Mr Jonathan Stanley Root                            WQI0021

Written evidence submitted by Mr Jonathan Stanley Root

Environmental Audit Committee call for evidence before oral evidence session on 15 May 2024

Stanley Root, 2 May 2024

How effective is Ofwat’s regulation of water companies?

What is being done to ensure the financial resilience of water companies?

Is Ofwat facilitating adequate investment in improving water quality and water security?

This paper addresses financial aspects of the above questions, based on an independent review of 34 years of privatized water utilities’ financial statements including a comparison with those of publicly owned Scottish Water. It considers:

• how effectively Ofwat has regulated the level of returns to shareholders
• how effectively Ofwat has regulated the level of company debt and its consequences for the financial resilience of water companies
• how successful Ofwat has been in facilitating adequate financial investment into the water companies by shareholders both in terms of fresh injections of equity and retaining profits within the company to fund capital expenditure and strengthen company financial resilience
• how successfully Ofwat has regulated the financial cost of capital investment and the value for money customers are getting for the bills they pay
• Ofwat’s effectiveness in ensuring transparency of financial costs related to capital expenditure

Key points

1. Ofwat has allowed dividends to be unreasonably generous for too long. This was justified by the need to make shareholder returns sufficiently generous to attract investment. But shareholders have not invested. Across the industry they have invested minimal fresh equity while extracting large dividends. Why has Ofwat spent 34 years giving generously to shareholders who only take and do not give back?

2. Ofwat has allowed unreasonably high levels of debt to finance these dividends. These large dividends have been financed thanks to Ofwat accepting unreasonably high levels of debt.  This was, and still is, justified by the ‘mortgage myth.’  However, financial statements demonstrate the mortgage analogy to be false. A better analogy is the credit card. Ofwat effectively gave the industry a credit card with a limit many times annual revenues which companies eagerly seized upon to run up large debts.

3. As a result, under Ofwat’s watch, total finance cost (dividends + interest) has become unreasonably expensive. For example, for every £ 100 spent on capital expenditure another £ 55 - £75 or more is spent by regulated companies on dividends and interest.

4. Given the need for bill increases to fund significant capital expenditure, Ofwat may struggle to persuade customers to continue to fund such generosity. At a time when higher levels of capital expenditure are urgently needed, customers willingness to pay has never been more critical. While customers may be prepared to pay for the necessary capital expenditure, they will be reluctant to see such a large part of these bill increases go towards such high levels of financial cost.

5. Ofwat permits companies to be less transparent than desirable about these costs. For example, Cathryn Ross, director at Thames Water recently claimed in a presentation that only 3% of customer billings went towards finance costs.[i] Even a cursory glance at financial statements proves this is not true. The real cash cost is closer to 11% and the total finance cost including losses due to inflation etc. is closer to 28%.[ii] When a leading company official and former head of Ofwat misrepresents the facts by an order of magnitude it suggests that excessive finance cost is an issue the industry does not wish to acknowledge. Another example comes from a previous owner of Thames Water, Macquarie[iii]  The same is true of many economic commentaries upon industry. They tread lightly on the subject of shareholder returns and, if mentioned at all, it is by referring to them a general sort of way as being unobjectionably low. But financial statements demonstrate otherwise.

Effectiveness of Ofwat’s economic regulation

1. Unreasonably high levels of dividends

1. Has Ofwat ensured returns to shareholders are no more than reasonable?

1. No. Ofwat has allowed excessively high rates of dividends. Here, for example United Utilities cost of debt has averaged around 3.3 % since privatization. Meanwhile their dividend payments as a percentage of the equity they have put into the company (share capital, share premium and retained earnings) has averaged around 13.4%. This is not a couple of percentage points equity premium as is often indicated in a general sort of way in Ofwat’s technical literature. This is more than four times the market rate for debt.

Similar Charts can be found here for Severn Trent[iv], United Utilities[v]

2. And if we look at the risk level, for which such generous returns have been rolled out for 34 years, we see a very low level indeed.  The company is a monopoly protected from aggressive competition. Its product is one of the few that is undeniably proof against technical obsolescence. Its revenues are guaranteed by the government to rise with inflation. Even its profits are guaranteed providing it achieves annual performance targets agreed with Ofwat, many of which are self-reported and audited with a light touch. Why did Ofwat allow such high dividend payments for such low risk?

3. By comparison Scottish Water’s cost of debt is more straightforward to calculate. It is simply the market rate of interest (around 5.6%) charged by the government on its loans to encourage efficient financial performance.

