Environment, Food and Rural Affairs Committee

Regulation of the Water Industry Inquiry

Written evidence submitted by Dr Kate Bayliss, SOAS, University of London and University of Leeds and Professor David Hall, PSIRU, University of Greenwich

Executive Summary

Over the past decade water and sewerage companies (WASCs) have financed investment with debt while almost all surplus has been extracted as profit. Payments to directors have increased and tax payments have declined. The main concerns with this are:

• Upward pressure on costs
• Lack of accountability and transparency
• Increased inequality and declining affordability

The question is whether regulation is able to intervene to protect the interests of consumers. This paper considers two areas of focus of the regulator: increased emphasis on customers and proposed gain-sharing of high gearing in water companies.

Overall, we conclude that the emphasis on customers is misguided as their opinions are shaped by a variety of influences while they do not have the information on which to assess aspects of company performance. Furthermore, recent interventions by the regulator to tighten the returns made by companies have led to a downturn in company credit ratings. The regulator is caught in an impossible bind as its two objectives – to promote the interests of customers and to ensure that firms are able to finance their operation – are contradictory.

Introduction

1. In 2017, building on a detailed, EU-funded study of water in England and Wales (EW)[1] , we published a Research Paper[2] which showed that for the past decade, investment in the water sector has been financed by debt while almost all post-tax profit was paid out in dividends. Furthermore, companies paid little tax and some water company directors were paid high salaries, in some cases more than £2m in 2016.

2. Our findings attracted considerable media attention[3] and have been echoed in policy. In March 2018 the Secretary of State raised all of these issues in a speech at the Water UK City Conference.[4] The Labour Party included public ownership of water in their 2017 Manifesto.

3. This submission considers the question of whether regulation of the sector is benefitting consumers and / or encouraging responsible behaviour. Overall our conclusion is that regulation is fighting a losing and ultimately unwinnable battle in bringing in ever more complex interventions to address the methods that private investors find to maximise profits.

The problem: increases in debt, dividends and directors’ pay

4. The past ten years have seen a decline in equity investment in water and sewerage companies (WASCs) while debt has increased substantially.[5] Over this period almost all post-tax profit, some £18 billion, has been extracted from the sector by shareholders. This is permitted by the regulator that has (at least until recently) seen dividends and corporate structures as “market outcomes”, while companies are required to operate within a system of price controls. The only intervention in capital structures has been the requirement for companies to retain a credit rating that is investment grade.

5. The hike in gearing (ratio of debt to equity (or sometimes Regulatory Capital Value, RCV)) in some companies was associated with a takeover by over by financial investors. Despite careful reading of company accounts it is not clear how the funds raised from increased borrowing have been used but it appears that in some cases debt finance was used to pay off acquisition debt (so the cost of buying the utility is added to the debts of the licensed utility following refinancing) and/or to pay special dividends.

6. Some water companies, notably those owned by financial investors, have carried out a complex financing mechanism called “whole business securitisation” (WBS), in each case via a subsidiary in the Cayman Islands. WBS allows them to sustain higher levels of gearing without a commensurate decline in their credit ratings, so they remain within the investment grade boundaries of their licence. This debt sits with the licensed water utility and the cost of debt finance interest is paid via customer bills.

7. The first whole business securitisation (WBS) was carried out by Welsh Water in 2001 when it was bought almost entirely by debt by not-for-profit Glas Cymru. The second was by Anglian Water in 2002,[6]  followed by Southern Water in 2003 where net debt increased following WBS in 2003/04 from £1.2m to £2.0m.[7]

8. While the first WBS for Anglian Water took place in 2003, when it was taken over by Osprey in 2007, debt was increased further. An explanation of this is provided by Ofwat in their consultation paper on the takeover: “Anglian Water’s gearing will increase … from around 78% up to a maximum of 83% as a result of a dividend payment to the consortium members by Anglian Water. A dividend of £215m was paid to the consortium members by Anglian Water on 7 March to facilitate achieving the increase in gearing”.[8] In 2007, the year that Yorkshire Water was sold to a consortium of financial investors, gearing increased from 48.8% to 71.7% and net debt increased from £1,553.8m to £2,412.0m, “following the payment of additional special dividends to Kelda of £717.0m in relation to their proposed return of capital to shareholders”.[9]

9. When Affinity Water was bought by a group of financial investors in 2012, gearing increased from 65% to 77% and net debt rose by 61%. The company accounts for 2013 state that “The company’s dividend policy is primarily based on maintaining a target level of gearing of 80 per cent”. The small print of the accounts read that the acquisition was primarily funded by external bank debt of £552.1m (p.26) and the company has since refinanced the acquisition debt by way of a securitization of Affinity Water Ltd.

