Cox eyes dividends and gearing in water company crackdown

Ofwat chairman Jonson Cox has set out a sweeping programme of reform for water companies that includes a radical overhaul of dividends, action on highly leveraged capital structures, and changes to companies’ licences.

Speaking at Water UK’s annual City Conference for investors in London today (March 1), Cox was responding to high-profile criticism of corporate behaviour in the sector from secretary of state for the environment Michael Gove, also speaking at the event. Cox has promised to revert to Gove by early April this year with a progress report and next steps, and said he was “thinking aloud” ahead of this deadline.

Cox said the water sector is suffering a “crisis of confidence” on a scale not seen since the windfall tax of 1997. He blamed this on the financial structure of companies rather than their operational performance – specifically, on highly leveraged companies with gearing above 70 per cent. Ofwat regulates water companies on the basis of a ‘notional structure’ of 60 per cent gearing.

Cox said: “The damage to the reputation of the sector is being caused principally by those companies who have adopted what the public see as inappropriately aggressive financial structures for a public service utility. It’s damaging the whole industry.”

In response, Cox called for action on the levels of dividends paid out to shareholders. He detailed a potential four-step policy on dividends which, he said, was based on suggestions made to him by “progressive companies” in recent conversations.

The policy would see a ‘gateway’ introduced for dividend payouts, meaning dividends would only be paid if the company is delivering on its agreed outcomes. It would also see a base dividend of about 4 per cent, reflecting Ofwat’s notional structure. This would be adjusted downward pro-rata if the company was more highly geared. In addition, a company could earn an outperformance dividend, set in such a way that cash returned to shareholders was matched by cash returned to customers in the form of bill cuts. Finally, the dividend would only be paid after “strong regard” had been given to “employee interests”. For example, a company would be expected to tackle its pension deficit ahead of paying out dividends.

Cox said: “Doesn’t that begin to sound more like a public service utility…? I’d encourage all companies to reflect on these ideas as they consider their own dividend policy.” He added that dividend policy would be a key part of business plan assessment at the upcoming price review, PR19.

Cox called, once again, for companies with highly leveraged structures to “urgently” consider their business models. He said Ofwat “expect[s] to see sound, stress-tested capital structures, not just solutions which simply ‘scrape by’ into AMP7”.

In a bid to use transparency to highlight the impact of highly leveraged structures, he said all companies would have to publish a comparison of their actual returns on regulated equity versus what they would have been under Ofwat’s notional structure, from the business year 2017-18 onwards.

Cox went on to set out three changes to company licenses Ofwat is considering. The first would see a duty to put customers’ and society’s interest at the heart of the business in the license. The second would be around resilience – of financial structure as well as operations and service – and could see companies obliged to maintain a standard investment-grade credit rating.

Finally, in an echo of the controversial Section 13 row, Ofwat is considering asking for increased powers to “make simpler” the process for licence changes.

Speaking at the same event, Gove reiterated his pledge to give Ofwat any extra powers it considers necessary. He said: “I will back them in whatever action they need to take to get the water companies – all of you – to up their game.”