2. Have generous dividends succeeding is attracting fresh equity from investors?

1. No. There has been minimal new investment since the day of privatization. Thames Water is an example. Investors contributed new share capital to Thames Water on only two occasions other than the day of privatization. And in each of the three years they contributed capital, they withdrew more in dividends.

Similar charts can be found here for Severn Trent[vi] and United Utilities Water Limited[vii]

3. Has Ofwat succeeded in getting investors to leave their profits in the company to fund capital investment and increase financial resilience?

1. No. Shareholders have taken out in dividends as much of profit after tax as they could. Here for example, once again, is Thames Water Utilities

As a result, most companies have taken seen their shareholder equity decline significantly after adjusting for inflation over the period[viii]

Similar Charts can be found here for Severn Trent [ix] and United Utilities Water Limited[x]

2. By contrast Scottish Water has shown a steady increase in retained earnings since its establishment in 2002 since there is no requirement to pay dividends to shareholders. Surplus cash contributed by customer billings has been retained to fund capital expenditure and strengthen company financial resilience.

4. But investors have spent £ billions buying companies in private sale or on the stock exchange, where has that money gone?

1. These large amounts of money bypass the regulated company, just as when landlords buy and sell old Victorian terrace properties between them. The money they pay and the profits they make do not go into, for instance repairing the house’s worn out drains. They go into the pockets of another landlord.

2. So, for instance when RWE bought Thames Water in 2000, shareholders pocketed the £ 3.6 billion sales proceeds, but all Thames Water got was a new owner who proceeded to extract dividends and increase debt at a much faster rate than their predecessors.

3. And when Macquarie bought Thames from RWE in 2006, none of the £ 4.8 billion purchase price went towards improving Thames infrastructure, it went to previous owners RWE. All Thames Water got was a new owner who needed to extract even more cash to pay for the debts taken out to fund the purchase. This kind of flipping of utilities from one owner to the next brings not measurable benefit to the companies themselves no matter how much cash is involved.

5. But what about the £ billions shareholders claim to have invested in capital expenditure?

1. The word investment has several different meanings. As shown above shareholders have not invested little in their utilities since privatisation, either with fresh equity or allowing profit to be retained in the company. But they have taken customer cash and used it to buy fixed assets. This is what they call their investment in the company.

2. The following graph shows United Utilities cash generated after tax and net capital expenditure since privatization. In only 6 years was capex greater than cash generated. The entirety of United Utilities capital investment programme could have been funded directly from customer billings with £ 5.8 bn to spare by March 2023.

3. Scottish Water have also invested significant amounts in capital expenditure while ensuring that the cost was met by customer billings.

2. Unreasonably high levels of debt

1. Has Ofwat economic regulation kept debt down to reasonable levels?

1. No. Debt quickly rose to unreasonable levels at most companies soon after privatization and now has become a burden with which all companies struggle. Companies successfully used the argument that since debt was cheaper than equity gearing levels should be allowed upwards of 80%.

2. They also persuaded Ofwat to measure gearing against a notional cost of fixed called Regulate Capital Value (RCV). RCV uplifts the value of fixed assets by the annual inflation rate, and so grows higher than the book value of fixed assets which is measured at historical cost. And so Ofwat readily accepted much higher real cash debt levels by measuring against a purely notional RCV.

3. The table below shows gearing measured based on financial statements as is the practice with most other companies.

2. Was this debt necessary to fund increased capital investment following privatization?

1. No. Ofwat accepted companies’ argument of the mortgage analogy, i.e., that long term investment should not be paid for by current customer billings but by debt, just as when you or I buy a house many times more than our annual income could afford. However, thanks to generous price rises permitted by Ofwat immediately following privatization, net cash generated from operations could have comfortably financed all subsequent capital investment with cash to spare for most companies. (Net cash generated from operations is all the cash that is left out of annual revenues after paying for all day to day operating costs of the business such as wages, maintenance, etc.)

2. However, the mortgage analogy was inappropriate. A better analogy would be the credit card. It was as if Ofwat had handed new shareholders a credit card with a limit many times annual revenues. These were eagerly used to pay excessive dividends or run up debts in order to finance the initial grand ambitions of new owners to build, through mergers and acquisitions world class multinational utilities.

3. Net debt plotted against cumulative dividends and gross finance costs at Thames Water is shown in the figure below. In practice debt was taken out not to fund capital investment but to fund generous dividend payments. In due course more debt was taken out to fund the interest payments on debt taken out to fund generous dividend payments.  And so on. This is how we get to the large debt levels under which most companies now struggle.

