Water utilities attractive investment for pension companies

Photo courtesy: Thames Water

With the attractive and stable returns being generated by Water Companies its inevitable that more investment funds will seek to move into the water sector. Already a number of pension funds have significant investment in the water sector including for example, Canadian Pension Plan and Ontario Teachers Pension Fund.

The water utilities are very attractive to long term investors as they offer:

• Mature assets operating under a strict regulatory regime
• Limited demand risk due to the monopolistic position
• Revenues linked to inflation
• On going capital investment providing revenue growth
• Long term and predictable cash flows
• Being in Europe a stable political and legal environment further reducing risk

Returns to pension companies have been very attractive at around 11%. The big change in AMP5 is that whereas before all the water companies have made similar returns now with the new capital incentive scheme introduced by Ofwat and other changes in the periodic review the gap between the best and worst performing water companies is likely to increase significantly. This will put even more pressure on management teams to perform and means that the top performing water companies like Anglian, Yorkshire and Wessex will become even more attractive to investors.

Equally the move by the big infrastructure investment funds to invest in the water utilities should be good for the industry as they provide a very long term (40 year) stable presence and can consequently encourage water companies to take a long term view.   

Water: our thirsty world

It is not usually the role of a blog to promote another publication. But having read April’s edition of The National Geographic magazine the blog has no hesitation in suggesting readers should get a copy. It’s a special issue on Water and contains stunning photographs as one would expect but also some very illuminating articles.

Photo: National Geographic 

Severn Trent questions whether water industry is sustainable

In a constructive move, Severn Trent has published its views on the challenges facing the water industry. The report called “Changing course” challenges whether its sustainable for water bills to continue to rise – up 45% in real terms since privatization. 

Debt has increased to around £33bn from nothing at privatization and carbon emissions are rising in direct contrast to the Government target of a 34% drop by 2020.Severn Trent questions whether these trends can continue.

The main changes proposed are:

• A review of the current regulatory framework including a more efficient price setting process involving customers, and a more flexible approach to implementing the EU Water Framework Directive
• Greater support for competition and trading within the industry allowing more efficient distribution of water resources, benefiting customers, stakeholders and the environment.
• Greater policy support for energy efficiency which rewards those companies which significantly reduce carbon emissions, and a consenting regime which recognises the trade-off between higher absolute standards and curbing increases in carbon emissions

It is a critical time for everyone on the water industry. It is clear that with bad debts spiraling out of control and carbon emissions rising the current plans are not viable. It is vital to stand back and question the way forward currently proposed. This report is a welcome contribution to the debate and worth reading. 

Flood and Water Management Bill gains Royal Assent

Image courtesy: Thames Water

At the vary last minute (8^th April) the Flood and Water Management Bill has gained Royal Assent.  The act will implement several key recommendations of Sir Michael Pitt’s Review of the summer 2007 floods.   

The Act’s provisions include:

• New statutory responsibilities for managing flood risk – There will be national strategies and guidance on managing flood risk in England and Wales.  Unitary and county councils will bring together the relevant bodies, who will have a duty to cooperate, to develop local strategies for managing local flood risk.

• Protection of assets which help manage flood risk – The Environment Agency, local authorities and internal drainage boards will be able to ensure that private assets which help manage the risks of floods cannot be altered without consent.  For example, putting a gate in a wall that is helping protect an area could increase the risk of flooding.

• Powers to carry out environmental works – the Environment Agency, local authorities and internal drainage boards will be able to manage water levels to deliver leisure, habitat and other environmental benefit.

• Sustainable drainage – drainage systems for all new developments will need to be in line with new National Standards to help manage and reduce the flow of surface water into the sewerage system.

• New sewer standards – all sewers will be built to agreed standards in future so that they are adopted and maintained by the relevant sewerage company.

• Reservoir safety – the public will be protected by a new risk-based regime for reservoir safety.  It will reduce the burden on regulated reservoirs where people are not at risk, but introduce regulation for some potentially risky reservoirs currently outside of the system.

