Financing the private water and sewerage Companies of England and Wales

Ofwat - The Misguided Watchdog

Last update Wednesday 15th July 2010

There is no dispute that since flotation in 1989, South West Water household bills for water and sewerage services have been, and remain, the highest in England and Wales. The general understanding has been that the charges of all the privatised companies had to be high because of the cost of the capital investment programme necessary to make good past neglect, meet improved standards for water quality and to protect the environment but that South West Water bills were inordinately high because of the additional cost of “Clean Sweep”, the programme to install sewage treatment works around the long peninsular coastline and to discontinue the discharge of raw sewage from about 250 sea outfalls.

This explanation for the excessive South West Water household charges was at least partly true until recently but no longer applies since Clean Sweep is now essentially complete. This is confirmed in the recent Walker report (Table 8, page 159) which shows the capital expenditure per household, by company, for the period 2010-15 and that South West Water customers, for the next 5 years, are to be charged an average of £558 per household to finance the capital investment programme (compared to the industry average of £549). That is, the present average South West Water charge per household to finance the capital investment programme is actually less than £2 a year above the industry average. The inordinately high South West Water household bills can obviously no longer be attributed to the cost of the ongoing South West Water capital investment programme.

There is no doubt that South West Water household bills remain inordinately high, at around 40% above the average, and that this is certainly not, as previously understood, due to the cost of the capital investment programme. However, we are fortunate that the explanation for the continuing excessive charges is also given in the Walker report (table 7, page 158) which shows the average Regulatory Capital Value (RCV) per property, by company, accrued since flotation. As might be expected, on the basis of the excessive charges that have been paid by South West Water customers to finance the capital investment programme, the accrued capital value for South West Water is well above the industry average. In fact, the South West Water accrued RCV since flotation amounts to no less than £3,053 per household which is more than twice the industry average of £1,441. The significance of the figures, as the Walker report indicates (paragraph 14.3.1, page 159) is that customers are charged in full on these post flotation assets in order to pay the companies, and their shareholders, a so-called “return on capital”.

Ofwat and Defra, when questioned, attach great importance to “return on capital” as essential to attract investors but this is an obvious sophistry which falsely implies that shareholders, not water customers, have financed the capital investment programme. However, the assertion does at least confirm that the return on capital element in the Ofwat financial projections is not intended to finance any function but is intended to be accounted as profit. As can be seen in the Ofwat financial projections given in Appendix 3 (pages 152 and 153) of “Future water and sewerage charges 2010-15:Final determinations”, the 5 year aggregate “return on capital” for South West Water is £618 million. Together with a tax provision of £110 million, the total “profit before tax” projected by Ofwat is no less than £728 million within a total revenue provision of £2,082 million. At 36% this is a ridiculous profit provision for a monopoly run-of-the-mill water and sewerage utility with all expenses paid even to the inclusion of a fully funded capital investment programme.

The Walker review at least recognised that South West Water charges are excessive and recommended “corrective adjustments” aimed at reducing bills by about £50. It is suggested that these adjustments might comprise subsidies of around £33 million a year or a one-off transfer to South West Water of about £650 million, these payments to be funded directly by the government or by other water customers. These proposals have certainly caused a stir in the South West but are naive and not likely to be implemented. Even if the payments were to be government funded, customers of other companies with bills above average will no doubt argue that they too deserve some relief. If to be funded by other water customers there will be further claims for exemption from the additional charges and, anyway, why should customers of other water companies pay for the excessive profits of South West Water?

The imposition of charges for a reward to shareholders, but based on the value of assets that shareholders did not finance, clearly has no justification and the references to “return on capital” are absurd in the evident deceit. That these charges are imposed on customers who actually financed the capital investment is perverse and so wrong-headed that we must wonder what other horrors might be veiled by the lax Ofwat regulation and lack of transparency. Certainly the “return on capital” charge accounts for the continuing excessive household bills of South West Water even though “Clean Sweep”, the coastal clean-up, is now complete. It may be some consolation that the household bills of other companies are not as high as those of South West Water but it should be noted that all the companies have these unjustified and unnecessary allowances for “return on capital” included in their price determinations. The fact is that all household water and sewerage bills in England and Wales, even if not as high as those of South West Water, are certainly much more than they need be.

With such large sums of money involved, coupled with lax financial regulation and less than rigorous audit, it would be surprising if there were not yet more questions arising from a more detailed enquiry. The following paragraphs summarise the main points discussed above and outline further problems related particularly to South West Water finances and the potential impact of excessive water company dividends on the reported Pennon Group profitability.

