Changing ownership of UK water companies

Photo: construction underway at Peacehaven, Southern Water

The last few months has seen major changes to the ownership of the UK’s water companies. Cheung Kong Holdings has acquired Northumbrian Water, the Canadian investment fund Capstone has bough Bristol Water and this week came news that a Chinese wealth fund has acquired 8.7% of Thames Water. The later deal may have more to do with Santander selling its stake to raise cash due to the Euro Crisis and the withdrawal by investors of funds from European banks.

However its clear that the UK water sector remains very attractive to investors. This is further underlined by the successful bond issues by several water companies like the £250 million bond issue at 4.875% by Severn Trent. Its not surprising the water sector is attractive, given its totally secure cash flow – its customers wont stop using water! The regulated structure means that their income for the next few years is certain. Better still water prices are linked to the retail price index so are currently increasing by over 5% a year – not many businesses have that luxury.

The 64 000 dollar question is has the regulator got the balance right between a fair charge to customers and an adequate return to reward investors? The appetite to buy UK water companies implies not.

Valuing water

Water is a precious resource. Its importance is universally recognised. Over recent decades, it has become an increasingly prominent issue. We face a number of new challenges, including a changing and unpredictable climate, population growth in water scarce areas and affordability issues.

“These challenges mean that we have to look carefully at how we use water. We need to value it and manage it responsibly. The problem is that we do not actually have a value for water. The price that customers pay reflects what has been done to get the water to the tap, but not the value of the resource itself. So, we must start valuing water, using a range of tools to reveal that value, including regulation and water trading” This quote from the Ofwat Valuing Water report misses the point. Water only has a value when it is available at the point of use. The water in Lake Windermere has no value. Its only because there is an water main running all the way down to Manchester that it is then valuable to the people of Manchester. It is of precisely no value to people in London as it would be prohibitively expensive to transport it to London from the Lake District. Ofwat need to recognize that the value is not in the water but in the assets used to store, treat and purify the water. The real question is how can these assets be used more effectively? 

The other implicit assumption behind the Ofwat report is that competition is a good thing. Ofwat  show the electricity and gas markets as ones to aspire to. Yet only today the Energy Secretary has called in the big six energy companies as its clear to everyone that the energy market is not working.

Ofwat should forget about competition and focus instead on ensuring there is a regulatory system that is not biased towards capital solutions and one that encourages and rewards innovation. 

Capex bias in the water and sewage sector

Ofwat’s report on Capex bias is an important contribution to the debate. This is a vital issue for three main reasons.

•  The water industry will continue to need massive investment £22bn over AMP5; the financial structure must ensure that this investment can be funded.
•  Water bills are continuing to rise and with the squeeze on household incomes it is even more important that everything is done to minimise costs.
•  Everyone agrees the water sector needs a lot more innovation. It faces some huge challenges from climate change and rising population and if these are to be solved at a cost customers can afford then new innovative solutions will be needed.  Capex bias limits the options open and is a major constraint on innovation.

Ofwat’s paper makes clear there is a capex bias as this quote illustrates: “When we consulted on SuDS, a number of (water) companies considered that the existing regulatory framework incentivises capex rather than opex solutions. So, they thought that they have incentives to build sewers, rather than investigate alternative approaches”.

The bias is even more starkly illustrated by the Abington reservoir inquiry. The Inspector concluded that Thames Water had not adequately investigated the alternative solutions such as demand management. Instead it had favored the highest capital cost solution. The current debate over the Thames Tideway Tunnel is raising this issue up the political agenda.

The water companies can not be criticized for working to ensure the best return for their shareholders. It is the regulatory framework that must change. This is an issue that has been around since privatization 25 years ago. It is time to stop talking and take action. The responsibility clearly lies with the Government and Ofwat. Decisive action is needed from the Ofwat “future price limits project” supported by the water white paper when it is published at the end of this year.    

Capex bias in the water sector

Ofwat’s discussion paper on Capex bias clearly outlines the drivers for Capex bias but is silent on what it intends to do. Water companies in their evidence to Ofwat indicated that earning a return on capital is a key driver of Capex bias. This is compounded by the financial ownership structure with many water company boards having performance targets to increase their Regulated Capital Value and hence return to its shareholders.

This was starkly highlighted by BBC Panorama this week (report on water abstraction). The example quoted was Thames Water’s focus on a new £1bn reservoir at Abington. The Public Enquiry early this year comprehensively rejected Thames Water’s proposals and said it had not adequately examined the alternatives.

