Following on from OFWAT’s 55% indicative preferred gearing, signals from DEFRA are that it would like to make this a legally binding upper limit. At first glance this sounds like a good idea. It would prevent the sorts of gearing that have got Thames Water into trouble and which might yet bring others down in its wake.
But before the government rushes to legislate, there are some serious questions to answer. Why is 55% the right number? Why should it be the same for all the water companies? How does it relate to the £100 billion water industry investment programme? Is another whack-a-mole sticky plaster change to the law the right approach?
The answers are: no it isn’t the right number; it shouldn’t be the same for all companies; it relates badly to the investment programme; and legislating for 55% is definitely not the right approach.
What is the question that all this borrowing is supposed to be the answer to?
The place to start is with the rationale for borrowing. Why borrow? What is the borrowing for? If OFWAT and previous governments had asked these questions, the whole sad episode in financial engineering might have been avoided.
In the “bad old days” of the nationalised water companies, there wasn’t much borrowing at all. Why? Because customers paid on the basis of pay-as-you-go. Current customers paid for both the current spending (operating expenditure, OPEX, and capital maintenance) and for investment. Each generation paid its way to bequeath a largely debt-free water and sewerage system to the next. There was some working capital borrowing and some interplay with government borrowing, but the basic social contract between the generations stuck. Borrowing and the high gearing that has emerged across all the privatised utilities is a post-privatisation reality, but not a pre-privatisation one.
The key difference which privatisation brought to the scene was a switch from pay-as-you-go to pay-when-delivered. Faced in the 1980s with the chronic state of public finances and with the need to impose some strict controls on the public sector borrowing requirement, privatisation was the way investment could be financed by borrowing against the bills of future customers who would be the beneficiaries – and not the bills of the current customers (and current voters).
From this follows the point of the privatised utility balance sheets, and the rationale for borrowing. The borrowing – and hence the gearing – would reflect the investment until such time as future customers had paid back the sums invested on their behalf.
Borrowing should be for genuine investment
The implication is obvious: the current gearing should reflect that investment, and only that investment. Only it doesn’t. It has virtually nothing to do with the investments, for two separate reasons. The first – and most egregious – is that the new owners were able to swap equity for debt, and make supernormal profits on the debt. They had several incentives to do this. The application of a weighted average cost of capital (WACC) in setting the allowed-returns assumptions was, by definition, a wide open goal to financial engineering. A WACC overpays the debt and underpays the equity. Hence, swapping equity for debt is a very profitable strategy. Adding leverage also helped the mergers and acquisitions (M&As): the buyer could borrow to acquire and then extract returns for the resulting debt. All sorts of financial structures were set up in the M&A bonanza to exploit the opportunities. Then there was the fact that the regulators systematically overestimated future interest rates at periodic reviews in the first 30 years after privatisation. It turned out that financial engineering and the gap between the OFWAT forecast interest rates and the outturns were the most profitable aspects of the new privatised utilities. This was not what was intended at privatisation.
Eventually all the companies joined in, and if they were tempted to be more prudent, they faced being taken over anyway and then spiced up with “leverage”.
The second reason is less obvious and possibly in the long run even more damaging. The regulators let the companies call lots of capital maintenance “investment”. It suited all sides. The regulator could then hold prices down lower, shifting more spending into the pay-when-delivered box. The companies could grow their regulated asset bases, and gain the advantage of the cost of debt over the cost of equity in adding capital maintenance into the “investment box”.
The combination of these two factors has played out in the case of Thames Water. It has overgeared, and it has not done the capital maintenance to the standard it should have.
What should DEFRA and OFWAT do about all this? The first thing both reach for is the punishment box: apply lots of fines, legislate to “lock them up”, and then go for an arbitrary gearing number: the 55%. Instead of sorting out the root causes of the problems they now confront, they reach for simplistic solutions.
The right answer
The right answer is pretty straightforward, but it is also challenging for OFWAT and by implication for the government too. Start with the privatisation balance sheet. This was cash-positive: the companies were given an initial cash sum, called a “green dowry”, to get them started on the immediate requirements – which came mainly in the form of the relevant EU Directives. Next, add to the balance sheet (the regulated asset base, RAB) that investment which is not paid for by current customers. This can be financed by a mix of debt and equity during the carrying out of the projects, but, once in the RAB, it can then be just debt. Although there is a good reason that the new assets should be treated as assets-in-perpetuity, depreciation has been applied to the RABs, paying back the capital invested, and hence the debts should fall pari passu.
It is immediately apparent that each company’s gearing will differ according to its investment programmes. The answer will be different. A uniform answer – such as 55% – is at best arbitrary. But, worse, it is driven by the further error in the regulatory regime, which is to focus the question of the gearing level on the investment-grade credit ratings. Instead of working out the values of outstanding pay-when-delivered investments, OFWAT focused on the capacity of the companies to borrow more, and in consequence on whether their actual gearing challenged their ability to borrow yet more money.
