Changes to the UK water industry: a time for hope or hype

We need long-term thinking, not short-term politics

The UK government has declared that water regulation in England and Wales is “broken.” The announcement, made by Environment Secretary Steve Reed wasn’t exactly a great insight. Pretty much everyone in the country is aware that raw sewage is frequently discharged into our rivers and at least one water company is on the verge of financial collapse. So the grand announcement was a statement that played to the gallery more than it informed the public.

The same can be said of the Secretary of State’s declaration that Ofwat is to be “abolished”. As Ofwat is the economic piece in our current water regulation jigsaw, its abolition – if it really were to happen – would leave a huge gap in the overall picture. But elsewhere in his announcement, the Secretary of State made it clear that Ofwat and three other regulators are to be merged, rather than any of them being eliminated.

If real change is to be achieved by this move, what matters is the extent to which the decisions of the new regulator will be different from those of present and past incumbents. To a very great extent, that will depend on whether the combined regulator is given different powers and/or populated with different people – and, if so, what powers and which people. We have yet to be told.

Right now, it is open season on criticising the water industry. So much so that a commentator on the BBC’s flagship political show on Sunday morning went unchallenged when he described the drinking water in London as “disgusting”, “foul” and “comes out of the tap like milk”. (In fact, international comparisons across OECD countries show that UK drinking water is amongst the safest. A milky look is just air bubbles.)

I won’t be defending the water industry in the remainder of this article. But I will try to bring a modicum of common sense into a discussion that is often unruly and ill-informed.

"Hot Raw Sewage" by Trey Ratcliff

Predicting the future

It is natural to want to blame the current incumbents for current problems. But the problems of today are not always the result of recent action (or inaction). The water sector depends on infrastructure that takes years, or even decades, to build. That is why the Secretary of State promised no more than a halving of sewage discharge over the next five years. If it were simply a matter of tougher regulation, or tougher regulators, the discharges should stop right away. But it isn’t.

In many of the UK’s older sewer systems, wastewater from kitchens and bathrooms runs through the same drainage pipes as rainwater. When there is more of this combined wastewater than the pipes can cope with, only a manageable volume can be sent to the treatment works. The rest is released into our rivers and seas (hence the discharge of untreated sewage).

One reason why the sewage system cannot now cope where once it could is population growth. Another is the increased frequency and intensity of flooding as a result of climate change. (A third factor to watch out for in the coming years will be artificial intelligence which consumes a heck of a lot of water.) I hesitate to criticise the poor souls currently facing the blame for not foreseeing the huge spikes in both immigration and flooding, especially not those (and I bet there are some) who did actually predict these events but whose warnings were not acted upon. The work needed to make Britain’s sewage system capable of handling the current level of demand would have been very costly at a time when the political pressure was all pointing towards keeping water costs down.

I am intrigued by just how many people still call for costs to be kept down, often saying: “We’ve already paid for the industry to function properly, so why should we pay again?” Well, we haven’t paid. And, sadly, it’s nonsense to believe that we have. With all the benefits of hindsight, it is now clear that we, the public, should have been paying more. Water companies should have invested more. And regulators should have been allowed by the government to require both of those things to happen.

And yet the current government is telling us that the new regulator will prevent “the shocking bill hikes” needed to bring the system up to scratch.

Misdescribing the past

Water companies in England and Wales were privatised in 1989. The government imposed a cap on price increases for the next ten years. Ofwat stepped in after five years with a new, lower set of caps. Ofwat’s methodology was very sophisticated and yet beautifully simple. The regulator used econometric models to compare the costs of each company and, armed with those comparisons, determined a set of benchmark costs that an efficient company should be able to match.

Allowances were made for differences between the companies – geography, population, availability of water supplies and so forth – so that each company was given a suitable efficiency target that matched their own circumstances. (That was the sophisticated part of the process.) Allowances were also made for growth needs in any particular area.

