The latest news from the water industry no longer has the capacity to shock. This time it is South East Water (SEW) and its fine for its past failures, and yet another fiasco at Thames Water (Thames) over a burst waterpipe. Meanwhile, as the citizens of SEW’s Tunbridge Wells have become experts at, bottled water and closed schools are what we need to get used to.
In any other private industry, heads would roll and companies would go into administration. But not in the water industry. To the now endless rounds of “negotiations” with OFWAT over Thames’s future, we now have the spectacle of SEW going to court to try to get its fines kept secret. Thames’s “turnaround” plan remains a distant aspiration. The costs of its legal advisers, consultants and bankers are already in the hundreds of millions. In the case of SEW, its managers have, despite endless warnings and past failures, still not shown the capacity to do even the managerial basics.
Even locating the latest leak proved a challenge for Thames, just as determining the extent of its sewage discharges had been, which Peter Hammond had to show to it. There appears to be a lack of spare parts, and behind all this lies a very poorly maintained network. SEW lacks even the basic requirement of a water company – enough water ready to supply 24/7.
It really is very hard to make all this up. Imagine back at privatisation this sad mess had been predicted. Would anyone, even the government at the time, have gone ahead with it? Suppose water had not been privatised. Would it have been this bad?
We will never know. Counterfactuals are just that. They are not facts, because they did not happen. Those on the left will confidently answer that the state would have been better; those on the right, that it would have been even worse. What matters is that we are where we are. It is unsustainable, and it shows no signs of being sustained.
Instead of putting these companies out of their misery, as would happen in a private competitive industry, the government and the regulators propose timid tilts of the regulatory tiller. Steve Reed, during his one-year stint as Secretary of State for Environment, Food and Rural Affairs (they are almost all stints of about one year), promised a radical shake-up, with vaguely defined and non-credible targets like “halving” the sewage spills by 2030, and putting failing executives in jail. All the sorts of stuff that could be publicised on X. His successor, Emma Reynolds, launched the White Paper, “A New Vision for Water”, by highlighting its three main points for the media: to appoint a chief engineer at OFWAT; to carry out annual MOTs on the state of the assets; and to get on with smart metering. Yes, that’s it. It tells us that the current mess will go on and on.
Never mind, perhaps these are only the headlines – the political messaging. Look instead at the “meat” of the White Paper. As Reed laid the blame at OFWAT’s door, he proudly announced that OFWAT would be abolished. The White Paper endorses a massive expansion of regulation – there are going to be new supervisors for the water companies. These will be augmented by the regional new quangos based on regional planning. All of this new regulatory burden will be placed on top of the current periodic review processes and the conventional (and necessary but much maligned) empirical comparison exercises.
So much for the Chancellor’s and the Prime Minister’s drive to cut regulation. The new super-regulator is to combine all of what OFWAT currently does + the supervisors + the input for the new regional catchment planning bodies + the water side of the Environment Agency (EA) + the Drinking Water Inspectorate + bits from Natural England. The political message is: “OFWAT is dead”. The reality is: “Long live the super-OFWAT”.
This new mega-regulator will not be easy to design, and it looks like a very bumpy path to come through Parliament, even if it actually makes it to the King’s Speech and gets introduced into Parliament. In the classic “whack a mole” approach to the demands to “do something”, the new regulator approach adds more, and subtracts nothing. Worse, the government has not given much thought to the unintended consequences.
The bit that is ignored is that, in seeking to solve the dire state of Thames and SEW (and perhaps some others), the government is throwing out the central tenet of the existing environmental regime. Perhaps it just doesn’t bother to read any history. The EA was set up with a central purpose in mind: integrated pollution control. This fundamental principle is that water, land and air pollution should not be pursued in isolated silos, but in an integrated way. What the new super-regulator for water is going to pursue is disintegrated pollution control.
There are arguments for and against disintegrating pollution control. It is remiss of the government to let this happen by accident to deal with the problems that Reed has pinned almost solely on OFWAT, and for two reasons. First, the current mess cannot be simply down to the decision of successive leaders of OFWAT. Second, in the rush to be seen to be “doing something”, the government should have first thought through what is going to happen to the residual EA. Successive OFWAT leaders made many mistakes, some of which were very serious, but they did not do all this on their own. Successive governments put pressure on them to keep bills down, and the current government is obviously pushing to make sure a Special Administration Regime (SAR) is avoided, for fear of the Exchequer costs and to prevent the foreign investors being scared off.
