The Issue with Water: Private Equity, not Private Ownership

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In 1989, on the brink of privatization, the European Commission took legal action against the UK government due to its failure to meet drinking water standards.

This did not disrupt the flotation of regional water authorities in England and Wales, as they were given additional time to achieve the standards they were supposed to meet in 1985. The rationale behind privatization, as outlined in the regulator’s “book of numbers,” was that the private sector would address the much-needed investment that was neglected by the government.

To some extent, this proved true. Capital investment increased by 85% during the decade following privatization, and concerns about drinking water quality were alleviated. Additionally, leakage has decreased by a third since the mid-1990s.

However, the current structure implemented during privatization has proven to be inadequate. The significant investment required to address population growth and the changing climate is now uncertain.

It is essential to examine the failures. One of these failures pertains to the financial resilience of water companies. For instance, Thames Water, burdened with £14bn in debt, may necessitate state assistance. Similarly, Yorkshire Water has raised £500mn from private equity and sovereign wealth fund shareholders. This issue primarily stems from private equity rather than private ownership.

The three listed companies in the sector, Severn Trent, United Utilities, and South West Water (through Pennon Group), along with the not-for-profit Welsh water company Dwr Cymru, have the lowest levels of regulatory gearing, aligning with the “notionally efficient” level set by Ofwat, which has gradually increased over time.

Gearing levels provided by Martin Young at Investec demonstrate a significant increase in Thames’ gearing after its acquisition by Australian firm Macquarie in 2006. Similarly, Southern Water experienced a surge in gearing when Royal Bank of Scotland took control in 2003. However, the regulator did not express concerns about resilience until 2014.

“The regulatory structure established in 1989 functioned relatively well until more aggressive private equity firms entered the scene. These firms operated within the rules, increasing the debt and extracting substantial returns to shareholders in ways that were not anticipated,” explained Kate Bayliss, an infrastructure expert at Soas, University of London.

This does not absolve or overlook the operational shortcomings of listed water companies. No company has a clean record regarding environmental issues such as leakage and sewage overflows, including Dwr Cymru or publicly-owned Scottish Water. South West has had a particularly poor pollution record, and United’s sewage pumping was the cause of a recent bathing ban on Blackpool beach.

Ofwat, driven by the prevailing political sentiment, prioritized keeping bills low over investing in deteriorating and overwhelmed infrastructure. Today, bill payers are paying the price for that failure, just as some investors are accountable for the extraction of dividends by previous owners. However, investors had a choice in their involvement, unlike bill payers.

Nevertheless, some companies are making progress in tackling these issues. The regulator fast-tracked the business plans of Severn, United, and South West in 2019, indicating that they had set ambitious targets for improvements. Additionally, water companies underspent on their regulatory investment allowance in 2020-22, with the exception of Severn and United.

The majority of additional investment approved under the 2021 green economic recovery program for England’s water industry came from the three listed companies. United and South West are leading the way in advancing investment spending to strengthen ailing infrastructure.

Companies with less burdened balance sheets have more flexibility to address public outrage and regulatory demands. It is not helpful to dismiss all providers of long-term private capital, given the significant investment requirements in the water and energy sectors.

However, treating all investors equally, to the extent of welcoming Macquarie back as an owner of struggling Southern Water, four and a half years after their departure from Thames, is problematic. There are no easy solutions, as striking a balance between attracting substantial investment and implementing stricter operational and financial regulations is challenging. Thus, evaluating who proves to be a responsible owner, while considering the restraining influence of the public equity markets, seems like a reasonable starting point.

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