Ofwat’s reform agenda

Environment secretary Michael Gove has called for the amelioration of the water sector and has offered to give Ofwat more powers to make this happen. Now Ofwat has responded with its plans for how the water sector will be reformed. Katey Pigden investigates.

Over the past few months, the water sector has witnessed something akin to a tennis match between environment secretary Michael Gove and Ofwat chairman Jonson Cox, as they bat back and forth suggestions on how to get the water sector to clean up its act.

The latest instalment in this rather slow match is a letter from Cox to Gove, sent on 10 April, which sets out the regulator’s agenda to improve corporate behaviours. This includes:

• Reform company licences to make it even clearer that companies must put customers at the heart of everything they do;
• Look to companies to share with customers any financial benefits they make from taking on additional gearing;
• Set tighter standards to make sure companies are financially resilient in the long term;
• Step up demands on transparency around dividends and profits, including a clear expectation that companies meet their obligations to customers before making dividend payments; and,
• Address concerns around executive pay, including an expectation that water company boards explain executive bonuses by reference to exceptional delivery for customers.

Echoing Gove’s words from the Water UK City Conference in March, Cox’s letter indicates: “Some water companies appear to be focused too much on financial engineering at the expense of public service.

“Alongside this, we’ve seen significant service failures, most recently following last month’s cold snap and quick thaw, which led to tens of thousands of customers being left without water. All of these things have damaged trust in water. Ofwat has been pushing water companies to up their game for some time; but we need to go further, faster.”

He adds: “That is why we have set out an agenda of reform to bring the water sector back in balance, including getting back to a proper sense of public service provided under private ownership.

“We expect the water sector to own the challenge by taking the lead in engaging with customers and the wider public about how it can redefine its role and rebuild trust. Companies who wish to be leaders in the sector will step up, voluntarily accept the need for change and put customers’ interests at the heart of everything they do, as an essential step in rebuilding trust.”

Water companies claim they have been doing just that. After being labelled by Gove, last month, as one of four companies which “make particularly keen use of financial engineering”, Anglian Water announced plans to embark on a transparency overhaul. A spokesperson for the firm tells Utility Week: “Ofwat has said companies who wish to be leaders in the sector will step up and put customers interests at the heart of everything they do. Anglian Water has already committed to do that. We were the first to act following Gove’s comments at the City Conference, announcing changes that will put public interest right at the heart of what we do.

“The comprehensive series of financial and corporate initiatives will improve transparency, trust and customer confidence. These include simplifying our corporate structure, speeding up the removal of our Cayman Islands subsidiary, significantly reducing shareholder dividends to reduce gearing and to enable us to fast track investment in resilience between 2018 and 2020.”

Meanwhile, towards the end of last year, Yorkshire Water and Thames Water both vowed to close their Cayman Islands subsidiaries. A spokesperson from Yorkshire Water says: “This is a welcome move from Ofwat and we strongly support the proposed steps to formalise the obligation for companies to act in the public interest and the proposals to improve financial resilience and transparency.

“Yorkshire Water responded to customer concerns about offshore structures by announcing plans to remove Cayman Islands companies from its structure. That process remains on track and we expect it to be completed around the time we report our financial results in July.

“We are also about to launch a consultation with customers to better understand their expectations on financial transparency and what they would like us to publish and in what formats. Our early evidence from talking to customers strongly suggests that the more open we are about our finances and performance; the more customers trust us to deliver their essential public service.”

In his letter, Cox outlines the regulator wants company licences to “reflect what is expected of those privileged to run and own public service monopolies”. Ofwat says it “may potentially need support and new powers” to implement some of the changes it proposes.

A spokesperson from the Department for Environment, Food and Rural Affairs, says: “It is vital that concerns over poor corporate practice by the water companies are addressed. That is why the environment secretary asked Ofwat to investigate what action should be taken to ensure high standards and responsible behaviour. We are grateful for Ofwat’s report and will respond in due course.”

Emma Howard Boyd, chair of the Environment Agency, adds: “We welcome the secretary of state and Ofwat’s call for water companies to act as diligently for their customers and the natural world as their owners. Since 2005, the water companies have invested billions in the environment, but they are responsible for at least one serious pollution incident every week. They also need to do more to act on increased flood and drought risk from climate change, in line with the ambition of the government’s 25-year environment plan.”

Ofwat’s chief executive Rachel Fletcher has since warned water companies must address concerns around corporate behaviour alongside producing their business plans for PR19. She has written to the chief executives of all water companies to set out how the regulator will progress with plans to put the sector back in balance in the coming months. “Our goal is a thriving water sector that holds the trust and confidence of customers and wider society. The corporate behaviour of some companies, along with significant service failures, has damaged that trust.”

She adds: “Much of the input we need from companies in the programme of work occurs while companies are devising their business plans for PR19 and the next regulatory period. The concerns around corporate behaviour and the damage to public trust mean this work cannot wait.”

After a lengthy rally, the ball is now firmly in the water sector’s court.

Cox and Gove’s tennis match

Back in mid-January, Gove served up a warning to legislate against water companies over their use of offshore tax arrangements unless they start to behave in a “responsible fashion” after a talk with Cox about the corporate practices of some water companies.

In an interview with The Sunday Times, Gove signalled he would support Ofwat’s chairman to act and would give him “new legal powers”, if necessary. He said: “The regulator has a responsibility to safeguard the public interest. If he [Cox] needs more, I’ll do everything possible to back him up.”

A spokesperson on behalf of Ofwat at the time, responded: “We’re pleased the secretary of state recognises what we are doing as a strong regulator. We have been leading the charge in confronting issues that can damage public confidence. Our approach of greater transparency and scrutiny is working. We are pushing companies harder than ever to make sure their houses are in order and that as public utilities, they deliver more of what matters for customers.”

Then, at the end of January, Gove put his thoughts down in writing in a direct letter to Cox reiterating that the government was prepared to give the regulator more powers to tackle poor practices in the industry. “The water sector has rightly come under even closer scrutiny in recent months with growing concern about the behaviour of water companies. The use by some companies of opaque financial structures based in tax havens and high gearing is deeply concerning. I also share your concern that some water companies have for many years been making excessive profits,” he wrote.

Gove thanked the regulator for “pressing companies hard” to change behaviour “not least where it has a direct bearing on their corporate, financial and operational resilience.”

He stressed there is “more to be done” and listed behaviours which undermine trust, including offshore financial arrangements; securitisation; highly geared structures; high levels of executive pay and high dividend payments.

In Cox’s response, he described it as an “immense privilege” for a company to hold a monopoly public service licence and said it “must not be taken lightly”.

He said the forthcoming price review, PR19 will require companies to demonstrate their business plans are financially resilient now and over the long-term.

Cox told Gove Ofwat was expecting to get responses from all highly leveraged companies and would report back by early April to provide an update.

Fast-forward a few months and Ofwat has now formally responded to the secretary of state with its proposed programme of reform to bring the water sector “back in balance” and rebuild public trust.

Although the interim period wasn’t exactly quiet as Cox took the opportunity to “think aloud”, ahead of the deadline, at Water UK’s 18^th annual City Conference in London on 1 March.

He outlined plans, which included a radical overhaul of dividends, action on highly leveraged capital structures and changes to companies’ licences.

Hard on his heels was Gove, who also gave a keynote speech, in which he accused some water companies of exploiting their monopoly power by “playing the system”. Gove also directly challenged the sector to be “transparent and accountable”.

Planned activity from Ofwat over the next six months to improve its regulatory regime