The leaky water sector in Britain is experiencing a tsunami of issues. The financial issues at Thames Water have drawn attention to the privately owned utilities in Britain. However, the likelihood of considerably higher investment demands in the upcoming years will result in higher costs and more political scrutiny. This might make it challenging to keep ownership models in place as they are.
For a sector that the Conservative government privatized in 1989, Thames Water's struggles raise challenging considerations. Between 2006 and 2016, while under the control of Australian investor Macquarie, Thames' debt increased to over 80% of the group's regulatory value of capital , a concept used in the business world to represent the value of a firm's assets. It is now in a bad position to handle an increase in investment which might reach 10 billion pounds as a result. If the organization can't raise money or fulfill its legal obligations, the government might put it under administration.
Until a certain point, Thames seems an outlier. Companies that are publicly traded carry less debt, such as Severn Trent. The industry as a whole did, however, borrow money in 2022 at a rate of 69% of RCV, which is more than the 60% threshold that regulator Ofwat advises. Additionally, considering the recent outrage against sewage breaches, which totaled 372,000 in 2021, years of profits and huge CEO compensation suddenly seem out of place. The consequences pose two important issues: whether the regulatory system is effective and whether private ownership of Britain's water corporations is still appropriate.
Regulators are partially to blame. In the 1990s, water firms emerged from the state with spotless balance sheets and huge investment needs to preserve the condition of their assets. These expenses are eventually covered by raising prices for customers. However, businesses discovered a way to boost profits in the 2000s by taking on more debt than the regulator anticipated when determining the sector's expected cost of capital. Regulators may have placed too much emphasis on bill-cutting and not enough on penalizing ineffective employees or requiring investments to upgrade aging Victorian sewage infrastructure.
The good thing is that regulations are far stricter now than they were. The cost of poor performance has also increased. The regulator estimates that the sector's permitted yearly return on equity over the following five years may only be 4.14%, or 6.14% after accounting for inflation - nearly 1.5 percentage points less than between 2015 and 2020.
Even while the regulatory framework may be more stringent, the UK would still stand out as an outlier for allowing individual water utilities in the first place. Consumers are forced to pay more because of return-seeking shareholders, and there is a risk of moral hazard since owners can be motivated to continue doing what they previously did — borrowing excessively and forgoing investments. There are alternative options, even inside the UK: The Scottish government runs its own water corporation. Water in Wales is governed by the non-profit Dwr Cymru, which is also subject to Ofwat regulation.
Consumers wouldn't necessarily benefit more from companies being returned to public or not-for-profit status. Compared to Scotland's 409 pounds, the average water bill in the UK this year is 448 pounds. This, according to Barclays analysts, is less than in Germany and the US. Since privatization, the quantity of water lost by leakage has decreased from 30% to roughly 20%, which is less than in Scotland and other nations.
However, a much bigger test for the sector is soon to come. Low inflation has defined the decades since privatization. Bills will rise as a result of the recent price increase, further raising the question of where consumers' money is going. Investment demands are also skyrocketing, which is more concerning. Britain must modernize its sewage systems and prepare for the hotter, changing environment. An additional 56 billion pounds, or ten years' worth of customary industry expenditure, might be spent alone on dealing with sewage spills. Even before accounting for the high inflation rate at the moment, Barclays analysts predict that annual bills will increase by 60% by 2030.
Another option would be to abandon the private paradigm, either by nationalizing businesses or by forcefully transforming them into not-for-profit organizations like Dwr Cymru, which is solely funded by debt. That would result in cost savings. To provide enough returns on the capital of equity holders, a portion of each customer bill is included.
The difficulty is that any significant improvements can result in brand-new issues. A segment of not-for-profit organizations might become less transparent and rely more on passive bondholders to uphold sound financial practices. Full-scale nationalization may even result in a decrease in capital expenditures; two years after privatization, in 1991, investment was approximately double that of 1986. However, if sector pressure increases, smaller businesses will probably struggle. Whether it likes it or not, the government might be compelled to test a new model.