common with other water companies, it has used index-linked bonds for its borrowing, meaning that interest payments rise as general rates of interest increase.
Thames is partly owned by state entities from China and Abu Dhabi and Ofwat seems to have had no success in securing prudent conduct from its foreign shareholders. Thames Water has a debt ratio of around 80 percent, against the Ofwat recommendation of 60 percent. Auditors PricewaterhouseCoopers routinely gave the company a clean bill of health even though it lacked financial resilience. As the Bank of England increased interest rates, Thames found that it could not make the minimalist required investment and service its debt.
The distress at Thames Water is due to the failure of privatisation, profiteering, financial engineering and customer exploitation. Auditors have been silent. The City didn’t care much and Ofwat has done little to check predatory practices. Interestingly, Cathryn Ross, the current joint chief executive of Thames, is a former head of Ofwat. Its Director of Regulatory Policy and Investigations, and Director of Regulatory Strategy and Innovation are also former Ofwat executives.
Ending the Scandal
There is public clamour for the renationalisation of water. However, the Conservative government is unlikely to do that. In 2020, during his campaign to become leader of the Labour Party, Keir Starmer promised to bring the water industry into public ownership but has since reneged. Leaked emails suggest that Labour leadership and water companies have secretly been discussing the possibility of forming ‘social purpose’ companies that would stay in private hands but give greater weight to the needs of customers, staff and the environment.
Section 172 of the Companies Act 2006 requires company directors to have regard for the interests of ‘employees’, ‘‘customers’, and ‘the community and the environment’ in making decisions. Water company directors have shown little regard for that duty. The woolly concept of ‘social purpose’ is unlikely to curb rapacious practices.
The toxic influence of shareholders and dash for maximum returns needs to be checked by public ownership and customer empowerment. Water company shares would be practically worthless if environmental and customer protection standards were to be rigorously enforced. In the event of default, secured creditors are unlikely to get much, and the government can buy the assets cheaply. The cost can be funded by issuing public bonds to local people with the inducement that in addition to interest payments, bondholders will get discounts on their water bills. In addition, customers should be empowered to vote on executive pay. That will ensure that executives face public scrutiny and will not be rewarded for abusive practices.