The new Labour government in the United Kingdom has an immediate task in its hands: reforming the private water sector. Why are we saying so? Britain’s embattled Thames Water has been placed under closer regulatory scrutiny owing to serious financial difficulties.
The announcement, made by the industry watchdog Ofwat, comes at a time when the Keir Starmer government needs to decide whether taxpayers should renationalise Britain’s biggest water supplier after it avoided a state rescue under the previous Conservative administration.
In a simultaneous development, Ofwat published a five-year financing plan for all English and Welsh water firms born out of the privatisation of the industry in 1989. The regulator has now proposed that customers would face an average increase of 21% or £19 ($25) per year until 2030. In recent times, the sector has also come under fierce criticism over failures to plug leaks and raw sewage discharges on beaches and in rivers.
A sector in crisis
In the sweltering summer of 1995, Yorkshire Water’s managing director, Trevor Newton, gained notoriety for motivating consumers to use less of the company’s product by saying, “I personally have not had a bath or shower for three months.”
Newton invited the media to watch him wash with a flannel and bowl following a round of jokes about “the filthy rich,” because megabucks paid water company executives was also a big story back then. He had been visiting his parents and in-laws’ houses for soaks, it was later discovered, occasionally leaving Yorkshire.
The episode infuriated the public due to the discrepancy between investor rewards and the quality of service being offered by a privatised utility. Bradford was in danger of going bankrupt, despite Yorkshire having just distributed a £50 million dividend to shareholders.
The company had to rely on tanker transportation through the Dales to move water since the new grid was running behind schedule. The story also highlighted the water infrastructure’s poor condition, which was cited as the primary justification for privatisation. Because of pollution in its rivers and on its beaches, the UK was once referred to as the “dirty man of Europe.”
The industry’s expenditure on replacing its sewage treatment plants and pipes had decreased between the mid-1970s and the mid-1980s, and the UK was now required to adhere to new pollution regulations set by the European Community.
The same infrastructure needs to be upgraded significantly more than thirty years later, and the costs will increase dramatically. The ten water and wastewater companies in England and Wales have paid out £78 billion in dividends since 1989, but they have also accrued £60 billion in debt. The industry has come to be associated with poor management, corporate greed, and pollution.
The trade-off between price hikes, investment and the environment will test the country’s new Labour government. Water companies have routinely released sewage into rivers and seas, which has made Britain’s waters increasingly dirty, putting the regulator, Ofwat, under intense pressure to act.
Thames had asked for a 44% increase in bills over the period, excluding inflation, while other providers sought varying amounts, from Southern Water’s 73% hike to Severn Trent’s 36% rise and United Utilities’ 25% rise.
The companies say the bill hikes are needed to upgrade ageing pipe networks and help accommodate a growing British population, and say more frequent droughts and storms have helped cause sewage spills. However, critics argue that the companies have under-invested for decades while taking billions of pounds in dividends for shareholders and paying large bonuses to executives.
While the government might want the Ofwat to take a tough line on the water companies, it also needs investors onside as Starmer seeks tens of billions of pounds of private investment to upgrade infrastructure and revive Britain’s economic growth.
In 2019, Ofwat agreed to a plan for average water bills to fall by 12% before inflation over the five years. Since then, inflation and interest rates have jumped, making price rises in the next period inevitable to allow investors to make returns.
A number of major international funds have already sold out of Thames bonds in recent months, after its parent company Kemble Water defaulted in April 2024 amid a standoff with shareholders over providing more equity.
Sold on the cheap
In 1989, the UK government cancelled all of the previous water authorities’ long-term debt and gave money as a “green dowry” to the newly formed companies to facilitate privatisation. Even after selling the businesses for a total of £7.6 billion, these exercises meant that the net proceeds to the Treasury were almost zero.
However, investors in the stock market listings saw their typical fast profit: within a month, shares of the ten companies increased by an average of 20%. Half of the small investors were persuaded to buy, and after a year they took their profits and sold their shares. However, additional funding did materialise. In the four years following the sellout, investment almost doubled to £6 billion annually from £3 billion. Supporters of privatisation might counter that underperformers might be forced to improve by the discipline of a stock market listing combined with a scolding from an impartial regulator.
