Last week I watched an amusing “documentary” on the sewage processing by the whimsical Channel 4 comedian Joe Lycett. Unsurprisingly for Channel 4 his conclusion was that shareholders should pay to reduce the amount of sewage entering our waters by not paying dividends. This is a bit of a straw man because the largest water company Thames Water does not pay dividends and won’t for many years to come. It is essentially gone bust.

Since I and millions of other pensioners rely on dividends from Thames Water I thought I would find out why.

TLDR

Millions of people who live in the cities, often on low incomes don’t want to pay larger bills so that a few posh kids can go surfing in clean water. Oddly Mr Lycett did not interview them for his Channel 4 discharge.

The problem the Government has to solve

Water supply and drainage is a “natural monopoly” because it never makes sense to build two sets of supply pipes and drains to a property. Whoever owns the infrastructure can charge whatever they want and customers have to pay.
To solve this problem the Government has to set the price of water and drainage so that the asset owners make a fair return that enables them maintain the system and make a fair surplus for reinvestment. If the assets are privately owned then the owners must be rewarded for taking on the risks associated with delivering the service. I will return to this later.

Which is better public or private ownership of monopoly assets?

Most informed observers believe that private ownership of monopoly assets is better than direct ownership by the Government. This is because there is no effective control on how Governments use the income stream from the asset. In South Africa ministers simply steal the money, in the UK they are more likely to spend it on hospitals and buying votes than fixing leaks.

In the UK we sold the assets to private businesses in 1989 and in the six years after water bills rose 40% as companies began repairing damage due to decades of underinvestment by the Government owner.

However, who owns the assets is not nearly as important as what price they are allowed to charge for their services. Too low and the sewers will collapse because of under investment. Too high and customers have no way to avoid being ripped off.

The Regulator sets the price

The current UK minister with responsibility for the water industry is Rebecca Pow, serving as the Parliamentary Under Secretary of State at the Department for Environment, Food and Rural Affairs (Defra). In her role, Pow is responsible for a wide range of areas including water resource management and quality, flooding and coastal erosion, climate change adaptation, environmental regulation, and waste management, among others​​. Obviously she can’t set the price of drainage herself so she has to rely on experts to do this.

OFWAT

The Water Services Regulation Authority, commonly known as Ofwat, is the economic regulator of the water and sewage sectors in England and Wales. Established in 1989 alongside the privatization of water and sewerage companies in England and Wales, Ofwat’s primary mission is to ensure that water companies provide customers with good quality service at fair prices while maintaining environmental and financial sustainability. It sets price limits for water companies through periodic reviews, with the most recent review in 2019 and the next scheduled for 2024. Ofwat also promotes competition within the sector to improve service and efficiency. The regulator operates independently of direct government control, although it aligns with overall policy directions from the Department for Environment, Food and Rural Affairs (Defra) in England and the Welsh Government in Wales.

How OFWAT sets the price of your water

The water regulator is meant to balance the interests of the country, the individual consumer, the industry and the environment.

It is a tough job. For example, the UK population has grown by 2m people over the last 5 years during a time when the Government was claiming to reduce immigration.

The water regulators revealed preference (“what it does, rather than what it says”) is for low bills to the consumer at the expense of resilience and the environment.

OFWAT and the Weighted Aggregate Cost of Capital

At this point most observers want to leave the lecture. They have got the take away – low bills mean more leaks and more poo in the sea. However if you want to learn more about how our water industry is run then read on.

Capital is the money that Government or private owners have to find to build new reservoirs and sewers.

If the Government wants to raise capital it can print more banknotes (which causes inflation), raise taxes (which loses votes) or borrow money (which raises interest rates). You can see that all these are very unpleasant options when what the Government wants to do is fund vote winning projects like new hospitals and schools. This is a major reason that the Conservative government sold off water in 1986 and subsequent Labour governments did not buy it back. Water is just a vote loser.

If private industry wants to raise capital it can get it in two ways,

• Equity – capital from the owners of the business that is at risk if the business does not perform well. However if the business does well and makes a profit then that profit can be paid out as dividends. “Dividends” are the owners reward for taking risk.
• Bonds – capital from other people that has first call on the income from the business and are low risk.

This two sorts of capital cost different amounts.

• Equity is expensive because if the business goes bust you get nothing
• Bonds are cheaper because if the business goes bust you get first call on the assets.

The regulator know that private businesses (typically pension funds) won’t invest in water unless they are allowed to make a reasonable return and it has to decide what this return should be. This is called the Weighted Average Cost of Capital (WACC).

In 2019 it OFWAT decided that investors would be allowed a 2% return down from 2.5%. Great news for customers!

The rub

In 1986 when the water industry was privatised it was a “safe bet”. Everyone knows that water is boring infrastructure industry that would pay reliable dividends and there were few good alternatives

In 2024 equity investors have lots of different ways they can invest their money. Green energy is an obvious choice, backed by huge amounts of Government investment and with regulators who are desperate to succeed it is an attractive choice.

Water suddenly does not look so safe. A regulator who wants low bills, a crumbling infrastructure and huge inflation in construction costs makes water look really risky.

Real market data shows that investors want a 8% return for taking the risk. Put simply the chance of making a profit is too low to make it worth investing in Thames Water (or any UK water company).

Hotel California – You can check-in but never leave

This discrepancy between the regulated rate of return and the market rate of return was so great that in 2007 Thames Water was bought by an financial engineering specialist Macquarie Bank.

They noted that because bond capital is cheaper than equity capital they could reduce the gap between the regulated WACC and the market WACC by replacing equity with debt. They “loaded up with debt” and reduced shareholder’s equity.

This helped solve the their Hotel California problem because they could now sell the debt to other institutions “because everyone knows that water is safe – right”.

They then cut capital expenditure as much as they could so that as much of the income as possible could be used to service debt which was then sold off. The net effect of this was to sell equity capital for more than they had paid for it. During this time they took the income from their crumbling assets but did not replace them.

Now for the bit that investment banks are good at. Finding and idiot to buy the business from them. As insiders Macquarie had a perfect understanding of their business and they could present it in the best possible light. They found suitable idiots in the form of USS (a pension fund for ex-academics like me) and others and in 2017 left the business entirely.

The business was left with crumbling assets and was soon hit with massive fines for environment breaches that have rendered it insolvent. The new investors USS etc could be wiped out and the UK is left with crumbling assets that will cost a fortune to repair.

How could this have been avoided?

To criticize Macquarie for its investment banking practices is like criticizing wolves for eating cattle. We need wolves to kill off the sick and injured but need to guard our healthy cattle against predation.

The fact that Thames Water is now insolvent is a clear failure of the regulation. The financial structure set up by Macquarie was so opaque that gaining a clear view of the business was difficult. This was a red flag that should have been very visible to both the regulator and the subsequent purchasers.

What next for water bills?

If the Government decided that it wants more sewage treatment plants then it will need to raise capital.

If the Government want private investors to invest in UK water rather than other opportunities they will have allow a greater return on capital.

The need for more capital at a greater cost will cause water bills to rise substantially.