4. Generous dividends were also extracted by holding companies for the purposes of mergers and acquisitions but the holding company. In the heady days following privatization and the freeing up of management from the shackles of government bureaucracy, many companies had ambitions to become, through energetic mergers and acquisitions, world leading, multinational conglomerates. This is how entrepreneurial managers drive growth and increase shareholder value. Here is, for instance Sir Desmond Pitcher, from the new named United Utilities group plc annual report of 1996.

“

“A momentous year

I am pleased to report to you for the first time as shareholders in United Utilities PLC. Our company has made substantial progress during a momentous year. The acquisition of NORWEB plc, with its electricity, gas, and telecommunications interests, fundamentally changed the Group and the benefits that are already being achieved have exceeded our expectations.

[Our] structure reflects the outcome of the comprehensive review we have conducted of strategy and of each of our operations. United Utilities will be distinguished as a focused provider of high quality utility services in the United Kingdom and around the world.

And so, another eminently reasonable sounding reason for taking large dividends out of the regulated company and taking on large debt at the holding company level was to buy other business in the UK and around the world.

But these plans were to come to nothing after 15 years. United Utilities bit by bit sold off its overseas holdings, and in 2006 divested its landmark acquisition, NORWEB. Now the only thing that remains of United Utilities is the name, as the group had concentrated solely upon the business of the regulated entity.

The chart below shows for United Utilities Group the period of global ambition, followed by the realization that the group should really focus on its core business. Exactly the same story was repeated at Severn Trent plc and Thames Water plc. When United Utilities sold off Norweb it did not plough the proceeds into the regulated business.  It simply returned cash to shareholders. And so, the grand notion that holding companies would grow and strengthen their business to become a support to their regulated entities evaporated one by one at each of the big water utilities. Now holding companies are more or less a burden on the back of their regulated companies, some more so than others.

5. United Utilities plc had big plans to establish an international utility conglomerate, but around 2006 the idea was abandoned to focus on the core business of the regulated company, United Utilities Water Limited

More or less the same thing happened at Severn Trent around the same time too.

3. Ofwat has allowed total finance cost to rise to unacceptably high levels.

1. For example, at Thames Water for every £ 100 of capital expenditure there has been a finance cost of around £ 57.

See similar charts for Severn Trent[xi] and United Utilities [xii]

2. By contrast Scottish Water’s comparable financial overhead on capital expenditure is around 10%

Concluding remarks

In the short term, given the significant level that total finance costs, (gross interest charges plus dividends) have now attained after 34 years of Ofwat economic regulation, it is to be hoped that water companies become more transparent about these costs. This could begin with their current proposals for AMP 8. It is not sufficient to make promises about impressive levels of capital investment. These need to be accompanied by an explanation of where the funding will come from, and what will be the cost of delivering this capital expenditure in terms of estimated gross interest and dividends. It is also to be hoped that Ofwat will require disclosure of the proposed total finance cost related to companies’ capital expenditure plans, so that customers can see clearly where the cash from their steeply increased bills is going and no longer continue to be confused as they have been by corporate presentations such as those of Cathryn Ross and Macquarie.

In the longer term, consideration ought to be given to the reasonableness of these finance costs. Is it sustainable to keep this snowball of debt rolling down hill, borrowing to pay dividends, and then borrowing to pay the interest on those dividends, no matter how strongly it is advocated by the companies themselves and their professional advisors who have for a generation made a handsome living from the fees it generates?

Scottish Water appears to demonstrate that a water company can be run financially efficiently and achieve performance improvements comparable to those of English and Welsh utilities without the motor of profit motive behind every effort of improvement or the burden of external shareholders who have little connection to the business other than an appetite for steady and increasing dividend cash flow. Does the complex paraphernalia of dozens of individual performance targets together with cash rewards and penalties for each, contribute to real efficiency or rather, given the demands of external shareholders, encourage gaming of the system, and dishonest self-reporting, and overall excessive cost?

About the author

I am a retired audit partner, having spent most of my professional life working in Russia for one of the big four accounting firms. I consider the debate about the future of the water industry to be a highly significant social issue, and so decided to research the story that company financial statements tell about the industry to compare with what company management and their advisors say. When my research is complete in the coming months I will publish online, freely accessible, searchable proforma financial statements in standard format of all major water utilities, regulated company and holding company, for the 34 years since privatization. All charts in this report are drawn directly from the financial statements of the relevant company.

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