• Water company charges – there will be protection against unaffordable charges for surface water drainage for community groups such as churches, scouts and others.  Future water company charges can include social tariffs for those who would otherwise face difficulty meeting their bills.

• Protection of water supplies – there will be wider powers for water companies to control non-essential domestic uses of water in times of drought.

• Other protection for water company customers – there will be new powers to reduce the level of bad debt, new arrangements for managing very risky infrastructure projects which could be a threat to the ability of the water company to provide its services, and updated arrangements for administration of water companies should they get into difficulties.

United Utilities bullish about prospects

In a recent investor presentation United Utilities Chief Executive Philip Green said that: “we are well prepared for this next price review period (April 2010-2015) and we are confident of delivering out performance.

This confidence stems from a number of actions United Utilities have undertaken:

•                  Low cost of their debt portfolio of 1.8% real compared to Ofwat’s assumption of 3.6%
•   A reduction in the number of employees in their regulatory business of 7%
•          Streamlining processes and rationalizing IT infrastructure
•   New supplier contracts on improved terms 

United Utilities have secured an increase in their capital expenditure plans of £400m in real terms compared to the previous AMP period 2005-10, with planned expenditure of £3.6bn. United Utilities are particularly pleased that their regulatory capital value (RCV) will grow by 12% in real terms by 2015.

This is worrying for two reasons. Firstly it shows the continuing importance water utilities place on high cost capital schemes – there is in effect an incentive on the water company to promote the highest capital cost scheme that they believe the regulator will support. This mitigates against finding schemes with the lowest whole life cost especially those with higher Opex. Its also worrying as this high level of growth in the RCV has to be paid for by customers – the question is how much longer will customers accept steadily increasing customer bills?

Can the water industry afford major capital schemes?

In the budget Chancellor Alistair Darling announced he is commissioning an investigation into the cost of civil engineering works for major infrastructure projects, building on “existing evidence” of “potentially high costs” of UK schemes compared to the rest of Europe.

Affordability of water bills is likely to become a big issue over the next few years. Already Thames Water is seeing sustained opposition to its Tideway Tunnel proposals from the likes of Hammersmith Borough Council who are concerned about the ability of its residents to afford the bill increases needed to fund the massive investment.

Over the last 20 years, water and sewerage bills have increased by over 40% in real terms. One aspect is that the cost of bad debt is rising and now accounts for about £12 on each customer’s bill. In areas like the far SW water bills are already a major political issue. With the large investment required to meet the challenges posed by Ofwat’s strategy for delivering sustainable water the situation is likely to get worse. It will only increase the incentive for water customers who avoid paying their bills even though they could afford them.

This poses a real challenge for all of us in the water sector. Major capital schemes have often been seen as the preferred option given the way the regulatory and financial framework is tilted in favor of capital schemes. Finding significantly lower cost alternatives perhaps involving more Opex, will require a step change in innovation and that we attract bright young graduates into the industry – neither looks likely at the moment.  

Innovation in the water sector

At a conference run by British Water last week the steps needed to improve innovation (defined as fresh thinking that creates value) in the water sector were discussed. As the Cave Review recognised Innovation is essential for the water sector although the current level of R & D investment in the water sector is extremely small.

The Technology Strategy Board (TSB) established by the current Government with a budget of £1bn over 3 years and 100 staff is the main vehicle for driving business innovation. Groups have already been established by the TSB to look at Low Impact Housing and Sustainable Agriculture and Food. Now Martin Griffiths is leading work to build a case for a new group to stimulate innovation in the water sector. A decision on whether a new group will be formed is not likely til after the election and in the Autumn at the earliest.

Its clear much more needs to be done to encourage innovation. The current situation where the water companies undertake very little true R & D and where the current framework agreements mitigate against innovation is not healthy for the long term future of the industry. A new commercial reality is needed that enables suppliers to be rewarded for investing in innovation that benefits the water sector.