As to the remnants of integrated pollution control, and what to do with what is left of the EA, there is no evidence at all that any serious thought has been given to this, and nothing about it in the White Paper. It would be a huge failure of the House of Lords in its scrutiny of the eventual legislation not to ask the obvious questions, and to propose amendments to the Bill accordingly.
In the meantime we are promised a “transition plan” sometime before the end of this year. This presumably is going to urge OFWAT and the EA as they currently are to get on with the recommendations in the Cunliffe Report that are identified in its annexes as not needing legislation. In other words, the things that could be done anyway – and several of which should already have been done. Whilst we all wait without bated breath for the Bill and wonder when (and even if) it might become law, and hence when the super-regulator is actually going to formally start, the water sector is doomed to another periodic review in 2029, after which it will be some new government’s problem.
It probably won’t work. The industry is on the brink of a gradual collapse, starting with Thames and SEW. Unintentionally, the government’s hostility to calling in a Special Administrator may well precipitate the very thing its leadership want to avoid: nationalisation.
This is how it may well happen: rising real interest rates; turnarounds make matters worse before they get better; the investors may draw in their horns and get their money out asap – they might anyway, as the private equity model comes under financial market pressures; there may be more scandals and less and less tolerance; the executives may leave the sinking ships…
It does not have to be like this
What can be done to avoid this bad outcome? Try as the government might to eventually get some supervisors to supervise Thames and SEW, it is not going to work. Why? Think of how the intensive “negotiations” between Thames and OFWAT have been going. Thames, after all, has already been under a “Temporary Oversight Regime” since July 2024. What exactly is it finding to keep talking about? The financial facts are well known, so is the fines-based environmental law. There isn’t anything more to know. If the government and OFWAT want only the existing bondholders in the room, rather than new bidders to take the company over, then it is about decisions.
The trouble is that these decisions are environmentally, economically and politically very poisonous. What makes them doubly so is that they are not being tested against other bids to take on Thames. If all the government and OFWAT are prepared to talk to are the existing bondholders and if a SAR is ruled out, then the distressed-debt specialists that lead the bondholders have the government and OFWAT over a barrel. Hence the offer by the London Valley Group: a haircut roughly equal to the discount the distressed-debt holders bought in on; the interest paid; and exemption from the rule of environmental law and the associated fines for over a decade.
The answer is obvious. In both the Thames and the SEW cases, the companies have failed. Failure should mean the application of the failure regime. They should be put into administration. There is a ready-made SAR. It is “special” because of the need to ensure the continuation of the services. Otherwise, it is an administration regime.
Step forward the panic peddlers in the government. Up come estimates that it would cost the government billions. This is simply rubbish, and should be seen as such. The SAR makes HM Treasury (HMT) the first claimant on the proceeds of a sale. Both Thames and SEW have regulated asset bases (RABs) in excess of all and any of their liabilities, including the costs of the administration. The net cost to HMT of guaranteeing the continuity of the service during the period of administration should be zero.
So why not go for a SAR? The answer is simple: the government fears that its backbenchers will use the SAR to push for renationalisation. The response should be to set out clearly a fast-track process that gets from here to new owners quickly. There is a mass of data and information already, not least the material produced as a result of the hundreds of millions already spent on advisers’ fees. There are potential bidders in the wings. The problem is that the way the government will probably proceed is to appoint administrators who will have every incentive to drag the whole process out. But it does not need to be like this.
The irony of the ultra-cautious approach by the government will be to hasten the eventual demise of Thames and probably SEW too. The longer this situation goes on, the worse Thames and SEW will get. None is serious about deep turnaround plans. Imagine if the government and OFWAT had spent the last couple of years preparing for a SAR. Imagine if they had recognised the importance of public listings. Imagine if they had formulated preferred plans for the break-up of Thames, so that it is no longer too big to manage and too big to fail. It is late in the day, but they should get on with the job asap.