Affordability and funding and the limits on borrowing
If OFWAT and successive governments had seriously worried about the ability to borrow more, they would have focused on a very simple question: are the customers willing and able to pay the interest on the borrowing and repay the capital? Finance derives from funding, and if customers are doing the funding, the answer to whether investment can be financed is whether customers can do the funding.
Failing to ask this question results in another of the current difficulties. The incoming PM is committed to bringing down water and energy bills, and for the very good reasons that voters are indicating that this is what they want: cheaper water and cheaper energy. The implication is that they are not willing to fund the investment to the degree required to improve the assets and the wider environmental outcomes. Customers don’t want raw sewage in the rivers and on the beaches, but they also don’t want to pay to clean it up. Politicians are prone to simple promises (like halving the sewage spills by 2030 and achieving net zero electricity by 2030). However, in wishing these simplistic ends, they not only conspicuously fail to deliver the means, but actively side with the customers who don’t want to pay. It cannot be repeated too often that it is affordability, not credit ratings, that are the test of the financeability of investment.
What to do now
The sad fact is that the horses have already bolted. The great financial engineering produced significant profits and it is hard to blame investors, confronted with such an open goal, for exploiting the opportunities. This is not a fault of “capitalism”, but rather a fault of bad regulation. The answer was to set the cost of debt on the debt and the cost of equity on the equity, and never to have set a WACC. It was also to index the cost of debt from the start.
If the incentives were not there – and, at privatisation, they were never intended to be there – much of the ensuing debt bonanza would not have happened. If the debt had been indexed from the start, the excess returns would not have materialised. The past cannot be rewritten, but the split cost of capital should be applied immediately as should indexation. Having argued at the time for both measures, OFWAT cannot claim that it was not made aware both of the incentives it had created and the consequences of its actions, and that it was in ignorance of practical solutions for both of these.
Having imposed a split cost of capital, the next step is to restate the balance sheets on a pro-forma basis, rolled forward from privatisation. This should identify the investments not immediately paid for by customers, and then adjust as the RABs are depreciated. This creates a pro-forma balance sheet with the appropriate debt. It is to this that the cost of debt should be applied and allowed.
How is all this to be dealt with now? The starting point is to do two things: fix the split cost of capital; and rewrite the regulatory accounts. These might seem technical and, to many politicians, lacking the opportunities for performance politics that are so prevalent in water and energy, but they are both essential building blocks.
Do this and the full scale of the debacle at Thames Water will be revealed. Whatever the “right” gearing might be, it is neither 55% nor 80%. What we need to know is what the accounts would reveal as the outstanding genuine capital enhancements (the genuine investment) that have not yet been paid back by customers. We should also ask: what would the state of the assets be if Thames had properly maintained them? Thames might say that the regulators and the politicians encouraged it to push the capital maintenance into the “investment” box, but it has had the licence and the licence obligations. If it felt in the past that the periodic reviews did not take proper account of all these considerations, it should have appealed to the competition authorities – the Monopolies and Mergers Commission, the Competition Commission and now the Competition and Markets Authority. It didn’t and that is its fault.
The result would almost certainly tip Thames Water into special administration. It should. Then the company can be properly rebased, according to the proper regulatory accounts, and a new set of owners and managers can start the desperately needed turnaround that keeps getting postponed through the endless financial negotiations. It remains a mystery why DEFRA has not pulled the special administration trigger (other than the fear that the backbenchers would use it as a mechanism for full nationalisation).
More challenging still is to recognise that the vast majority of the water companies’ activities are operations and capital maintenance. The services are required in perpetuity, the assets are de facto in perpetuity, and it is the job of the companies to make sure that the water treatment works, the sewerage works and the pipes are properly maintained. This should be paid for by current customers.
This bit is really challenging for both customers and politicians. Unlike in the “bad old days” of nationalisation, we are not paying our fair share of the social contract between the generations. We are not paying to maintain the systems, but instead deferring this to future customers. We get a holiday on the investments, and we get a holiday on much of the capital maintenance by calling it investment, when it isn’t. The consequence: bills will have to go up.
By how much? This depends upon how fast the great deficit in capital maintenance needs to be caught up with. It is true that the population has gone up and that means that more assets are needed, but, as with electricity in the great surge in power stations development before privatisation, current customers could pay because there were more of them across which to spread the costs. A higher population does increase demand, but it also increases the number of people paying the bills.
But perhaps we don’t want to pay to sort out the mess that the water industry is in. Perhaps when push comes to shove we are more concerned about affordability than environmental pollution and the state of our rivers and beaches. Perhaps we like living beyond our environmental means and perhaps we don’t want to honour the social contract between the generations. But if so, politicians should be honest and stop promising both cleaner rivers and lower bills.
