In the long game of this periodic review of the water industry, Ofwat has fired off its first stab at the “right answer”.[1] Understandably, it is a messy compromise but, whatever its short-term merits (and there are some), it is more sticky plasters, rather than a serious solution to the problems of the industry. These will most likely get worse not better.
To see why it’s a case of kicking the can down the road, it is usually helpful in such circumstances to start by asking what questions the interim determinations are supposed to be an answer to, identifying what is widely agreed upon and what is not, and then look at the specific solutions on offer. Unfortunately in water, and in so much else of the UK’s infrastructure, the starting point has been a different one: to decide first upon the answer, and then seek to fit the questions to this preferred outcome. In water, this inverted logic has been the norm for the past 35 years. The trouble is that if you ask the wrong question, you are almost certainly going to get the wrong answer to the right question.
The fundamentals
The provision of water and the collection and disposal of sewage are amongst the simplest of tasks to define. The former needs a supply (rain, either collected in the past in aquifers or current rainfall), water treatment works, to make sure the water is fit to drink, and pipes. Because water has to be instantaneously and continuously supplied, some storage is needed. When it comes to sewage, it is the reverse: a system of pipes to collect the stuff, sewage treatment works and natural capital capacity to deal with it, and then a disposal system.
It is hard to find anyone who thinks there is no need for more available water resources, not least because of the significant growth in population, and it is patently obvious that the sewers are not fit for purpose, and not least because of the crazy way in which roads, house and developments have failed to take account of their impacts on the speed of run-offs.
The state of the raw water – and the state of the rivers, estuaries and coasts more generally – is not entirely in the hands of the water companies. Farmers, representing around only 0.5% of GDP in the UK, are major polluters of water systems (as well as emitting high levels of greenhouse gases). Pharmaceuticals and other industrial companies add new chemicals and microplastics to the rivers, and, most importantly, you and I, as consumers, flush all sorts of chemical wastes down the toilet. There are multiple polluters, and all should pay for the pollution they cause.
What everyone agrees about is that the provision of both water and sewerage services needs a big upgrade. The right question that Ofwat should be asking is: what water and sewerage systems are needed to meet the needs of the mid-twenty-first century, and then how to get from here to there. Instead the question Ofwat asks is: given the current water and sewerage systems, what are the minimum set of incremental increases in capital maintenance and investment needed to stop things getting worse, and to make some limited progress, all constrained by Ofwat’s concept of affordability. Put simply, what is the minimum that has to be done at minimum cost to consumers.
The companies collude in Ofwat’s approach. They build up business plans for the next period, knowing that these must add up to little by way of real price increases. They then haggle over the details with Ofwat. They have little choice: they have to live within Ofwat’s implicit pre-set answer about prices. And so it has been since 1990, with occasional fireworks and in particular conflicts between the Environment Agency (EA) (and its predecessor the National Rivers Authority) and Ofwat. In all of this Ofwat has succeeded; and the result of this is a Pyrrhic victory that can be seen in the sewage discharges, the failures of supply, and the general state of badly maintained infrastructure.
Not surprisingly, in focusing on the wrong question, the main disagreements are about who should pay and the speed with which the incremental upgrades should be delivered. Within each service, there is disagreement about the balance between natural capital and “concrete” solutions, and about how far demand and households, roads, developments and farmers should contribute at source.
As politicians and regulators know, someone has to pay, and confronted with the true state of the assets and what a proper systems approach would amount to, the appeal of cake-ism is apparent. Politicians, regulators and we the consumers (and the ultimate polluters) do not want to pay. We want the investment, but don’t want to pay for it. The politicians and Ofwat tell us we can have both. As with the path to net zero in energy, it is lots of investment and limited pain. Cake-ism in water has three temptations. The first is to make someone else pay – the water companies (and the farmers). The second is to take the price increase and the investment requirement and divide by two and space out the investment over a longer period. The third is to try to delay and avoid doing much at all and hence avoid paying at all. Ofwat, the last government and the current government are trying a bit of all three: squeezing company dividends; making companies catch up on the capital maintenance and investment they should but have not done; and trying to reduce the investment bill increases to meet the affordability considerations. The first – dividends – is tempting, but raises the ugly question of why investors should put more money in. The second is obviously a good idea, and the third means more sewage discharges for longer and weaker supplies. Neither governments nor regulators have yet been brave enough to make farmers pay for their pollution.