The problems of Thames and SEW are central to the ways the industry could be reformed and what a Water Bill should be doing. The Cunliffe Commission offered the government one way forward, towards more and more intrusive regulation. It will end up in a morass of overlapping bodies and approaches, and the water companies will have every opportunity to capture these – especially if the revolving doors put ex-company directors and financiers in the supervisory roles. In the case of financial regulation which Cunliffe drew upon, note that a former Barclays Bank executive is to take over the reins to supervise the banks. We have already had water regulators going on to work for water companies, directly or indirectly via consultancies.
The alternative is to stick to the rules-based approach. Leave it to the boards of these companies to decide how to run their businesses, but in the clear understanding that should they fail, the SAR will come into play. Rules get followed not out of altruism, but because, if they are not, there are real and painful consequences. This has finally been realised when it comes to environmental regulation. The companies are getting fined heavily for failures. It hurts them. It is supposed to.
This is where the future of the water industry hangs in the balance over Thames and SEW. If there is no price of failure, and no serious threat of detection and punishment, they have little incentive to radically change their game. Thames and SEW can just carry on. Supervisors are not going to solve this problem, and not in time to save the industry from nationalisation.
Beefing up the failure regime
The fact that the SAR has not been deployed and the fact that Thames can seriously propose not to be complying with environmental law until 2040 illustrate why enforcement needs a radical upgrade. This is what should be at the heart of the Water Bill. Although the EA was set up to deliver integrated pollution control, it was hampered from the get-go by the failure at the time to address its structure ex ante, and instead to cobble together the National Rivers Authority (NRA) and HM Inspectorate of Pollution (HMIP). The NRA was the spawling inheritance from splitting out a whole set of functions from the public sector water authorities. It started with around 6,000 employees, set against the 420 for HMIP, 220 of whom were inspectors.
The opportunity now is to get back to the HMIP model – a small, tight enforcement agency, what might be renamed the Environment Protection Agency (EPA). That would mean splitting out the operational aspects of the EA on water, and maintaining the inspection and prosecution functions in the new EPA. Out would go the flood protection activities and related works on rivers. Instead of merging the environmental regulation of water functions into the new super-OFWAT, these should be transferred to the EPA. The institutional reform should start with the EA as the main priority, and then assign to the super-OFWAT only the consequences of transferring out the floods activities, so that the super-OFWAT could add the regulation of flood activities to its duties.
What of the super-OFWAT parts? This is very badly misconceived. It is not a good idea to go down the supervision route. It will get more burdensome, more captured and the private boards will be able to saddle the supervisors with supporting their business models. Better would be to take the passing concern for catchment regulation in the Cunliffe report and set up proper catchment regulation, with catchment plans and the Catchment Regulator taking on the auctioning out of the necessary works. It should draw on the National Electricity System Operator (NESO) model in energy (howbeit minus the operational activities of despatching the power stations in the system operations). The Catchment Regulator should run digital mapping of the catchments, it should make the maps open-access, and it should set out longer-term plans to sort out the mess that 35 years of privatisation under the OFWAT model have left us with. The Catchment Regulator and Catchment System Operator model is further set out in my earlier papers.[1]
In the meantime
The rivers are in a terrible state. It does not help to say that they were once even worse. This is the beginning of the second quarter of the twenty-first century, not the 1960s and 1970s. There are lots of new and emerging pollution problems, lots of ill-located new developments in flood plains and new catchment challenges.
The choice facing government is simple to state, and demanding to address. That choice is: either to drift on with the status quo, burdened with ever more supervisors in the belief that the system is basically sound, and only needs more oversight; or to re-set the regime fit to take us to 2050 and beyond. Piecemeal reform almost always means adding yet more bodies, functions and regulators. Radical reform means re-setting the overall environmental protection regime, focusing on the catchment systems, properly defining the outcomes, and then enforcing those outcomes.
It is rarely the case that public policy changes in advance of a crisis. It takes a big crisis to motivate change when it becomes apparent that we simply cannot go on as we are. The good news is that that crisis is well upon us.
[1] Helm, D. (2015), “Catchment management, abstraction and flooding: the case for a catchment system operator and coordinated competition”, and Helm, D. (2019), “The Systems Regulation Model”, 12 February.