This is important as innovation is vital to the water industry if it is to meet the challenges ahead. A financial system that rules out operating cost solutions is not in the best interests of the industry or its customers. Lets hope the forthcoming Water Bill and Ofwat in their “future regulation’ review take ‘decisive action’.

Adapting to climate change in the water sector

Ofwat’s “adapting to climate change report” is another step forward to ensuring the water industry changes to cope with climate change. It’s a huge challenge for the industry against a backdrop of uncertainty in the science and difficulty in predicting what the impact will be. Will summers really get hotter and dryer as some forecasts suggest – hard to believe given the wet August?

What does seem certain is that there will be more extreme events. The cost implications for the water sector are huge. Just look at the vulnerability of many sewage treatment and water treatment sites to flooding. The big stumbling block is gaining political acceptance for increasing bills to pay for the investment. Certainly in PR09 that was a step too far and now with the more challenging economic climate it is even more difficult.

Ofwat rightly aims to encourage more innovation. Anglian Water’s success so far in meeting its target to half its embodied carbon in the building of new assets shows what can be done when there is a real commitment to act. They are on track to meet the goal and do it within the tight price limits. The passion inherent in the Anglian Water Love Every Drop campaign needs to spread across the industry.

With the dark evenings approaching the books to read are Taleb’s Black Swan (The impact of the highly improbable) and Fooled by Randomness. 

Ofwat review backs slimmer regulation

Photo source: Thames Water - Beckton, Europe's largest treatment works

Defra has published David Gray’s review of Ofwat. The main conclusion is that the regulatory review process has worked well and that there is no need for major change. It does suggest that a lighter, less prescriptive approach is needed back by much clearer guidance from Government on the objectives.

The review has recognised the highly negative impact on the industry of the current 5 year roller coaster of investment and all the unnecessary costs this imposes on the supply chain.  The reviews recommendation to reduce the burden of reporting is to be welcomed.   

The concern is that the current regulatory process encourages capital intensive, end of pipe solutions and does not adequately address the need for the industry to become more sustainable and adapt to the challenges of climate change and population growth. Gray does recognize that currently there is an incentive for water companies to increase their regulatory capital valve and hence return to shareholders and suggests that there needs to be a review by Ofwat of the current rewards and penalties and framework of incentives. There is increasing concern in the industry that some current shareholders are only there for the short term gains – as evidenced by the bid for Northumbrian Water and that some water companies are selling key assets like buildings and then leasing them back – the model that ultimately led to the downfall of Southern Cross.

The industry has some massive challenges – especially the unprecedented growth in population and the uncertainty of climate change. Innovation and sustainable solutions like reuse of water and management of catchments must become the norm – it is disappointing that Gray has not taken this on board. Lets hope that Richard Benyon in the forthcoming water white paper rises to the challenge.    

Push, pull, nudge to save water

Photo source: Ofwat

Ofwat’s new focus report on reducing water consumption is to be welcomed if it promotes debate. It suggests various ideas to reduce the consumption of water. While the environmental case to reduce water usage is clear the financial case from the viewpoint of the customer is not.

Water suffers from two main problems, its too cheap and most of the costs are fixed not variable. Ofwat proposes that there should be much greater use of metering but is this really going to change behavior? In most cases water meters are installed in the pavement outside the property boundary so it is impossible for the customer to read them even if they wanted to.

Smart meters may help but so far it is far from certain these will influence consumption and the cost is currently excessive.

What about nudging behaviour and persuading customers to buy appliances that use less water. Here again the low cost of water is the issue. Typically a dishwasher that uses less water costs considerably more, perhaps £100 yet the annual water saving is at best £5, hardly a compelling financial investment case. Instead the trend of consumers to install power showers is continuing unabated. There needs to be some realism in the debate and a recognition that most customers lives are far too busy to want to worry about water consumption. Other solutions need to be found such as improving social housing by installing showers in houses that only have baths.

Water retail competition is a distraction

One of the subjects in the forthcoming water White Paper expected this summer is bound to be competition, especially after retail competition was proposed by both Ofwat and the independent Cave Review. This week Deloitte published a new report on retail competition. This confirmed what many of those in the industry already thought, that introducing competition is an expensive process and that the benefits are very limited so it fails the cost benefit test.

