Water Bill

Viscount Hanworth Excerpts

Monday 27th January 2014 Lords Chamber

[Viscount Hanworth (Lab)]

My Lords, I should like to talk about the financial circumstances of our water companies, but first I must describe some of their recent history and its relevance to their prospects.

From the middle of the 19th century for a period of 100 years, the water utilities in the UK and elsewhere became progressively concentrated under public and municipal ownership. Then, in the UK in 1989, the process was reversed through privatisation. Now the UK water utilities are owned almost entirely by private profit-seeking firms, of which the majority are in foreign ownership. The motives for privatisation in the UK and elsewhere were both ideological and fiscal. By the late 1980s, the water utilities were in a parlous state. Successive Governments, who had been intent on limiting public expenditure, had been unwilling to afford the necessary capital expenditure that was required for maintaining the water network. The water mains were corroded and the sewerage system was in a state of collapse.

The effect of privatisation was to release the water industry from this burden of financial stringency and to allow it to fund its investment by borrowing from the financial markets. Soon, the beneficial effects of the increased capital funding became evident. There were significant improvements in the state of repair of the water network, and the cleanliness of our rivers and beaches began to approach the standards that had been mandated by European legislation. In the six years after privatisation, the companies invested £17 billion, compared with the £9.3 billion that had been invested in the six years before privatisation.

The proponents of privatisation regarded the improvements as a validation of their philosophy. However, the improvements were at a cost to the consumers. Tariffs increased by 46% in real terms during the first nine years after privatisation. Operating profits increased by 142% in the first eight years, which is to say that they more than doubled. The private profitability of the water industry has increased in the ensuing years and has reached astonishing levels, but now there is an impending crisis in the provision of the services. Our water supplies are coming under increasing pressure as a result of a growing population and a changing climate. The summer droughts and the winter inundations that have been experienced in recent years are set to become increasingly severe.

The necessary investments to meet this crisis have not been forthcoming and the Government no longer have the power to compel the private companies to meet the needs. It is only by dint of increasing investment in the water infrastructure that the resulting problems can be alleviated. The requirement is for a nationwide strategic initiative aimed at upgrading the infrastructure, and this is what we should expect from a water Bill. The current Bill falls far short of what is required. It seems to embody the delusions of the protagonists of privatisation.

The intention of the Bill is to address the emerging problems by creating a competitive environment in which the water companies can operate. Thus it has been asserted in a document of the Department for Environment, Food and Rural Affairs that:

“Allowing more competition in the sector will drive forward both innovation and efficiency, by bringing in new players and new ways of thinking, and by using market forces to keep down customer costs”.

The hope is that:

“This will benefit not only customers and stimulate growth, but will also contribute to our future resilience and the environment”.

This prescription must be utterly bemusing to anyone who is mindful of the circumstances of a natural monopoly. It is as if by tinkering at the edges of the industry, the major demographic and climatic problems that we face can be addressed.

It is appropriate, at this point, to examine what has happened to the ownership of the industry since it was privatised, and to explain why the Government can have little influence over its investment decisions. The firms of the water industry have become vehicles for financial profit-seeking by owners who have used their guaranteed profitability to pay exorbitant dividends to themselves. In fact, the ultimate ownership of the firms is often obscure and has to be traced through hierarchies of holding companies back to private equity companies, which often reside in offshore tax havens, or to sovereign wealth funds. The tenure of ownership is often fleeting—five years being a typical duration.

The owners have used the equity of the water companies as a means towards some highly leveraged borrowing of funds that can be used for purposes that have nothing whatever to do with the financing of investment in the infrastructure of the water industry. The attraction of the water companies to the financiers has been on account of the highly assured income streams that they generate. There is no likelihood of a reduction in the demand for water, and some generously remunerative water tariffs are fixed for five-year periods by the regulator Ofwat. Such circumstances are liable to lead to favourable appraisals by the credit rating agencies, which enable the borrowing of funds at low rates of interest.

As a result of their borrowings, the leverage ratios of the water companies, which are the ratios of their total borrowings to the enterprise value—which is the sum of the borrowings and the equity capital—have reached astronomical levels. It is reported, for example, that the leverage ratio of Thames Water reached 80% in 2013; and figures as high as 95% have been reported for other companies. On the eve of privatisation, virtually all the enterprise value of the water companies was in equity capital, which is to say that their leverage ratios were close to zero. A high leverage ratio constitutes a significant tax advantage. It implies that the debt servicing of the company is predominantly via interest payments as opposed to dividend payments. Interest payments are regarded as part of the operating costs of the company and are deducted from the income before the residue is taxed. By contrast, dividend payments enter into the calculation of the tax liabilities.

A disadvantage of a heightened leverage ratio is that it is liable to prejudice the credit rating of the company. Given that variations in the size of the dividend payments can provide a significant buffer in the event of a loss of profitability, the financial vulnerability of a highly leveraged company is increased and, therefore, its ability to borrow is decreased. In consequence of its heightened leverage ratio, Thames Water is facing financial difficulties and cannot borrow the money it needs to finance the Thames Tunnel project. As a private equity company it is unwilling to raise more equity, since this would entail a loss of control in favour of the shareholders. Instead, it is asking for help from the Government.

This may be the first of a series of similar circumstances affecting our water companies. Companies will have difficulty in financing other similar investment projects that will be vital to our future environmental security or resilience, as the Government’s documents term it. Therefore, it is probably inevitable that the Government will have to provide the necessary funds. This should also provide the Government with an opportunity to restore the water utilities to some degree of public or municipal ownership and control.

There is one outstanding example of what can be achieved by the appropriate governance of a water company: Welsh Water, which is run as a not-for-profit company. It was bought from its owners in 2000 at a cut price when it got into financial difficulties through an ill advised programme of diverse acquisitions. The buyers were a group of former industry executives and public servants, and their leveraged buyout was financed entirely by debt. Since this acquisition, the performance of the company has been outstanding. Its surpluses have been invested in the network and have been used to augment the company’s financial reserves. Shares have not been issued but the ratio of the company’s debts to its total asset value has fallen from 93% to 65%, thereby giving it the best credit rating in the entire UK utilities sector. This is a model of responsible ownership and governance that could be replicated throughout the water industry.