Thames Water and the limits of regulation: Part 1

[This article draws upon my experience in working with the water industry over several decades, including as Chairman of the Water Industry Commission of Scotland, which regulates the water industry in Scotland, from 2011 to 2017. For a period in the early 2000s I worked for NERA Economic Consulting which had Thames Water plc as a client. However, I have had no direct involvement with the company for more than 20 years.

This is a lengthy article running to over 5,000 words. To make it more digestible I have split it into three sections. The first part provides the background to the structure of the water industry in England and Wales as well as the problems faced by its regulators.]

At the beginning of April 2024 Thames Water announced that its parent company had defaulted on some debt. This is one step in a long running process by which the utility is trying to refinance its operations. The announcement has been greeted by many articles criticising Thames Water specifically but also denouncing both the privatisation of the water industry in England and Wales and the failures of regulation which, it is claimed, led to the current situation. Reality, of course, is more complicated and highlights the difficulties of managing and regulating infrastructure with long-lived and very expensive capital assets.

Utility companies in general and Thames Water in particular are not easy to defend. They provide essential services which attract attention only when they fail or when customers are upset about the costs of the services. They are usually rather bureaucratic and unimaginative – being boring and reliable is a large part of the job description. Still, many have been convinced by PR advisers that they should engage with the public via largely empty virtue-signalling. This goes down poorly when, as always happens, things go wrong either because of company mistakes or external circumstances.

By design, most of the strategic decisions made by utilities are driven by regulatory and other policy decisions. The job of utilities is to implement those decisions in a competent and cost-effective manner. However, the media and politicians, all of whom are both ignorant of and uninterested in detailed policy issues, want to have visible villains who can be blamed when things go wrong, especially when what has gone wrong is the foreseeable consequence of decisions made by others. The managements of utilities themselves often fail to understand that they are the designated fall guys and get upset by what they regard as unfair criticism.  But, at least, they can be well compensated for playing this role, though that too is a source of outrage in the media.

In principle, the regulatory and policy decisions which determine what utilities do are subject to public scrutiny with the publication of lengthy consultation documents and various kinds of public hearings. Much of this is bureaucratic time-wasting with the volume of documents substituting for any focus on key decisions. Even then, when challenged the usual response is that legislation or third parties mandate the options which have been chosen.

The Thames Tideway Tunnel, discussed below, is a classic example. There was – still is – a genuine problem that could have been addressed in various ways, some much less expensive than others. Government officials and Thames Water itself preferred the most expensive option, even though alternatives were cheaper and would have brought much quicker environmental improvements. When challenged during the planning process and in court cases, the government claimed that their preferred option was necessary to comply with EU legislation. Anyone familiar with the EU was aware that EU rules are as flexible as a long piece of elastic, while many countries ignore them or rely on distinctly local interpretations of what they require.

The decision to pursue a very large and expensive project was entirely the product of domestic bureaucratic and commercial decisions, which meant that London has suffered more than 15 years of pollution incidents that could have been either avoided or minimised at a modest cost.  One irony is that, after extended delays, Thames Water did not have the balance sheet to finance the project, so it was developed by a completely different entity though it will be operated by the company. Nonetheless, millions of Thames Water customers who will in no way benefit from the scheme will be required to contribute to its costs for more than 40 years.

Blaming the company for outcomes over which it has no control is perhaps rough justice for its failure to give priority of the interests of its customers. The whole episode – and many others – illustrates the core lesson that, notwithstanding the rhetoric of economic and environmental regulators, the interests of consumers are rarely the dominant concern of policymakers who determine the behaviour of utilities. Customers may constrain the amount of money that is available to achieve public and private goals, but the core decisions are rarely made in a transparent manner and often rely upon very partial presentations of evidence and assessments of the economic or other trade-offs.

With this context in mind, our story goes back more than half a century to the Water Act 1973 which created 10 regional water authorities by merging many local authority departments and companies. The hope was that greater scale and freedom from local political influences would enable the authorities to operate more efficiently and mobilise the technical skills required to manage large investment projects. Unfortunately, bigger did not mean better in too many cases, while the water authorities had severe internal conflicts of interest between their responsibility for the management of water resources in river basins and their operational role as water and wastewater utilities.

The problem came to a head in the late 1980s. What the public saw was a doctrinaire rush to privatise public services including the water industry, an option that many people felt should never have been contemplated. For those in the industry, the issue was quite different. In the late 1980s the EU proposed different pieces of legislation to deal with (a) water treatment, and (b) urban wastewater collection and treatment. It was clear to everyone that implementing the provisions of this legislation would be technically challenging and very expensive – not just in the UK but throughout Europe. However, the legislation was strongly supported by Germany and the UK government felt that it had to accept the proposals as a quid pro quo for German support for the UK’s single market proposals.

Preliminary estimates of the capital cost of complying with the new EU legislation were greater than £10 billion. Since the water authorities were public bodies, this money would have to raised via the Public Works Loan Board at a time when the government was trying to reduce the public sector borrowing requirement. Privatisation of the water industry was not a doctrinaire decision, but it was a financial sleight of hand. The existing debt of the water authorities was transferred to central government and the companies were floated with balance sheets that were free of debt. This would allow the new companies to borrow against their existing assets and cash flow to finance the investment required for compliance with the EU directives.