Competition may have worked in other industries like energy and telecoms but water is a very different market. It does not have a national network that allows physical transfer, secondly it would need major consolidation from the twentyone current businesses into about six if benefits are to be achieved.

What is far more important to the sector is securing low cost finance for the massive investment needed. Here any move to retail competition could cause debt and equity investors to lose confidence. Any resultant increase in finance costs would dwarf savings from retail competition. Secondly the new Service Incentive Mechanism puts a heavy premium on customer complaints and handling. The experience in the energy sector shows that competition is far from universally popular and certainly wont decrease the number of complaints. Rather than worrying over competition it would be much better to focus on innovation and finding ways to delivery the capital programme more cost effectively.     

Water regulatory cycle likely to be extended

“Thoughtful change” and “we need to be careful not to spook investors” as well as “we need to get it right” were key messages from the Minister for Natural Environment Richard Benyon’s keynote speech last night at the British Water House of Lords reception. Roughly translated this means that we should not expect significant new policies in the water and environment White Papers due this summer.

It does seem at last that the message on how much harm the five year regulatory cycle inflicts on the water sector is getting through. Water company Chief Executives alongside key suppliers all lined up together to make this message very clear. The Minister did promise action on this. But it is equally clear that there is firm support for having an independent regulator. All the positive lobbying by British Water backed up by hard quantification of the cost and some imaginative ideas on possible solutions have had the desired effect. It is equally clear that there is firm support for having an independent regulator. 

The climate has changed. Consultation is now key in Government and there is real opportunity to shape the future direction of the water industry. But is does require a real commitment to engaging with Government and senior civil servants. and actively working to shape the forthcoming white paper. The water sector can learn a lot from how effectively other sectors have managed this.

OFT and Ofwat investigate market for organic waste and anaerobic digestion

At first sight the decision by the Office of Fair Trading to investigate the market for organic waste sounds surprising. The investigation was triggered by a request from Ofwat, not because it had competition concerns but because it was concerned that the appropriate incentives may not be in place to encourage anaerobic treatment of organic waste from food scraps from household waste and waste products from the food and farming industry.

Heather Clayton, OFT Senior Director of Infrastructure, said:'Advanced organic waste treatment techniques like anaerobic digestion offer tremendous opportunities to produce clean energy and reduce unnecessary waste. 'We need to make sure that the conditions are right to maximize the potential for these technologies to benefit the UK.'

There is a concern over competition as the water companies may have a regional monopoly and with the dominant impact of transport costs may be able to exploit an unfair market advantage. But perhaps more importantly if the market for organic waste is to develop it needs a more commercial attitude to developing new sources of supply than the water companies have so far shown. This is where Ofwat and the OFT may have a role to stimulate activity. 

Managing risk of water supply failure

Photo source: Ofwat

Extreme weather events such as the 2007 Gloucestershire floods led to the flooding of many water and sewerage assets and left 350 000 consumers without water supplies for 16 days. It brought into sharp relief the threat to our normal way of life that extreme weather events pose. Since then there has been significant investment in ‘resilience’ reducing the risk of service disruption.

Ofwat’s latest focus report on resilience is to be welcomed. Its central argument is that risk should be looked at not in terms of asset failure but on the effect on service to people. Taking a customer based approach has to be right. Who cares if a critical pump fails provided the water supply can still be maintained from another source? 

Water leakage targets missed

Photo source: Thames Water

News from Ofwat that more than a quarter of all water companies failed to meet their leakage targets last year will add to the pressure to improve performance. Yorkshire under performed by a massive 7.3 % and Southern and Northumbrian also missed their targets.

Ofwat is threatening tough action to force compliance. There is no doubt that last years hard winter made the situation much more difficult. However hitting leakage targets is also becoming more difficult for several reasons especially:

• o   The use of more plastic pipework
• o   An increasing 24/7 lifestyle and multi occupancy houses
• o   The aging water distribution network

All the trends are going the wrong way on leakage and meeting the every tighter leakage targets is becoming significantly more difficult. Water companies are trying new technologies but are not keeping pace with a toughening climate.     

Sustainable Water- will it lead to a smaller Ofwat?

The Sustainable Water review that Ofwat is currently undertaking is looking at how regulation needs to change to reflect the major change affecting the industry and ensure a sustainable long term business. Ofwat is currently looking at price regulation and its impact on maintaining financial stability, especially the vital importance of reputation to water companies, as well as social sustainability and environmental sustainability.

