The Government launched a major review of the water sector this week. This comes amid ongoing anger over sewage outflows, new measures to punish misbehaving industry chiefs with prison time and speculation that the regulator, Ofwat, could itself be dumped.
Liberal Democrat MP Tim Farron fired back that this isn’t nearly enough. He wants ‘far more urgency’ and a new regulator ‘with real teeth and power’ to take on the industry. Others, like Matthew Topham, from We Own It have complained that the review is ‘deaf to the calls’ to address the ‘root cause of the sewage crisis: privatisation’.
Interestingly, however, the new Government’s tone appears to be shifting. The review announcement this week was less fire and brimstone and more focused on attracting private sector investment to address the sector’s challenges. Environment Secretary Steve Reed has warned that nationalisation would cost up to £100 billion and ‘not resolve the problems’. The appointment of former Bank of England Deputy Governor Jon Cunliffe to lead the review is a further signal to the sector that the Government wants investment not clampdowns.
At the heart of the problem is Britain’s Victorian-era water system, which mixes sewage with rainwater and requires releases into waterways in heavy downpours. The alternative, until there is enough treatment capacity, would be for raw sewage to come back up through toilets. It’s a similar story for pipe leakage, which reflects the ageing infrastructure. There are also issues about water shortages, which, like pretty much everything else in Britain, often comes down to Nimby obstructionists (see the Abingdon reservoir in Oxfordshire).
The sector needs hundreds of billions in investment to resolve these challenges and upgrade the system over the coming decades. But whether companies are allowed to invest is not actually within their control – it’s up to Ofwat.
The water companies are, if anything, being held back from investing as much as they want. In their draft response to industry investment plans for the rest of the decade, Ofwat has cut £16bn from the £105bn of investment proposed. This is to keep down consumer bills, which are a function of investment levels. But it comes with a significant trade-off of less money for environmental goods.
It also carries another risk: lower returns could result in water companies going bust.
Moody Ratings has warned that Ofwat’s proposal ‘increases the risk that sector returns may not be enough to attract the equity funding the companies need to support increasing investment. If the draft is adopted unchanged we could lower our view of the regulatory framework’s stability, predictability and supportiveness’.
As it stands, Thames Water’s shareholders are refusing to inject the necessary funds to keep the company afloat because of Ofwat’s draft determination. This could mean pushing the company into special administrative measures. Other water companies in precarious financial positions are also facing the prospect of higher borrowing costs and even bankruptcy, according to Barclays Research. This would mean higher costs for billpayers, taxpayers and deter private industry investment.
But the implications could be even broader than that. The messy situation in the water sector, which usually involves stable returns for the likes of risk-averse Canadian pension funds, is creating an investment downturn contagion. The UK has gone into negative territory for international infrastructure investors, significantly lagging behind the likes of the US, Canada, Germany, France, Ireland and even Italy, according to an industry survey.
Luke Hickmore, the Investment Director at investment firm abdrn, has warned that, ‘We’re talking to international investors, and they’re very nervous about the UK. That’s largely around the uncertainty on regulation’. Singapore sovereign wealth fund GIC halted investments into the UK’s regulated water, electricity and gas utilities following the crisis engulfing Thames Water. The problems in the water sector are even posing a risk to financing for the Sizewell C nuclear power plant, which is seeking private sector funding following the banishment of Chinese investors from the project.
It appears, at least in the new regulatory review, the Government has begun to heed warnings from investors. But this is far from guaranteed. There is some talk of forced sales of firms into a not-for-profit model. This would, the advocates say, mean final profits are returned to the company. But it comes with a serious flaw: without the prospect of profits, who will be willing to invest? Who will be able to raise the capital for these buy-outs? What is the incentive to improve efficiency? It’s worth remembering that the water sector suffered many decades of severe underinvestment prior to privatisation.
In the short run, there is speculation that Ofwat will budge and let the sector invest more in their final determination due out before the end of the year. In the longer run, the Government’s water review is a prime opportunity to improve the underlying regulatory framework. The Government could impose an explicit growth duty on the regulator to force them to think about the broader implications of their decisions. The regulator could even take on planning and financing powers to enable more projects like Tideway Tunnel and approval of the Abingdon reservoir.
Righteous politicians may be tempted to keep lecturing the industry. But in the end, all that will matter is whether it can attract investment to solve its problems, and that depends on getting the regulation right more than anything else.
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