To these can be added that some have the silly idea that they can indeed get the investment and hold down bills, through nationalisation or expropriation of the companies, or both. They forget that the need to borrow is not escaped by nationalisation, that investment is a voluntary activity, and that the government has no longer got the capabilities to run major corporate activities. Nationalisation does not solve any of these problems; its rationale is based on the dubious claim that the government can run the companies better than the private sector.
The naivety of the periodic reviews and Ofwat’s multiple failures
Having asked the wrong question, it is not surprising that almost everything that could be wrong with the current periodic review process turns out to be wrong. Five-year horizons are not sensible given the decades-long investment requirements. Ofwat claims that it is taking 25-year environmental plans into account, but this is a sticky plaster on the overwhelming focus on five years. If it is serious about taking a long-term approach, that is where it should start, not the other way around, and it would not be squeezing the bills now so tightly. It would have started with a system answer to the question about what a sustainable water and sewerage system should look like mid-century and then worked backwards. As noted above, Ofwat has form on this: it has spent the past 35 years trying to squeeze the bills for the five years in front of it, pushing the investment out into the future. In Ofwat’s words, it has been about “getting off the price escalator” without explicitly admitting that this means “getting off the investment escalator”.
Ofwat should by now have recognised not only that the game has changed, putting investment in the driving seat, but also that it has moved on from a world where debt was the marginal source of finance to a new world of where new equity comes into play. For 35 years, debt has been very cheap, with at times negative real interest rates. It was a golden and missed opportunity to get a huge amount of investment done at very low cost. Not only is it going to be necessary to do the investment that should have been done already, but also at much higher costs.
Now that the balance sheets are exhausted due to the massive financial engineering Ofwat allowed to happen (more on this below), that opportunity has gone, and it is equity that is back in the driving seat. The trouble is that Ofwat’s approach to setting the cost of debt and equity makes this doubly hard to achieve. By setting a weighted average cost of capital (WACC) (which is the average of the cost of debt and the cost of equity), it over-rewards debt and under-rewards equity. Now investors are being asked to put more equity in, the upside for investors from over-rewarded debt in the past is replaced by the downside of under-rewarded equity. In this sense, the Thames Water investors who said the company is not investable are correct, as Ofwat now demands equity injections from the companies, but still relies on the WACC. The regulator rejected the split cost of capital which would have prevented overpaying for debt, just as it failed to stop the financial engineering of the balance sheet.[2] Just when it now needs equity, the WACC approach undermines the equity side of the average. This is a bad regulatory mistake.
Sadly this is not the end of the list of Ofwat’s regulatory failings. A second serious one has been to treat much of what is capital maintenance as if it is investment. That has the convenience of pushing capital maintenance out of current expenditure and therefore current bills in the periodic reviews into the longer grass of pay-when-delivered. Companies have followed, not least because this is what Ofwat’s accounting rules tell them to do. It keeps the bills down now, but builds up problems for the future. Indeed, that is precisely what it has done.
These failures are all serious, but they pale into insignificance when compared to the greatest failure of all – the failure to get a grip on the balance sheets and, in particular, to stop the obvious incentive to gear the balance sheets up. The result is all those private sector balance sheets that were designed to carry the burden of borrowing to finance the investment have instead proved extremely attractive vehicles for what can only be described as massive financial engineering.
To understand what has been going on, think of the incentives facing the owners of the privatised companies. With the essential assets in their hands, the option has been to mortgage these assets. In effect, the owners have gone to the banks and asked: “How much will you mortgage my assets for?” The answer turns out to be for most of the regulated asset values. In Thames Water’s case, it helps to take the initial ungeared balance sheet to around 80% gearing.