  1. The capital investment programme since flotation has been entirely financed by customers who have received none of the recognition that providers of investment capital are normally due - such as shares in the company they are capitalising. Also, despite the statutory requirement for the protection of customer interests, in particular by ensuring that a company “maintains and presents accounts in a suitable form and manner”, this expenditure is not accounted for in the annual regulatory financial reports submitted to Ofwat.
  2. Shareholders, the nominal investors in the private water companies, have in fact made no contribution whatsoever to financing the capital investment programme since flotation in 1989. Yet, as well as funding the ongoing capital investment programme, customers are also charged a levy based on the value of the accrued capital they have financed so far. This double charging is obviously an outrageously unfair imposition on customers and a completely unjustified benefit to shareholders. References to this second charge as a “return on capital” are disingenuous and misleading.
  3. The so-called “return” on the capital accrued since flotation provides the greater part of the reported “operating profit”. Apart from being an unjustified imposition on customers, this charge on the accrued value of the investment capital financed by customers is surely no sensible basis for fixing the “operating profit” that companies should be awarded. As noted above, the Ofwat financial projections for South West Water show a budgeted “profit before tax” over the next 5 years of no less than 36% of revenue. This is a ridiculously generous profit provision for such low risk, publicly funded monopolies and suggests that South West Water household charges are not the only ones that might be considered excessive.
  4. It is part of the lax Ofwat regulatory policy that dividends taken by parent companies are entirely a matter for the water company concerned. With such a generous provision of “operating profit”, there should be no surprise that the dividend policies of the companies are likewise “generous”. In fact, since the 2004 price review, South West Water dividends reported for the 5 years 2005-10 amount to a total of £530 million from a total revenue of £2,076 million, an average cost to customers of more than a quarter of their household water and sewerage bills.The average reported dividends for the industry as a whole, for the same period, was 24% which indicates again that South West Water customers are not alone in suffering excessive household bills.
  5. As can be seen, the Ofwat projections for “return on capital” are generous and, given the low risk nature of water and sewage treatment operations, are a sound basis for predicting the eventual reported profit with some precision - certainly with sufficient precision, as noted above, for Ofwat to include the expected corporation tax liability in the price determinations without reservation. The water company reported profits are of course included in the profits of the group and can generally be expected to make a significant, if misleading, contribution to the reported group profitability.
  6. The Pennon Group Plc apparently acquitted itself well in 2009-10 with a reported operating profit of £264.3 million in a total revenue of £1,068.9 million - an apparently respectable 24.7% profit. However, the report also shows that this operating profit comprised £191.5 million “profit” for South West Water from a total revenue of £444.2 million (43.1% “profit”). This clearly shows that Pennon, despite the whinging about supposedly tough Ofwat budgets, is heavily dependent on South West Water for the very creditable reported profitability. The crucial point is, of course, that the South West Water contribution to the reported profit is not commercial profit at all but, as discussed above, the “return on capital” allocated by Ofwat. The Pennon financial report is in fact grossly distorted with the reported group profitability heavily exaggerated by the South West Water revenue surplus. The actual commercial performance of the Pennon Group is indicated by the Viridor profits at £72.8 million from a total revenue of £626.5 million (11.6% profit) and that only with the benefit of substantial hidden subsidies from South West Water as discussed next.
  7. As previously noted, the dividends taken by Pennon from South West Water, for the 5 years 2005-10, totalled £530 million. During the same period, the dividends paid out to Pennon shareholders totalled about £350 million. Unfortunately there is no reference in the Pennon financial reports to the dividends taken from South West Water as such so we cannot know how the £180 million dividend retained by the group was spent. The average of about £45 million a year is a huge bonanza and will obviously be of immense benefit to the rest of the Pennon Group, primarily Viridor. The possibility of such huge subsidies casts serious doubt on even the 11.4% commercial profit reported for Viridor and further doubt on the reported commercial profitability of Pennon Group Plc. Indeed, there must be serious doubt about the potential for Viridor to even remain viable if it were not for the patently unfair trading advantage given by these hidden subsidies - subsidies financed, incidentally, by the excessive household bills imposed on South West Water customers.
  8. Having financed the capital investment programme since flotation in 1989 - having essentially made a gift to shareholders of the assets which comprise the RCV - South West Water customers are now paying a “return” on that RCV in order to provide shareholders with substantial profits. It should be noted that this scheme, which is not special to South West Water, is also likely to be costly for all water customers in future, if not already, since it is a direct incentive for companies to undertake capital investment projects. For normal private companies, capital expenditure must be fully justified against other demands, not least those for shareholder dividends, and any anticipated benefits, whether reduced costs or increased revenue, are by no means certain. For the regulated water companies, capital investment projects are quite different. Ofwat approval must of course be obtained but once this has been done it is gravy all the way. Projects are generously financed by customers through the Ofwat price determinations and, in due course, the investment is registered as additional RCV and the company begins to receive the guaranteed “return on capital”, again through the Ofwat price determinations.

The basic flaws in the regulation of the water companies are easily identified and are essentially favourable to the companies and seriously detrimental to the interests of customers. The following examples are by no means definitive.

(A)  The statutory requirement to ensure that companies are able to finance their functions is not clearly expressed and is being misapplied. Under clause (2A)(c), the regulator is required -

“to secure that companies are able (in particular, by securing reasonable returns on their capital) to finance the proper carrying out of those functions”.

The Ofwat interpretation of this is to focus on “return on capital”, as discussed above, without regard for the impact on customer bills. The fact is that the levy on the capital value accrued since flotation is neither reasonable nor a return to those who provided the cash. It should also be noted that there is no statutory authority for charging customers in order to finance the capital investment programme in the first place.

(B)  There is a blatant disregard of the requirement, stated in Clause (3)(d) of the 2003 Water Bill, to ensure that consumers are protected as respects any activities which are not attributable to the exercise the licensed functions, in particular by ensuring that the company, in relation to the exercise of its functions, maintains and presents accounts in a suitable form and manner.

(C)  The companies are monopolies, and essentially publicly funded, so the pretence that they can be regarded as normal commercial businesses is absurd. In particular, “commercial confidentiality” is concerned with keeping sensitive information from competitors and customers. The water companies have no competitors and should be required to make the case if they wish to keep secrets from customers.