Companies that were less efficient than the target set for them (including any growth targets) would not be able to make the level of profits their investors might have expected. That created a clear incentive to improve efficiency in order to restore profitability. At the same time, any companies that beat the target were able to earn an extra profit for a few years. So every water company, whether efficient already or struggling to achieve efficiency, had a clear incentive to force its costs further downwards.

Five years later, and every five years after that, the whole process would be repeated, each time comparing the companies’ new, lower unit costs and setting new, progressively tighter benchmarks. And so the process of setting and renewing the benchmarks would be repeated every five years in a never-ending pursuit of greater efficiency.

Although each company had a monopoly of supply for its local area, this process of using cost comparisons every five years to develop new efficiency benchmarks meant that every company was competing against every other in relation to its costs. If they failed to keep up with the industry benchmarks, their profits would go down. But the profit incentive was always there to ensure that efficient companies tried to become even more efficient.

That was the theory (known as “comparative competition”). And it was a good one. The complaint that the Thatcher government privatised the water companies without any competition is yet another in the series of misunderstandings that abound when complaints are made about the water sector.

But politicians change as the years go by (just as they should). Unfortunately, incoming UK governments haven’t been able to resist tinkering with legislation so as to steer the regulators in a direction that is politically convenient at the time. And it’s not just governments: parliamentary select committees can’t resist tearing the regulators off a strip whenever something looks awry. In the years after the global financial crisis, Ofwat imposed a set of price caps which overestimated how much it would cost water companies to borrow. As a direct result, companies were able to earn higher profits than intended. The subsequent political clamour to change the methodology in order to claw back prediction errors of this type led to a long-term process that had been working reasonably well being tinkered with to suit short-term political exigencies.

When Ofwat carried out its first review of prices in 1994, it described the methodology in a 48-page document. The equivalent document for the price review in 2024 was over 900 pages. Some people will doubtless argue that the twenty-fold increase in detail led to improved precision in the modelling of costs. I am of the view that the search for short-term accuracy was a major factor in long-term planning going out of the window. Where is the incentive to plan for decades ahead when the rules are changing every five years?

Penalising the greedy shareholders

That is not to suggest that Ofwat or the companies were blameless for what has occurred. Far from it. The financial mess that Thames Water now finds itself in is the direct result of a hugely misconceived financial reconstruction which took place almost twenty years ago when it was bought by Macquarie (who later sold it on). The financial restructuring was one of several at around that time. It was indefensible. But understanding what happened gives the lie to the oft-repeated allegation that Thames Water borrows money to pay dividends to its “greedy shareholders”.

As part of Macquarie’s purchase, the regulated water company that we call “Thames Water” (full name, Thames Water Utilities Ltd) borrowed money which it lent on to its parent, Thames Water Utilities Holding Ltd (which I shall refer to as “Thames Holding Company”). That money was passed up the chain to assist with Macquarie’s purchase of the business.

A key point in the story is that Thames Holding Company, the immediate parent, is fundamentally an empty shell with no trading activity and no commercial income of its own. In order for Thames Holding Company to pay interest on the money lent to it by Thames Water, it is necessary for Thames Holding Company to receive a dividend from Thames Water, which Thames Holding Company promptly returns to Thames Water to settle the interest.

That simple description is only part of a much more complex structure which was used to help Macquarie to purchase the group by borrowing against the regulated assets of the water business. By all means, use whatever description you wish to describe the people behind that restructuring (I certainly do!). But do take note that the so-called greedy shareholders who bought the business from Macquarie in 2017 have not received any dividends.

There is an argument to be had as to whether Ofwat had the power to prevent that restructuring before it happened. If it did have the power, I would say that it should certainly have used it. If it didn’t have the power, the legislation had left a serious gap.

But just as I suggested above that we should be wary of blaming those who didn’t foresee the increased immigration and flooding that the country is now faced with, I am wary of criticising the drafters of the Water Industry Act 1991 (under Thatcher) and the Water Act 2003 (under Blair) for failing to foresee the bizarre and byzantine financial structures devised (so I believe) by bankers to assist in the purchase of water companies. This was, after all, before the global financial crisis … and no one had yet grasped what risks the bankers were exposing us all to.