From an owner’s perspective, what is not to like about all this? The cost of debt is less than the WACC provides to them, and they can pay out what they borrow as special dividends, and as a way to fund their acquisitions. Private equity brought a whole new professionalism to the mortgaging of assets across economies, with the result that the corporate sector is widely geared now. The casualties are appearing as real interest rates rise, but they matter most in infrastructure because these are the essential backbones of the economy and its competitiveness. As interest rates rise, the priority is for boards of companies to find ways of paying the higher interest, and the business in effect becomes tied to this goal. To see the consequences, take a look at Thames Water’s preoccupations with trying to pay out from the regulated core to the debt holders.
All this did not need to happen in water. Ofwat allowed this to happen. The significance cannot be over-estimated: it undermined the rationale for privatisation and leaves us with companies, some of which like Thames, are best regarded as financial wrecks. The analogy is to allow the football referee to leave the field and even to remove the goalkeeper, and then to be surprised when the owners keep firing into the open goal. At privatisation, no one imagined this would be allowed to happen – indeed, had they been told, it is very unlikely that privatisation would have happened at all. The whole point of the new private balance sheets was to provide the basis for investment, to move from pay-as-you-go to pay-when-delivered. It was not to be used to pay dividends – these were supposed to come from extraordinary efficiencies through outperformance.
Remarkably in the light of this biggest of the regulatory failures, Ofwat now proposes to double down on debt. Having allowed the companies to exhaust the balance sheets and demanded they put equity back in (without as noted above providing the incentives to pay for it properly), Ofwat now wants to shift a lot of new investment into new balance sheets on a project-by-project basis, so that this new wave of private finance initiatives (PFIs) can load up with new debt, whilst the existing companies are told to switch towards equity. There are so many problems with this new approach which require a separate paper on its own (forthcoming).
Between lots of rocks and lots of hard places
Where does this leave the companies? It is surprising that anyone seriously wants to be a director of a water company now. What has not changed are the functions the companies are supposed to carry out. Whilst Ofwat squeezes the bills, it is also squeezing on compliance too, as are the EA and the government, and in addition new legal challenges are being encouraged.
The government proposes that a director of a water company may now face criminal prosecution for failures, and hence be personally liable. Effectively, the investors cannot take dividends without permission from Ofwat, and the EA (rightly) is not going to cap the fines as it ramps up its surveillance and enforcement. This is a risky personal place to be.
Perhaps directors should not worry and be reassured by Ofwat’s claim in the interim determination that it has allowed all environmental schemes proposed in the companies’ business plans and thereby their risks are limited? This is disingenuous. It is not whether Ofwat has allowed these schemes, but whether it has properly approved enough revenues to make them happen. As for example in Ofwat’s criticisms of Thames Water’s business plan, it has used the lowest costs for sewerage tanks that Severn Trent has proposed. It may well be that a very badly run company such as Thames Water has set costs above what they need to be (and on this Ofwat should crack the whip), but the problem for its directors is that delivering these investments in London and its region may actually turn out to have higher costs than Ofwat allows. If the directors had included in their business plans all the schemes that would be necessary to fully discharge their liabilities, and therefore set out a comprehensive and risk-averse business plan to deliver the sustainable systems, then it would be a battle about these unit costs. But, as noted at the outset, this is not the question the Interim Determination is answering; it is instead the one that Ofwat focuses on, and on which the companies implicitly collude with Ofwat about. If over the last 35 years the “answer” has been roughly RPI (or even CPI) – 0, then the liabilities are inevitably going to mount up, and now the EA and the courts have started to intervene, the directors are exposed.
