Britain risks a cripplingly expensive mistake if the water industry goes belly up

Sir Ed Davey's Liberal Democrats have announced plans for water companies – but not the two main parties
Sir Ed Davey's Lib Dems are the only major party to announce a plan for the water sector - Aaron Chown/PA

Sir Ed Davey has taken a couple of pratfalls off a paddle board in the Lake District and the Liberal Democrat have announced “bold” (read ‘unrealistic’) plans “to end the sewage scandal”.

But so far in this election campaign, the two main parties have spent very little time discussing a topic that will be near the top of the next government’s in-tray.

That’s hardly surprising.

When it comes to the UK’s water industry, logic is now fighting an uphill battle against emotion. The overwhelming majority of the public would like water companies to be nationalised.

Both the Tories and Labour know this would be a cripplingly expensive mistake, but aren’t keen to tell voters they’re wrong.

However, something clearly must be done.

Public ire about sewage in rivers and on the beaches keeps ratcheting up. Thames Water is in serious danger of defaulting on its debt and entering special measures. And less than a week after the election, the industry regulator Ofwat will set out its requirements for every English and Welsh water company for the five years from 2025, which is likely to kick-start months of heated wrangling.

The arguments about who is to blame for all this are well-rehearsed.

Critics of the water companies claim they have spent years paying out dividends to their investors and bonuses to their executives rather than investing in their networks.

Exhibit A for the prosecution is the sewage in the rivers; exhibit B is the lack of new reservoirs since 1991.

Behind closed doors, water industry insiders suggest they have been restrained from investing as much as they’d like by a regulator that, under pressure from its political masters, has prioritised low bills.

They are also struggling to deal with population growth, climate change and higher costs.

Overlaying all this is a public perception that water companies are wantonly polluting the UK’s rivers and beaches when in fact things are improving.

A recent report by Moody’s found that water treatment and sewage discharges are no worse than in most other countries but the salience of, for example, spills from storm overflows, had been fed by increased monitoring.

“There are two conclusions that one might draw at this point,” wrote John Earwaker of First Economics in a recent note.

“One might be that water companies just haven’t been up to the task recently and deserve at least some of the criticism they have been receiving.

“But an alternative view might be that, with the benefit of hindsight, companies were set an impossible challenge five years ago and are now paying the price for regulatory miscalculation.”

Likely it’s a bit of both.

The water industry is a three-way balancing act to ensure companies invest enough in their networks while ensuring shareholders can earn a reasonable return without consumer bills going through the roof.

That balance hangs on Ofwat’s assessment of the weighted average cost of capital, which includes the cost to a company of raising equity, servicing existing (embedded) debt, and issuing new debt.

There are two reasons why it will be particularly important for the next regulatory period.

First, water companies have proposed investing £96bn between 2025 and 2030 – a 90pc increase on the current five-year period.

And second, the regulator wants water companies to reduce their gearing ratio from 60pc to 55pc.

For utilities this is calculated by dividing debt by regulatory capital value, which is similar to enterprise value – equity plus net debt – in a standard company.

You don’t need to be a corporate finance expert to realise that if you are simultaneously making a huge capital investment while also reducing your gearing, you are going to need a shedload of fresh equity.

This will have to be provided by investors.

Despite the political turmoil, the water industry still holds plenty of attractions: utility providers are traditionally pretty steady-as-she-goes companies that chug along quite nicely regardless of the economic weather.

But even if you were convinced of the case for investing in a UK water company, why might you choose to invest in the equity rather than the debt?

Because more risk usually equates to higher returns.

Bond investors are lending a company money and will therefore get paid back no matter what (almost). Even if the company goes bankrupt they should have first dibs on any remaining assets.

Equity investors, on the other hand, are only buying the opportunity to share in the firm’s notional future profits.

But that risk-return trade-off is in danger of disappearing from the UK water industry.

Over the past 20 years the difference in return between a debt and equity investment for UK water companies has varied between 2.9 percentage points and 3.6 percentage points (for an average of 3.4 percentage points).

However, according to methodology that Ofwat has published for calculating the weighted average cost of capital (WACC) in the next regulatory period, the estimated cost of debt will be 3.28pc and the cost of equity will be 4.14pc.

This gives you a difference of just 0.86 percentage points.

For that, investors will have to bear the risk of the company overspending on projects.

This could, of course, be the result of mismanagement. But it might also be the result of, say, Russia invading Ukraine and sending the price of energy, of which water companies are big consumers, through the roof.

Equity holders will also be the ones ponying up if the company is penalised by the regulator for not hitting its targets or fined for messing up.

The net loss of profit experienced by shareholders over three years on account of their “operational performance” was around £3.5bn in three years to 2023, according to First Economics (a tad more than they paid out in dividends).

And, of course, equity investors will be at the front of the queue to lose their money if the company goes belly up.

Hardly seems worth it, does it? Yet if investors turn their backs on the UK water industry the Government really will be heading up an extremely polluted creek without a paddle.