10. The year after Thames Water was taken over by a consortium of financial investors in 2006, the company paid a dividend of £656.3m. In the same year they took out new loans of £1.2bn. Net debt increased by £2,348m (98%) between 2006 to 2008 (from £2.398bn to £4.746bn).[10] Gearing rose from about 45% in 2005/06 to around 75% in 2008/09 and is now over 80% (Fig 1,).

Fig 1: Gearing (net debt:RCV) Thames Water Utilities Ltd

Source: Moody’s Update on TWUL (October 2017).[11]

11. It is unclear what the additional debt of £2.3bn was used for and this was raised in a BBC documentary in 2017.[12] It seems that at least £2bn of it relates to acquisition debt which was repaid via a financial restructuring, so the additional debt was shifted from investors to the water utility itself and as a result seems to be paid from customers’ bills.

12. But, as this discussion shows it is difficult to say exactly what the funds from the hike in debt have been used for and if they have been used to finance investment or been used for other purposes. This inquiry would provide an opportunity to question water company executives to determine how this practice of gearing hikes has been in the public interest.

What are the problems with the structure?

13. First, debt, dividends and directors’ pay put upward pressure on prices as these are all financed by customer bills. In addition, high debt puts downward pressure on credit ratings and pushes up borrowing costs. In our 2017 paper we calculated that a transfer to public ownership could lead to cost savings of around £2.3bn with the removal of dividend payments and refinancing of private debt.

14. Second, there is a lack of transparency and accountability. The licensed water utility sits in a dense web of related companies. Large volumes of intercompany funds flow between subsidiaries as dividends, loans and interest payments. It is unclear what funds are flowing where. A number of water companies are owned in tax havens. Osprey which owns Anglian Water, Greensands Holdings which owns Southern Water and Kelda Holdings which owns Yorkshire Water are all registered in Jersey. Even going to the company accounts it is not possible to identify the ultimate parent. With Southern Water, the shareholder that seems to have the largest stake, or at least largest shareholder loan, is called IIF Int’l SW UK Investment Ltd. A Google search on this name leads to a company listed in the Cayman Islands and the identity of investors is unknown. In addition, information on the investments of Southern Water is blocked by a site that is password protected -https://www.southernwater.co.uk/investors-information. More clarification of company owners would be a useful outcome of this inquiry.

15. Third, the structure is regressive. Water is essential for life and for many social and economic processes. Payment of water bills can be likened to paying a tax in that it is an enforced contribution. According to Ofwat[13]  in 2014/15 over one third (34%) of the population of EW struggles to pay their water bill. Affordability is in decline. For the 10% of lowest income households, water bills represented 5.3% of spending in 2013, compared to 2.3% for the average household.[14]  The number of calls answered by National Debtline advisers from people seeking help with their water debts increased by 305% between 2007 and 2013.[15] Research from PWC in 2016 estimates that bad debts increased by 44 per cent over the previous five years; they are now estimated to add £21 a year to each household bill.[16] There is considerable evidence to indicate that those that do not pay their bills are usually poorer households,[17] and this crisis is taking place in the context of rising household debt across utilities more widely.[18]  Most companies have set up some kind of social tariff but these are funded by cross subsidies from other households. Yet customers are funding payouts of billions to (often offshore and unknown) shareholders. Investors in water are sometimes pension funds but often the world’s richest. Payments of water bills are a source of growing inequality.

Regulatory response

16. The regulator is clearly aware of concerns around the system of water provision in EW. Ofwat has shifted emphasis in recent years, particularly in the last few months. Two main themes are a greater attention to the needs of consumers and increased intervention in investment financing.