At the same time, the environmental responsibilities of the original water authorities were transferred to a separate body (the National Rivers Authority) that later became part of the Environment Agency. Most commentators accepted that the separation of environmental regulation, flood control and water resources management from the operations of the water industry would lead to greater transparency and better outcomes.  A separate economic regulator – now known as Ofwat – was created to monitor the economic performance of the new companies and set 5-yearly controls on tariffs.

Initially, this model worked relatively well. There was, of course, the usual criticism of how former public officials received large salary increases as senior executives of the newly privatised companies. However, the water authorities were over-staffed and not especially good at managing either operations or investment projects. Large savings in recurrent costs could be made by reorganising many aspects of operations, while the new companies improved their performance in designing and implementing large capital programs. The requirements of the EU directives – as understood at the time (which turns out to be very important) – were broadly met within 15 years from privatization without any need for public funds.

Looked at from the outside, this last achievement is remarkable because the EU and UK government had got their sums completely wrong. In the end the water companies in the UK spent about £60 billion on complying with the EU directives, six times the sum initially expected. The enormous cost over-run was not unique to the UK. The same pattern occurred in every EU country, and it mimics the earlier experience of environmental legislation covering water pollution in the United States. Legislators and environmental regulators around the world systematically underestimate the costs of compliance with rules which they propose. Nonetheless, starting with zero debt the privatised water companies were able to finance and implement the capital programs required.

However, this success has brought in its train a variety of problems whose consequences are only now being realised. To service the debt that was incurred to finance the investments, regulators had to allow the water companies to increase their charges substantially in real terms. From 1989 (immediately after privatisation) to 2011 the consumer price index for water and wastewater services increased by about 70% in real terms. This increase was much larger than the real increase in electricity prices over the same period, which was about 10%. Hence, by 2011 there was a growing level of customer and political unhappiness at the burden of water bills, especially for low-income households.

Though it was not obvious to the public, this real increase might have been substantially higher had the companies not been able to reduce both operating and capital costs. The UK relies upon a system of incentive regulation for utilities. This is implemented via what is called yardstick competition in the water sector. Companies are benchmarked against each other with respect to various indicators of costs and performance. Their price controls allow them to recover costs roughly equivalent to those incurred by the top third in performance terms adjusted by expected improvements in productivity over the next period.

This is a high incentive regime which rewards companies that succeed in reducing their costs relative to the industry average. In the first decade after privatization, the performance of companies improved a lot (more than 25% on many indicators) and these improvements contributed to keeping bills down in later periods. However, by 2011 the scope for large out-performance had largely disappeared and the differences between companies were much smaller.

For the price reviews implemented in 2015 and 2020 there was a large amount of pressure on regulators either to hold water bills constant in real terms or to reduce them over the review periods. There were only two ways of doing this: either to set lower targets for the required amounts of capital investment, and/or to lower the permitted return on capital. Both approaches were followed with consequences that have gradually become apparent.

Pressure for continued expenditure from the EU and environmental groups did not abate after 2005. New legislation on drinking water quality and the environmental quality of rivers, lakes and coastal was adopted between 2005 and 2015, while the older legislation was reinterpreted to require stricter standards. In addition, like many Victorian cities around the world, London has a major problem with old and decaying infrastructure. Water pipes leak, while replacing them is both expensive and very disruptive so it is unpopular.

London and other urban areas must also deal with the consequences of past investment decisions. To save money in some areas, surface water drains were combined with foul sewers or were used to manage overflows from sewers. This is not a problem if the water collected by combined drains is sent to wastewater treatment plants. However, doing that was more rather than less costly, so much of the water collected by combined sewers is discharged directly into rivers.

Under current interpretations of environmental rules this is no longer regarded as being acceptable. The problem has been exacerbated by the loss of natural surface drainage in urban areas as open areas have been paved over. Hence, there are regulatory and public pressures to improve the quality of rivers by either (a) separating surface water drains and foul sewers to prevent sewage spills to rivers or (b) collecting and treating most or all water collected in surface water drains.

This has been a particular problem in London because of the size of the city. In the past, water quality in the Thames was very poor, even after the construction of Bazalgette’s sewers under the Embankment. From the 1960s onward the quality of the Thames improved gradually as the sewer network was extended and more underground streams which had turned into sewers were diverted into the sewer network. The decline of industry, the spread of indoor sanitation and many other social changes contributed to this improvement. Better water quality led to greater recreational use of the river for boating and other purposes. However, with better monitoring it was realised that the river was being contaminated by raw sewage initially during episodes of severe rainfall but with increasing frequency as years passed.

Understandably, recreational users of the Thames wanted the frequency and severity of such contamination episodes to be reduced or eliminated. The decisive factor was that the EU with the agreement of UK environmental regulators interpreted such contamination as a violation of the urban wastewater directive and threatened enforcement action against the UK. A variety of solutions were proposed ranging from local changes to manage or divert the worst overflows to a grand project to collect all the stormwater discharges and transport them downstream via a lengthy tunnel for treatment in East London. Both the UK government and Thames Water favoured the grand scheme, called the Thames Tideway Tunnel, and forced it through against substantial opposition. The Tunnel has recently been completed at a reported cost of £5 billion. Whether it will solve the original problem remains uncertain.