This month, a group of institutional investors led by Macquarie, the Australian infrastructure investor, confirmed that it would invest a further £550m in Southern Water, on top of the 62% stake it acquired in 2021. As inflation and interest rates have risen in the UK, the debt of UK water companies – like Southern Water – has become progressively more costly to service, particularly since some of the debt interest is retail price index-linked.
In July, Thames Water faced such severe difficulties that the possibility of a government rescue was mooted. Ultimately, it secured a substantial equity injection from the university superannuation scheme (USS), one of its large institutional investors that include domestic and foreign pension funds, sovereign wealth funds and private equity funds. But both Thames and Southern have been fined in recent years for sewage discharges in rivers and offshore waters. While Macquarie also divested from Thames Water in 2017, leaving it saddled with a high debt-to-equity ratio.
When the water utilities in England were privatised in 1989, (water services in Scotland and Northern Ireland remained in the public sector, and Welsh Water has since become a ‘not for profit’ company), the new companies were unique. They were privatised as regional monopolies, based on river catchment areas and without debt. Their services are essential to public health and the way they are delivered and managed has a substantial environmental impact.
Hence, water companies clearly need to be regulated both as utility service providers and natural monopolies with potential to abuse their market power and cause environmental damage in their catchment areas (and offshore). As utilities, they have public duties and social responsibilities that should underpin their purpose, which should not be simply to maximise profit.
In recent years Ofwat, the industry regulator, urged them to develop a ‘social contract’ with their customers and local communities and other stakeholders, including employees, investors and activists lobbying for cleaner rivers and coastal waters (such as Feargal Sharkey and Surfers Against Sewage). Some, such as Anglian Water, responded enthusiastically. But others dragged their feet.
Ofwat is currently monitoring the debt-servicing capacity of four other large water companies with significant private equity (which tends to load its portfolio companies with debt) and institutional investors (who have a preference for the regular returns from infrastructure bond investments). During the prolonged period of low interest rates following the 2007-9 financial crisis, debt was cheap to service and the water companies were effectively mortgaged, with interest payments that were tax deductible as a business expense. Their sizeable profits were then distributed as dividends to their shareholders, rather than being re-invested.
As interest rates were aggressively raised by the Bank of England in the past year or so, with the aim of bringing inflation under control, it became more and more difficult for some water companies to service their increasingly substantial debts. Equity is behind debt in terms of seniority if a company is declared bankrupt and so, whilst equity investors risk losing their entire investment, bondholders are more likely to face a ‘haircut’. Hence, equity investors are reluctantly providing additional equity to financially stressed companies without similar commitments from government or leading investors (such as Macquarie and USS).
Meanwhile, many water companies, whilst paying record dividends, have been failing to meet targets agreed with the regulator to reduce water pipe leakage and storm sewage emissions into rivers and coastal waters – despite public outrage. More investment is now being required by Ofwat, but the big water companies want to fund this by increasing charges to customers rather than reducing dividends, which would be a disincentive to institutional equity investors. It should be noted that these are the same investors that present and future UK governments wish to engage in public-private infrastructure investment to stimulate growth and tackle the climate crisis.
In sum, large water companies have underinvested in their capacity to deliver their services efficiently and in an environmentally responsible way. Yet they were privatised with the aim of stimulating investment without drawing on the taxpayer or being funded through government borrowing. Whilst there has been substantial investment, it seems that privatisation of core utilities that allows substantial stakes to be built by overseas sovereign wealth and pension funds and private equity funds may be a step too far. You could say it’s been ‘over-privatisation’.
Not only should water companies have been more tightly regulated (environmental regulation has only recently been formalised and toughened), but also been given a special status as regional monopoly utility providers crucial to public health and environmental protection. Their articles of association should have included a clear ‘purpose’ stating their public duties and social responsibilities. This would have provided the basis for social contracts negotiated with their stakeholders. It seems unlikely that such public or social interest companies would have become so heavily debt-dependent.
Similar principles should also be applied to other core utility service providers, particularly energy suppliers, but also in transport and communications and – ultimately, under a responsible capitalism model – perhaps to all major companies.