MPs find water sector is failing and “deaf to the crisis” it is facing

The water industry and Ofwat, even after years of relentless criticism, are “deaf to the crisis the sector is facing”. That’s according to a damning report from the Environment Food and Rural Affairs (EFRA) Committee, following evidence sessions with ten firms and the regulator.

The MPs’ overall conclusions in Priorities for water sector reform included that “the water sector is failing,” has “completely lost sight of its purpose and increasingly operates as a network of financial services businesses rather than custodians of a public good,” and needs “root and branch reform”. Among the litany of specific failings listed were "poor financial management and misaligned priorities, which have kept bills and investment low, raised debt levels unsustainably and failed to improve outcomes for the environment”.

The MPs called for:

• Open-mindedness about the advantages and disadvantages of different ownership models, and for Government not to shy away from proposing alternatives to the status quo – including temporary nationalisation where this is in the public good (see below).

• Greater oversight of company structures and regulatory powers to vet and veto potential owners and investors. Regulatory powers should also extend to limiting dividends, pre-approving bonuses and shareholder payouts, and directing debt finance to investment.

• A shared understanding of acceptable financial reward for water sector investors and executives, which is policed against performance.

• Price review process reform. 

• The swift introduction of a single social tariff. 

• Open data.

EFRA noted similarities between its findings and the interim views of Sir Jon Cunliffe’s Independent Water Commission (IWC). However it also highlighted an “overall cultural problem within the sector” and called on the IWC “to put forward strong and significant reforms to put the sector back on track". 

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Comment: EFRA open to use of the Special Administration Regime – by Verity Mitchell

It has been clear listening to the EFRA committee meetings that the members are far more in favour of using the Special Administration Regime than the secretary of state and Ofwat, who prefer a market solution. The MPs said: “The Government should feel able to use its temporary nationalisation powers where invoking them is in the public good, though we are cognisant of the high initial costs that doing so could place on the Government’s balance sheet.”

In its Priorities for water sector reform report, the Committee acknowledged that commercial water companies, with access to three sources of revenue (equity, debt and bills), may have greater flexibility to draw on different revenue streams to prevent sudden bill and cost surges. They also avoid the political trade-offs that a government overseeing a state-owned company might face, for example on investment in health or education. Nonetheless, their view is that there remains flexibility on the ideal “privatised regulated model”.

The Committee agreed with the Independent Water Commission’s interim conclusion that a shared understanding of acceptable financial reward for water sector investors and executives should be developed. The Committee called for even more regulatory interference in pre-approving bonuses and dividends as well as the implementation of a ‘floor’ and a ‘ceiling’ for dividends to “provide reassurance to investors and consumers. Between these thresholds, that regulatory system should encourage higher dividends for better performance, and lower returns for poor performance.” 

This is highly unlikely to reduce the political and regulatory risk premium in the sector, given that the listed companies provide dividend certainty to investors by increasing dividends to match regulated revenue increased in line with CPIH inflation. Such dividend variability could therefore increase the perceived cost of equity, especially for the listed companies.

EFRA members also shared a view that debt is important, particularly for capital investment, but said that there is a case to be made that loans should be predominantly earmarked for investments, while bill revenues, broadly thought to be too low, should be increased to cover more day-to-day expenditure. They wanted to see more money from bills paying for operating expenses and less towards debt repayments or financial returns to investors and executives.

They pointed out that Thames Water has the highest gearing of all water companies and it has been reported that over a quarter of Thames’ revenues go towards financing debt. The problem with the aspiration is that legacy debt must be serviced, returns have to be generated annually and funding all infrastructure renewals and operating expenditure will push up bills for current customers to a base higher than at present.