Thames Water and the limits of regulation: Part 2

[In the first part of this article, I summarised the background to the structure of the water industry in England and Wales as well as the problems faced by its regulators. In the second part I describe how the industry regulators have sought to manage the financial and environmental choices that must be made when authorising investment programs and price caps.]

The issue of combined sewer outflows highlights the difficulties and choices which must be addressed by water companies, regulators and policymakers. After a long period of focusing on compliance with EU directives on drinking water and wastewater, which involved heavy capital expenditures and a substantial increase in the real level of water bills, there was an expectation of some respite from pressures for ever-increasing costs.

That was not to be, but few commentators are willing to be explicit about the trade-offs involved. Does the wish of recreational users of the Thames to avoid exposure to sewage discharges warrant increasing the bills paid by millions of households in the South of England by between 5% and 10%? How far should the case made by Surfers Against Sewage (SAS) concerning marine discharges of sewage be weighed against the interests of households – and businesses – who pay water bills in the South-West and other parts of England?

The standard trope is that all such discharges are due to greedy companies failing to do what is right. That is a fairy story, not real life. Water companies are as fallible as any other human organisation, but avoiding sewage discharges and protecting the environment is often difficult and very expensive. Those costs will inevitably fall on all of us, whether the companies are publicly or privately owned. The choices that must be made are ultimately political – they concern what we are collectively willing to pay for. More spending on pollution means less spending on health care or education or perhaps on foreign holidays.

In an open society there is no lack of highly vocal groups lobbying for their priorities in the hope that these will be paid for by the rest of us. Regulators find themselves in the position of having to decide how to allocate limited resources to competing and difficult to compare objectives. Is fixing leaks more important than reducing the frequency of combined sewer overflows? And should priority in either of these cases be given to London or Oxford, both served by the utility? Such choices are not really the competence of regulators. They can draw up and cost different lists of options. Choices between them are political rather than technocratic unless we are willing to embed value judgements in methods of project appraisal such as cost-benefit analysis. Following that route is often controversial, especially for those whose priorities are ranked relatively low.

The academic response is that such choices should be referred to some kind of political process, but that is an evasion. Politicians hate to make difficult choices and rarely have the competence or time to do so consistently. They are likely to follow recommendations from bureaucrats unless they have lobbied by the same groups whose claims are being assessed. And so the cycle begins again.

There is a parallel thread to the arguments made by many commentators and journalists. Water companies are said to be uninterested in controlling sewage spills because that increases their profits. Let us assume that authors believe their claims and are not just exaggerating for effect. That tells anyone with knowledge of how regulated utilities that the commentators don’t understand how regulation and businesses work. As explained above, water companies are, in effect, contractors employed to operate water and wastewater networks in accordance with decisions made by politicians and regulators. Their profits depend on the assets which they manage and their performance in meeting their targets.

At each price review water companies put forward plans to spend much more on operations and new assets than the regulator is willing to accept. For example, in the business plans submitted for the 2024 Price Review (PR24) the water companies have proposed spending 270% more on enhancements (mostly new assets) in the period 2025-30 than was authorised for the period 2020-25. At 2022-23 prices that would be £41 billion vs an authorised £11 billion in the current period. The route to greater profitability for water companies is to be allowed to spend more on assets and other quality improvements.

Nor is there any short-term gain from failing to prevent or deal with visible leaks, sewage spills, or other network failures. These cost money to fix, bring lots of bad publicity, and often cause the regulator to impose penalties. Businesses don’t deliberately bring the roof down on their heads. Set aside the pantomime villain view espoused by activist commentators and what you find, as noted in Part 1, are bureaucratic and usually boring organisations attempting to do a reasonable job with limited resources and conflicting expectations about what should be their priorities.

This brings us back to Thames Water. The central problem in their case was an attempt to add financial pizazz to the mundane cash flow generated by the operating business. It is one of the oldest strategies in the financial playbook – replacing equity by debt to increase the return on the remaining equity, thus gearing up the business. The only surprise is that the regulator didn’t put limits on the debt gearing ratio (defined as the ratio of net debt to the regulatory capital value of the company), since it was apparent to many outside observers that the strategy involved a significant risk if financial conditions were to change.

The expected variability of profits under a high incentive regime of regulation is much higher than alternatives. For example, the classic US approach is known as rate of return regulation, under which a utility earns a pre-determined rate of return if it meets certain standards of prudence and competence. It is normal under rate of return regulation for utilities to have a debt gearing ratio of 80-85%. Since debt is usually cheaper than equity, this structure has a lower overall cost of capital, but this is achieved by limiting direct financial incentives to improve performance – prudence is more important than greater efficiency.

In the past, the expected financial structure for UK water companies has been a debt gearing ratio of 50% which has increased to 60%. This provides a much larger equity buffer to absorb periods of poor profitability when companies do not meet or out-perform their targets. Over the first two decades of privatisation, this arrangement worked reasonably well – not only in the water sector but also for energy and telecoms networks – as productivity growth in regulated companies outstripped the rest of the economy.

However, by the 2010s the potential gains from out-performance had fallen relative to the regulated cost of capital and regulators looked for a way to reduce the increase in water bills while investments in the assets required to improve water quality and reduce pollution continued. The solution was to reduce the permitted cost of capital before adjustments for out-performance. There was a logic to this. The combination of low inflation and low interest rates meant that the cost of index-linked (inflation adjusted) debt was very low. It could also be argued that risk-adjusted rates of return on equity had fallen after the financial crises of 2007-09, though that might have been nothing more than a response to low rates of economic growth.

No matter what economists and regulators thought, financial markets did not receive the general reduction in the permitted returns on equity for regulated utilities well. There have been many mergers of network businesses alongside private equity buyouts which took companies off stock markets. Thames Water had been bought by a specialist infrastructure fund managed by the Macquarie Group in 2006. The fund sold the company to a consortium of private equity investors in 2017. In 2024 only 3 out of the 11 largest UK water companies are publicly listed. These three companies – Pennon, Severn Trent and United Utilities – have gone through periods over the last two decades when they were more interested in other business activities than their core water services activities. The changes in ownership and business strategy signal an underlying dissatisfaction with the standard return on equity that could be earned from regulated water businesses.

To increase their return on equity, the shareholders of Thames Water group have followed the usual private equity strategy of increasing the debt gearing ratio to pay special dividends. The reported debt gearing ratio of Thames Water in March 2023 was just over 80%. However, if allowance is made for debt owed by its parent company (excluding shareholder loans) the debt gearing ratio was over 85%. In addition, a substantial tranche of its debt – about £2.3 billion including interest liabilities - was due in 2023 and 2024, which would be difficult or very expensive to refinance. When the regulator imposed a heavy penalty for underperformance on various indicators, the fragile house of cards was near to collapse.

The response of the company’s shareholders has been to promise a sizeable injection of equity into the company, but only if it is allowed to increase its charges as if it were a rate of return regulated company. This poses a serious dilemma for the regulator. It will be very reluctant to accede to such threats and it may judge that the shareholders are very unlikely to walk away. On the other hand, Thames Water is a very large, if poorly managed, canary in the mine.