With external pressures on Ofwat, like the move to smaller government and less regulation and the David Gray review, Ofwat is proposing to take a more risk based approach to regulation. This has to be a sensible move. Its clear the burden of data reporting is getting excessive, for example the June return guidance has gone from about 65 pages to 800! A risk based approach would mean Ofwat only focusing in depth on the vital areas and in others regulating with a light touch. 

Directors from the water companies made it clear yesterday that they support the steady evolution from input based regulation through output based regulation (where we are now) to outcome based regulation. They see this as giving more room to water companies to manage their business and focus on what is really important to stakeholders. The difficult bit is defining the outcomes we all want from the water sector in terms that are not so broad as to be meaningless. A move to a risk based approach with clear prioritisation reflects what every good business does and has to be a step in the right direction. 

Strong performance by water companies

Photo source: Ofwat

The annual report by Ofwat on the financial performance and expenditure of the water companies in England and Wales shows they performed strongly in 2009-10. The companies operating profits rose to £3.5 billion an increase of 7% on the back of higher revenues. The companies overall return on capital was up at 7.2%.

Investment was £4 billion higher than assumed in the 2004 price limits but down 14.9 % from the peak in 2008-09.

The strong performance and figures so close to predictions underlines why the sector is so popular with infrastructure investment funds and pension companies. However in the current harsh economic performance customers may start to question whether they are getting value.

The 2010-2015 final determination means that sound, predictable performance will continue. Harold Macmillan, the former UK Prime Minister when asked about “his greatest worries” famously replied, “events , dear boy, events”. Its extreme weather events that are most likely to cause an upset in the industry and put it back under the spotlight.

Reform of water industry still under discussion

Photo source Paul Hipwell: Axbridge reservoir 

The Coalition Government has confirmed a white paper will be published in June 2011 on reform of the water industry to ensure more efficient use of water and to protect poorer households. It is seeking to enhance competition and improve conservation in the water industry.

As part of the major structural reform of Government underway Defra has published its departmental priorities aimed at reducing costs and achieving the reforms set out in the Coalition Agreement. The objectives include:

·          Help to enhance the environment and biodiversity to improve quality of life.

·          Support a strong and sustainable green economy, resilient to climate change

Having clear objectives is good business practice and Defra should be applauded for making its vision clear. The question now is now quickly will these high level objectives translate into action on the ground?

The debate on competition in the water sector at the recent market reform meeting chaired by Defra focused on a paper from Ofwat on the issues surrounding separating out retail from water operations and asset management. There was no mention of water conservation, efficient use of water or how to support poorer households. To be fair this paper would have been produced before Defra’s new objectives had been published.  It will be fascinating to observe but equally very important for the future of the industry to see whether in light of these new objectives from Defra the approach towards competition radically changes as the new high level objectives imply.

Water competition threat recedes

Photo source: Ofwat

Ofwat is to take a step to step approach to introducing competition into the water sector the regulator confirmed at its briefing to the City of London earlier this week. Readers of this blog wont be surprised by this news  - it was predicted back in March. It confirms that the medium-term risk to financeability  that some analysts had feared has reduced.

“At this stage , we are focusing on those areas of the value chain that are least asset-intensive, and where there will be little impact on investors’ confidence or the cost of capital,” said Ofwat Chief Executive Regina Finn.

This pragmatic approach is to be welcomed. There is no appetite from consumers for competition although value for money is key. The current disparity in water bills across the country is becoming an increasingly  sensitive issue especially in the South West.

In the next step Ofwat will be building on the ideas in the Cave review and looking at the potential for upstream water reform in particular water abstraction licensing. The underlying problem for the regulator is that there is no actual value for water, the price consumers pay reflects what has been done to get water to the tap but not the value of water itself. Given the very high fixed costs and low marginal cost this is unsolvable. It is only in areas like water supply where marginal costs can help inform decisions. The marginal cost of developing new water supplies varies dramatically across the country from almost zero in areas of surplus water to over 100p /m3 in water stressed areas. Focusing on valuing water better in these areas can help the industry to make better decisions and take a sustainable approach. 

Benchmarking the water utilities

Photo: Severn Trent Water

Severn Trent Water was named 2009 Utility Company of the Year last night (Monday 14^th December) at the Utility Industry Achievement Awards ceremony in London.

