Analysis: Change the investment mantra

Sharp increases in water charges since privatisation have always been justified by the corresponding increase in investment. But Nigel Hawkins says it’s time to change the record…

Since privatisation in 1989, average water charges in England and Wales have risen by more than 40 per cent above inflation. The sharp increase has generally been justified by the pronounced uplift in investment over the past 25 years; and this political refrain has been a staple of the industry’s apologists for decades.

Annual water investment broadly doubled between the mid-1980s and the mid-1990s as the heavy backlog – especially in delivering sewerage schemes – was tackled. Previously, such work had received a low priority because there were severe constraints on public expenditure.

Furthermore, far tougher environmental requirements – mostly EU-driven – were being placed on the water sector.

Today’s annual investment plans for the sector, though somewhat obscured by the new totex methodology adopted by Ofwat, envisage capital expenditure of about £4 billion a year. Importantly, too, Ofwat’s last price review did include modest price cuts for the 2015/16 to 2019/20 regulatory period.

Water charges were discussed by the Public Accounts Committee (PAC), chaired by Labour’s Meg Hillier, a former shadow energy minister, earlier this year.

The PAC concluded that “Ofwat has consistently overestimated water companies’ financing and taxation costs when setting price limits”, and customer bills were higher than they needed to be.

The PAC proposed that Ofwat “should review its approach to setting allowances for its cost of debt and corporation tax”.

Predictably, Ofwat chief executive Cathryn Ross’s response confirmed that “we will carefully consider the thoughts of the PAC”.

It is the case, too, that Ofwat had to contend with the financial impact of the 2008/09 credit crisis and the unprecedentedly low interest rates that it engendered.

The reality is that, over the past 15 years or so, Ofwat has seriously overestimated the cost of debt, which is driven by its weighted average cost of capital (Wacc) assumption.

Water companies have benefited from this financial oversight, notably by gearing up to very high levels, which has the added advantage of minimising their corporation tax liabilities. There is a strong argument for Ofwat to prescribe acceptable core business gearing figures and for the authorities – whether the Treasury or Ofwat – to tackle the absurdly low corporation tax rate once and for all: a former Ofwat chief executive argued it was “above her pay grade to do so”.

In fairness, the latest periodic review tackled some of these anomalies head on, especially by setting a much tighter 3.6 per cent Wacc figure.

Rather bizarrely, the regulatory regime designed for the privatised water sector has distinctive Marxist features in that – in terms of prices – the interests of customers are diametrically opposed to those of shareholders.

Hence, in the case of Severn Trent, a one percentage point reduction in its wholesale K is worth more than £15 million a year to customers but gives rise to a £15 million-plus cut in pre-tax profits for shareholders.

Figures since 1989 indicate quite clearly that it is investors who have prospered more – at the expense of water customers.

Severn Trent provides the best illustration, in that it remains essentially the same business since privatisation in 1989, when its shares were floated at a price of £2.40.

Its latest share price is about £22.20, an almost tenfold growth since flotation. Over the same period, the FTSE-100 Index has risen from 2,276 to about 6,200, less than three times higher. Also, in the intervening period, Severn Trent has paid out some generous dividends – well above the FTSE-100 average.

Of the other utilities privatised since the mid-1980s, retail gas and electricity prices have generally been driven by fluctuations in gas input costs, and those costs are heavily influenced by movements in oil prices – a correlation that is less clear-cut since oil prices started plunging in 2014.

In telecoms, where competition is now firmly embedded, the former monopoly, British Telecom, has cut its retail prices sharply, driven by the advent of mobile telephony.

Nonetheless, the question remains as to whether the water companies have been feather-bedded for too long and indulged by over-favourable regulation, particularly after the impact of the price cuts imposed by former water regulator, Sir Ian Byatt, in the 1999/2000 price review had worn off.

No doubt the investment mantra will again be cited. But, like a worn-out record, it is beginning to wear a bit thin.