Following the chaos in Yorkshire in 1995, Ofwat dispatched investigators, which resulted in a management shake-up. By the end of the tenth year, the company’s performance was the best in its class. Byatt also suggested that Yorkshire give customers a return of £40 million in the form of price reductions, and “it concurred after some discussion.”
Nevertheless, it was clear that the businesses had been acquired for far too little money. It was assumed at the time of sale that the companies would require quick access to funds to finance the increase in investment, so during the first five years, the average customer bill increased by a third. First, it was believed that debt levels could only account for up to 35% of the assets’ value, or the leverage ratio, also known as gearing. However, monopoly companies with captive clientele were able to obtain much larger loans from the bond market.
As odd as it may seem today, the regulator also wanted to see an increase in financial gearing. This was justified by the idea that customers would receive lower bills as a result of reduced funding costs. The initial five-year price review by Ofwat in 1994 prevented the anticipated increases in bills during privatisation, while the second one, conducted in 1999, resulted in an average 12% reduction in bills.
The companies were happy to play the debt game. A few people became enamoured with diversification during the boom years of the 1990s, thanks to cheap capital and rising share prices. Water networks in Chile and Indonesia were awarded to Thames. Welsh Water lost a lot of money by acquiring hotels and country clubs. A building company was acquired by Anglian Water in 2000.
Takeover games
In 1995, the government cancelled its golden shares in ten companies. France’s Lyonnaise des Eaux acquired Northumbrian Water and Highland Power acquired Southern Water. Wessex Water was purchased by US company Enron before its spectacular 2001 collapse.
Although water companies were prohibited from purchasing one another, some embraced the vogue of “multi utilities” and acquired local electricity providers, which were eventually privatised in 1990. Welsh Water rebranded as Hyder after taking over South Wales Electricity, and North West Water acquired its local supplier to become United Utilities.
A windfall tax imposed by the incoming Labour government in 1997 on the privatised utilities, including water, did not slow down any of this activity. For instance, Thames was sold for £922 million at privatisation, but in July 1997, the stock market valued it at £2.09 billion; similarly, Severn Trent’s value increased from £849 million to £3 billion.
The privatised water sector had undergone radical transformation by the end of the first ten years. The mixed effects of water privatisation were discussed in 1999 in this newspaper. One could argue that an excessive portion of the additional earnings had been “dissipated in unwarranted mega-increases in boardroom pay, excess dividends, and ill-advised diversifications.”
On the other hand, “We now have much-improved drinking water because a lot of money was invested in improving the infrastructure.”
Negotiations continued unabated. In 2000, the German utility RWE acquired Thames for £4.3 billion in cash and took on £2.5 billion in debt. The 240p per share that all ten water companies were sold for in 1989 was five times higher than the takeover price of £12.15 per share. UK utilities continued to attract foreign capital, which was viewed as a good thing in the spirit of the times. New Labour had no intention of tampering with the model.
Panic stations
A significant turning point was what came next. Following a string of horrific train disasters that claimed many lives in the early 2000s, Railtrack was placed into receivership and transformed into Network Rail. The majority of the nation’s nuclear plants are owned by British Energy, which required a bailout.
Both incidents sparked political panic, with the City trying to fuel worries that foreign investment would dry up if owners thought government action had short-changed them (the baseless accusation at Railtrack). Meanwhile, the water industry continued to vehemently protest that it had insufficient incentives to invest due to the alleged harshness of Ofwat’s 1999 price review.
Two decisions were made as a result, which in retrospect accelerated financial risk-taking. The water companies’ operating licences were originally set to expire in 2014, but were extended by Ofwat in 2002. They were replaced with 25-year rolling licenses.
“Companies and their investors will be able to plan more securely with the longer notice period,” stated Philip Fletcher, the late head of Ofwat, while interacting with the Guardian.