Tony Wray, Chief Executive of Severn Trent, said: “This national award is the latest milestone on Severn Trent’s journey of continuous improvement. It results from a clear and focused programme in which we drive for ever-higher standards to achieve better levels of customer satisfaction and improve our environmental, financial and regulatory performance.

Ofwat has also announced their view of who are the most efficient water and wastewater companies.  For the water service, the most efficient company, the frontier, is Southern Water, closely followed by Portsmouth, South Staffs and Yorkshire Water. For the sewerage service, Thames Water is the frontier company followed by Wessex Water.

These efficiency assessments are important and undoubtedly drive higher performance and stimulate competition. Its always tricky to ensure that like is being compared with like but the methodology has been extensively refined over the last twenty years and is a valuable tool. Benchmarking is a very powerful methodology to identify scope for improvement and a process all businesses should be using.

First fallout from Final Determination

Photo: Thames Water Beckton STW

Thames Water has announced that its Chief Executive Officer David Owens is to stand down after only three years at the top. The news, coming just four days after the Final Determination was announced combined with the fact that Mr Owens does not apparently have a job to go to suggests there is a link. Thames Water was hit hard in the final determination with Ofwat’s decision to allow prices rises of just 3% on average compared to 17% in Thames Water’s Final Business Plan (FBP).

The gap between the FBP and Ofwat’s view is even larger for some of the water only companies. Bristol Water had asked for price rises of 29% and were granted 7% while Sutton and East Surrey had asked for 27% and got 1% . Some such as United Utilities have actually got a decline in prices over the five year period of 3%.

This mismatch between ask and actuals is not healthy. It does imply that the water companies failed to understand the political reality in which they operate. At a time of recession a price increase of over 25% was never likely to be realistic. It also implies that either the water companies misread Ofwat or that they failed to present a well argued case. Its vital for the health of the water industry that the evident gap between the water companies and Ofwat is closed. Expect more fall out at the top of the water companies in the coming weeks.

Bathing Water quality improves

Photo: Defra

The quality of English and Welsh bathing waters improved in 2009. Results just published by Defra show that 98.6 per cent of beaches meet the mandatory standard up by 2% from last year. The pass rate at the more stringent EC guideline standard was over 10% better at 82.2%.

The improvement was partially the result of the average rainfall in 2009, which contrasted with exceptionally wet weather in 2008, which caused pollution from run off and more frequent use of combined sewer overflows.

Ofwat has allowed £220m of expenditure in the Final Determination to improve sewage works and unsatisfactory overflows affecting bathing beaches. However recent experience on the Flyde Coast has shown that tackling bathing water quality isn’t a simple issue partly due to all the various diffuse sources of pollution.

While the improvement in bathing water quality is welcomed, looking forward bathing waters are likely to become an even more emotive issue over the next couple of years. New standards, that set even more ambitious targets, come into force in 2015. Before that, in 2012, Councils are required to display much more visible and informative signage at bathing beaches. That fact, combined with more people holidaying in the UK, is likely to increase the pressure to improve and ensure bathing water quality remains a high profile area. 

Ofwat final determination due Thursday

Photo: courtesy Northumbrian Water

The expectation in the industry is that Ofwat’s final determination will be only slightly more generous than the draft determination. Ofwat will reveal the outcome on Thursday (26^th  November). Analysts are pessimistic about the impact on water companies suggesting that Northumbrian Water, Severn Trent, United Utilities., Pennon and Thames Water may have to raise capital to cope with the fall in revenue. In a surprising statement Northumbrian Water Group in their half year results issued today indicated that they felt they would be able to maintain their dividend policy of 3% p.a. real growth and have funding secured for the next two years.

The blog is concerned that the uncertainty is having a very negative impact on the supply chain. It wasn’t long ago that the industry was struggling to find the quality of people needed to handle the investment programme. There has always been a dip in demand through the regulatory review period but usually suppliers have been able to move staff to other more buoyant sectors. This time around with the regulatory review period coinciding in Scotland and England and Wales as well as the recession the situation is much more serious. 

Looking forward it is clear that the level of capital investment in AMP5 will be similar or maybe slightly higher than AMP4. In addition Ofwat is suggesting that the water companies need to spend an additional £400m on new flood defences and in light of the Cumbria floods this number will probably increase.  The concern is that the supplier base will have been so decimated by the current lack of work that the people will not be there to cope with the upturn when it comes. The supplier base needs some certainty if it is to pull through.