If the directors consider the Ofwat unit costs to be too low and the full capital programme to be insufficiently supported to carry out their required functions (let alone meet the public demands), they can (and should) appeal to the Competition and Markets Authority (CMA). If they don’t appeal, then they have no escape from the liability. If the CMA sides with Ofwat, then the next step is judicial review. If the directors then lose this, and if they have not already done so, they might be well advised to resign.
None of this is a defence of the excesses of executive salaries and bonuses and managerial failure. These have shown a disregard not just for the widespread public revulsion at the greed, but also the decencies of accountability and the linking of performance to outcomes. What exactly has been the outperformance at Thames Water that merits the bonuses to former Chief Executive, Sarah Bentley, and the new Chief Executive after just three months in office? And how exactly have the chief executives been so world-class as to demand several million per annum to run a water company? The only possible credible answer is that it is a payment for taking on such a reputationally risky job. Or just greed.
Claiming that these salaries are not paid for by customers is at best disingenuous. Where else does the money come from that the investors pay them? Their own pockets? Does anyone really think that investors put their money in water companies without getting back what the executives of the water companies get paid? Imagine a water company has to be listed and it has to limit its activities to water and sewerage only, then the salaries can come only from the customers’ bills. Where else could they possibly come from? Worse, if the directors were being paid from somewhere else, their loyalties would not be merely to the customers they are supposed to serve, but to the masters who pay part or all of their salaries too.
Applying new sticky plasters to directors’ salaries is not without consequences. Personal criminal liability, and salary and bonus caps can be justified in specific circumstances, but government and regulators should beware making the companies not only uninvestable, but also unattractive places to work. The obvious shift is between allowing the company owners to decide on these matters, or implicitly letting Ofwat determine how much they are paid and rewarded. In the case of Thames, it appears that Ofwat intends to make this explicit, with incitement from government too. It is another case of “beware what you wish for”.
What to do about Thames Water
In addition to resorting to PFIs, Ofwat’s “solution” to Thames Water’s multiple failures is not to use the obvious tool in its box – Special Administration – but instead to invent a whole new mechanism called a “Turnaround Oversight Regime” for Thames in the first instance (with others to possibly follow). This is pretty close to Special Administration without the clarity of an administrator or the clarity of the exit.
Under its new Turnaround Oversight Regime, Ofwat will put companies (in this case, Thames Water) in special measures akin to what goes on for failing schools and hospitals. It will in effect control the dividends, and the company will report to Ofwat on its turnaround plans, a delivery action plan, its financial resilience plan, and its operational performance. Ofwat will consider appointing a monitor who will have full access to the internal information of the company.
What is going on here is that Ofwat implicitly takes over the functions of the board of the company. Ofwat will in effect have directors reporting to it, and it will have the power to adjudicate on their actions. It becomes the de facto decision-maker.
In case it has escaped Ofwat’s attention, that is what a Special Administrator does in the period of administration.
The difference between Special Administration and a Turnaround Oversight Regime is that the former aims to place the company in the hands of new owners. The Special Administrator, in selling the business, determines what is left for the existing investors. It is not left to the existing debtholders and shareholders to fight like cats in a sack about who gets what, and to play hold-up and the other games such internal debt and equity restructuring typically entail. Special Administration takes these decisions out of the existing players’ hands.
At the heart of the Special Administration process lie two further things. The first is the process of replacing the directors of the company with a new board, driven by new owners. Does anyone think the current management team at Thames Water is up to the job? Clearly Ofwat does not from its withering criticisms of the company, its business plan and its performance. The second is that it opens up the question of the structure of the company. Even Ofwat now admits that breaking up Thames is probably a good idea. It is. Ofwat also embraces public listing. I set out the reasons for both in an earlier in an earlier paper.[3]
Yet even in admitting that Thames is too big, Ofwat thinks this is a “medium-term” issue. Why? Presumably it thinks that the current turnaround can work. If it thinks this, Thames will not need to be broken up. What Ofwat does not get is that breaking up Thames and having some public listing are means to the end of a better-managed company, not nice-to-have extras sometime in the next decade.
