Thames Water and the limits of regulation: Part 3
[In the Parts 1 & 2 of this article, I summarised the background to the structure of the water industry in England and Wales and explained how the industry regulators have sought to manage the financial and environmental choices that must be made when authorising investment programs and price caps. In this final part I examine the options for adjusting regulatory decisions in future to take account of the current environmental priorities as well as the financial constraints faced by the water industry.]
The central issue is that the regulatory model which has determined investment and pricing decisions since privatisation appears to have run into the sand. Initially, a combination of improvements in performance and a steady increase in the real level of water bills allowed the water companies to finance the large investments required to comply with EU directives and to reduce wastewater pollution. However, from 2010 onwards there was increasing political and public resistance to further real increases in water bills while the expected gains from future outperformance were very limited.
In response the regulator cut the amount of new investment which it approved and reduced the cost of capital used to determine price caps. The outcome was equivalent to squeezing a balloon. Public dissatisfaction with water bills transferred to increasingly vocal complaints about water leaks and sewage spills. These are the visible signs of networks that are ageing and having to cope with a rapidly growing population in the south of England.
At the same time, financial markets regarded the return on equity allowed in the price caps as inadequate and were reluctant to provide the additional equity required to finance even reduced levels of investment. Many quoted water companies were acquired by infrastructure funds and private equity investors who were willing to accept high risks by taking on more debt. The overall level of debt gearing increased gradually from around 55% in the 2000s to about 70% now. Thames Water is an extreme case but the whole sector has substituted debt for equity on a large scale.
the regulator has little choice other than to change direction, either in the current price review (PR24) to apply during 2025-30 or in the next one (PR29) for 2030-35,. Its public statements imply more of the same though with some real increase in water bills to fund new investment. Patently this will not work. One goal has been clearly expressed: this is to reduce the overall debt gearing of the sector from about 70% to about 55%. This would imply raising at least £15 billion of new equity plus 45% of the investments required to deal with the problem of water leaks and combined sewer overflows. (The regulatory capital value of the sector is over £100 billion in 2024 and the minimum level of enhancement investment in 2025-30 is likely to be £20 billion.)
The total amount of new equity needed would be of the order of £25 billion. This is an increase of over 75% of the existing equity of water companies serving England and Wales. Given the scepticism in financial markets about water companies this is probably unattainable. Even a much smaller exercise in raising new equity would require a large increase in the allowed cost of equity, which will directly pass through to the real level of water bills.
The regulator faces a set of deeply unattractive options. One way forward would be to abandon its high incentive regulatory regime, thus acceding in practice – though, of course, without admitting this - to the demand of the Thames Valley shareholders. By accepting that the future level of debt gearing ratios should fall in the range of 70% to 80% it would enable the water companies to increase their return on equity to raise new funds that would underpin a higher level of investment in network enhancements.
Water bills would increase at a modest rate in real terms, which can probably be accepted by a new Labour government. The cost of going down this route will be a much higher level of scrutiny of water company performance and frequent public disputes about whether investment programs are competently designed and implemented. No parties are likely to be happy with the process, but such are the costs of replacing incentives by regulatory bureaucracy.
The alternative is to attempt to preserve a less powerful incentive regime with some increase in the allowed cost of equity, the acceptance of a higher default level for the debt gearing ratio (perhaps 65%) and a less ambitious level for investment in network enhancements. Politically, this option may be contentious because it is likely to involve a significant increase in the real level of water bills by 2030 plus a slower improvement in network performance than sought by activists and many politicians.
No regulator wishes to be caught in this situation. The view of their function taken by most regulators is that they are technocrats implementing political and social choices as effectively as possible within the resources available. Some may seek the limelight, but even those want to present themselves as competent managers rather than being responsible for clearly political choices.
There is a third path, espoused by the “one leap and they were free” faction. This is to take the water sector back into public ownership and assume that public funds can finance all the improvements in network performance that are sought but without large increases in water bills. The naivete of this argument is breathtaking as it ignores all evidence from past experience of public ownership as well as the reality of those water companies which remain either under public control (Scottish Water and Northern Ireland Water) or as non-profit companies (Dŵr Cymru Welsh Water).
At the core of this proposal is the idea that eliminating private capital would remove the need to pay dividends to shareholders – claimed to be about £72 billion since privatisation or roughly £2 billion per year. However, bringing the water companies into public ownership would probably cost at least £30 billion and would involve the assumption of more than £70 billion of company debt. The rate of growth of public debt is already a major economic concern in the UK and adding debt amounting to about 4% of GDP would be no small matter. As ratio of public debt to GDP rises the long-term cost of borrowing will increase, so the net saving by substituting public debt for private capital will be significantly lower than the total amount of dividends currently paid.
The performance of Scottish Water and Dŵr Cymru Welsh Water shows that publicly owned or non-profit water companies can match that of private water companies, if they are treated in the same way with minimal external interference. The record of Northern Ireland Water – and water companies in Ireland – is much less encouraging, largely because of direct or indirect political interference. The supposed benefits of public ownership depend entirely on the extra powers conferred by public ownership not being exercised, an assumption that is barely credible in the longer term.
In practical terms, the key question concerning the effect of taking water companies into public ownership goes back to the arguments prior to privatisation in 1989. Will publicly owned water companies be able to finance investment at the level desired by a combination of higher water bills and public borrowing? The answer is almost certainly no! Scottish Water does not have to pay dividends, but it is subject to tight controls imposed by the Scottish Government on borrowing and the real level of water bills. The proposition that difficult financial choices can be avoided by public ownership is contrary to all evidence.
This brings us full circle. Cliches are cliches because they encapsulate all too common circumstances. There are no easy choices for regulators and operators in the water industry today. What is certain is that water bills must rise in real terms to fund the substantial increase in investment expenditures required to enhance the environmental performance of water and wastewater networks which appears to be expected by politicians and activists. This is not the outcome usually advocated as it is all easy to suggest that such improvements involve no additional costs. That is the economics of fairyland. In this world there may be less enthusiasm for large investments when the implications become clearer.
Even so, there is little escape from the combined effects of ageing networks, growing population and the need to offer a higher return on capital to cover the costs of raising more debt and equity. It is relatively late in the current price review, so Ofwat may be reluctant to change course too drastically – especially because we are close to an election which is likely to lead to an entirely different government. On the other hand, trying to maintain the current approach is likely to lead to more blow-ups like that of Thames Water and will mean that any change in direction will be larger and more difficult in five years’ time.
Economic and environmental regulation are not easy. For more than a decade, regulators have pretended that difficult choices could be glossed over and perhaps avoided. The crisis at Thames Water is a direct consequence of poor financial and operational management, but the seeds of the crisis were sown by regulatory decisions over three price reviews. For all the opprobrium that is understandably thrown at the shareholders and managers of Thames Water, this is not a special case. Other companies should bear in mind the warning that “there but for the grace of God, go I”.
For politicians and other commentators, the world of free environmental lunches disappeared more than 15 years ago. It is entirely reasonable to argue that higher priority should be given to reducing the environmental impacts of operating water and wastewater networks. However, it is dishonest to pretend that this can be achieved without any increase in the real level of water bills or diverting money from other public services.
Just as water company bosses are expected to play the role of designated pantomime villains, so too it is the job of economists to remove the punch bowl just as the party gets going.