Consumers

17. Ofwat increasingly requires companies to be customer focused. The latest price review (PR19) is described as providing “the framework for a resilient long-term future for water providing more of what matters to customers at a price they can afford and are willing to pay”.[19] With this in mind, a new performance target (C-MeX) provides companies with a financial incentive to improve the customer experience. The C-Mex score is based on a customer satisfaction survey and the Net Promoter Score which is a measure of the customer’s likelihood to recommend their company,[20] although this is hypothetical as household customers cannot choose their provider, but it creates the image of water being like other commodities.  This approach by Ofwat is based on the fact that successful companies in competitive markets operate in this way.

18. But mostly customers are happy with their water services. The Consumer Council for Water (CCW) has carried out an annual household satisfaction tracking survey since 2006. The 2016-17 survey[21] found that more than 90% were satisfied with the services; 73% were satisfied with value for money for their water services, and 7% for their sewerage.

19. But what are these opinions based on? In 2012, CCW commissioned researchers to investigate the ‘gap’ between customers’ satisfaction and their perception of value for money (VFM).[22] They found diverse influences on opinions including a perceived lack of competition in the sector, a sense that water is a ‘free’ resource and the water bills of friends and neighbours. Customers responded to advertising. For example, a campaign by Yorkshire Water that stated that the average person uses 150 litres per day for less than 35p caused some respondents to be more likely to feel they were getting VFM from water services.

20. Clearly, then, consumers lack the information necessary to judge if they are getting VFM for their water. Their views on customer service and reliability of water are certainly valid but for VFM, customers have to rely on the state to regulate water companies effectively. To meet customer satisfaction targets companies could be better off investing in advertising than improving performance.

Curbing excessive returns

21. Ofwat is proposing that firms will be required to share part of the perceived benefit of high gearing with customers. Where gearing levels are above the notional structure of 60%, based on a notional nominal cost of equity less actual cost of debt, the company would need to share 50% of the result with the end consumer. Regardless of its efficacy in achieving its stated aims, the policy risks increasing the cost of debt finance as credit ratings agency, Moody’s has reacted to this move by the regulator. Moody’s changed outlook to negative for Thames, Affinity, Anglian and Wessex in May 2018 following publication of Ofwat’s plans to introduce gain sharing. The reason for the shift to credit negative is that Moody’s sees these interventions in the sector as a “clear departure from previous practice” and a reaction to mounting political and public pressure on the sector. They also see “heightened risk of future political interference in the design of the regulatory framework”.[23] This comes on top of Moody’s move in December 2017 to assign negative outlooks to Anglian, Northumbrian, Portsmouth, Severn Trent, Southern and Yorkshire Water following Ofwat’s publication of its final methodology for PR19 which is likely to cut allowed returns and lead to more challenging efficiency targets.

22. This intervention from Ofwat captures only a small part of the gain from increased debt, as shown in Moody’s conclusion that the direct impact of gain sharing on the finances of Thames would be “modest”.[24] Yet this small move to support customers has had an immediate adverse impact on corporate financing.[25]

Conclusion – the role of the regulator is impossibly compromised

23. Ofwat’s core roles are to promote the interests of consumers and to ensure that firms are able to finance their operations but, as the above discussion shows, these are contradictory. For Ofwat: ‘there is significant scope to … incentivize companies to deliver more of what customers want by better aligning the interests of company management and investors with those of customers.’[26] This is supposedly achieved with a combination of sticks and carrots, mainly via target-setting in the price review process.

24. But private companies’ interests conflict with those of consumers. Consumers want lower prices and high quality and investors want high prices at low cost, possibly compromising quality as seen in the high-profile pollution incidents. Any regulatory intervention results in winners and losers.

25. Rather than aligning interests, the parameters set by the regulator can be seen as obstacles to be overcome in the name of maximising returns. The latest regulatory intervention is part of a trajectory of piecemeal measures introduced in response to actions of private companies. The result is a wealth of impenetrable documents that will fail to encourage customer engagement.

26. These latest measures do little to challenge the real concerns in the sector of financial engineering and lack of transparency, beyond the gain-sharing and a superficial requirement for firms to justify payments of dividends and directors’ pay in PR19. Yet the developments outlined above show that when the regulator does impose even slightly stricter rules on companies, their credit ratings fall. The regulator is thus caught in an impossible bind.