That was the plan, but the change also shielded underachievers from the possibility of being replaced in the medium run.
Then, in 2004, bills increased by 20% in what was widely perceived as a giveaway to the companies during the next five-year price review. Investors found water to be even more alluring.
After that, takeover activity accelerated dramatically. Investment banks, infrastructure funds, and pension funds were the new purchasers, not other utilities. The year 2006 saw Macquarie’s disastrous £8 billion purchase of Thames from RWE. The acquisition of Anglian’s parent company by a consortium of Australian and Canadian pension funds also occurred. After a battle with US investment bank Goldman Sachs, Southern Water was acquired by a group that included JP Morgan Asset Management in 2007. A group led by Citigroup and HSBC acquired Yorkshire Water’s owner, Kelda Group.
This is the time frame that former regulators have identified as when the game changed.
“Private equity infrastructure capital showed the hard face of capitalism, involving leveraged buyouts and short-term policies, namely high borrowing and high dividends,” Byatt wrote in his book “A Regulator’s Sign Off: Changing the Taps in Britain.”
This earned it widespread criticism for its lack of transparency and financial engineering.
Soon after leaving the regulator, Jonathan Cox, who had held leadership positions at Yorkshire and Anglian before serving as chair of Ofwat from 2012 to 2022, testified before a House of Lords committee that “investment banks started to realise in the 2000s that there was an opportunity to acquire the water company assets and to put significantly more leverage on to those capital structures. At that time, I wasn’t at Ofwat. That strategy has never appealed to me, and I think it’s terrible that it took place.”
He contended that investment banks produced “the predisposition of thinking of water companies as financial assets” and skewed incentives.
Financial engineering on steroids
Thames launched a “whole business securitisation” in 2007, shortly after Macquarie acquired it. The fundraising effort was dubbed “banal” despite its aggressive nature. An eight-layered corporate structure, including a subsidiary in the Cayman Islands, was used to package a once sombre business that dealt in pipes and sewage treatment works. This structure allowed debt to be piled on top of debt, much like the layers in a wedding cake.
Leverage ratios of 50% or 60% suddenly rose to 80% at certain companies that were taken off the stock market. In 2018, Thames explained how its complex corporate structure allowed it to borrow more money with the ratings agencies’ approval: “An investment grade credit rating allows for a higher level of leverage.”
Macquarie has justified its Thames business securitisation strategy by stating that it was “very common” at the time.
Martin Bradley, the head of infrastructure at the company, told Infrastructure Investor in 2023 that “it was a UK water utility product that was invented, advised, and constructed by UK banks.”
He cited annual gross returns of 12–13%, which he claimed were consistent with regulatory guidance during the 2005–09 periods, as justification for investors in Macquarie funds that profited from a staggered sale of Thames in 2017.
Additionally, the Australian bank has defended its overall management of Thames, stating that the business “undertook a record level of investment despite the returns allowed by Ofwat being reduced.”
But the industry’s mid-2000s debt binge still has an impact today. In 2021, Southern Water, which had implemented a complete business securitisation in 2003, needed to be saved from what appears to be a miniaturised version of the financial crisis currently engulfing Thames.
Macquarie, which controversially provided £1 billion in fresh equity to recapitalise the company, was the buyer at Southern. Ofwat realised the risks associated with excessive borrowing only much later. Only in 2023, did the company get the authority to halt dividend payments if doing so would jeopardise its stability.
Debt has also been used for its original purpose of accelerating investment, complementing the portion funded by bills. For example, is it a coincidence that the two companies that have been fined the most over the years, Thames and Southern, also have the most aggressive financing structures? The total investment made after privatisation is £190 billion. However, it is indisputable that excessive use of financial leverage is done to maximise profits for shareholders.
“For most companies, debt has been a prudent low-cost source of finance with low interest rates fixed for the long-term. However, some companies borrowed too much, most obviously Thames Water. The risk for this – and for correcting this – belongs to the company and its shareholders,” current Ofwat chief executive, David Black, addressed the point in 2023 when Thames’ financial crisis became acute.