Finally, the Special Administrator has an exit. Companies are not put into permanent administration. In Ofwat’s Turnaround Oversight Regime, it is not clear what the exit is. Could it be when Thames addresses all the concerns that Ofwat raises? How could this happen in the current mess? And suppose that Thames gets a bit better, whilst all its debt and equity owners are fighting. Will this be enough?
To protect its reputation, Ofwat will have to be minded that if it says the Turnover Oversight Regime has ended and things then go wrong, it will be blamed. It is like the Dangerous Dogs theorem I set out a long time ago.[4]It goes like this. Dog bites child. An Act of Parliament bans dangerous dogs. No dog bites child. No politician repeals the Act for fear that the next day dog bites another child. Once Ofwat is inside, it will find it very hard to get out.
The puzzle is why the past government, the present government and Ofwat don’t pull the plug on Thames Water now and call in a Special Administrator. The answer is partly political. The Conservatives did not want another failed privatisation on their hands ahead of the election. Labour fears its nationalising backbenches. Ofwat fears that this would reflect badly on it and highlight the many failures over the past 35 years.
As a result, all the other sticking plasters are being applied. None of these is a clean break; none administers a clear haircut to the existing investors and provides the monies to make good the management failures of the past; and none sorts out the structure of the business once and for all.
Perhaps, too, it is other fears that scare off the government and the regulator. Perhaps it is the fear that foreign investors won’t like it. Perhaps it is that the nationalisers might get their way. Perhaps they fear that the Treasury will end up with a big bill.
None of these possibilities should be showstoppers. Why? Foreign investors like clear rules. The Special Administration rules could not be clearer. Other investors would like Thames to be dealt with, for fear of infecting them too. Investors have already started to write off their investments anyway. Special Administration is not nationalisation, though of course any government can offer to buy Thames Water from the Administrator. But the government doesn’t have to, and the Treasury will not necessarily have the money to prioritise buying it. Finally, given that customers pay for the full return on the regulatory asset base (RAB), the cost of administration can easily be reclaimed in the sale, and will in effect be a reduction in the proceeds that the Administrator pays out to existing investors at the end of the process. The Treasury may have to guarantee supplier contracts in the administration period, but it can, should and would get its money back.
The irony of the multiple attempts to avoid the very device designed to deal with a case like that of Thames is that it will probably have to be used anyway, as the sticking plasters peel off. Ofwat (and the government) are placing a big bet that kicking the can down the road will actually work. But there are good reasons to think that it won’t, and what then follows down that road is likely to be much worse.
The generic aspects of Thames Water’s problems could bring the whole of the industry down. Then it will cost the Treasury a lot to pick up the pieces, and years will have been lost in sorting out the state of the rivers and water resources. Ofwat’s periodic review will aid the decline and further exacerbate the crisis it has partly caused through very poor regulation. It does not put the industry on a sustainable basis. Therefore it will not be sustained.
Special Administration would be a cathartic moment for the water industry, offering a chance to rebase the sector and its regulation for the next decades and facilitate an orderly transition. For the new government, better to sort water out now than face five more years of grief from the public, the media and the companies. Thames Water should be quickly not only put out of its misery, but also prevented from imposing more misery on all its customers and all the users of the rivers and the beaches. For good measure, the government should also get on with sorting out the agricultural pollution as soon as possible too.
[1] See Ofwat (2024), “Ofwat sets out record £88 billion upgrade to deliver cleaner rivers and seas, and better services for customers”, 11th July.
[2] For more on the split cost of capital, see Helm, D. (2009), “Infrastructure investment, the cost of capital, and regulation, an assessment”, Oxford Review of Economic Policy, 23:3, pp. 307–326.
[3] Helm, D.R. (2024), “Putting Thames Water into special administration and breaking it up”, 7th March.
[4] Helm, D. (2006), “Regulatory Reform, Capture, and the Regulatory Burden”, Oxford Review of Economic Policy, 22:2, pp. 169–185.
