Memorandum submitted by Martin Blaiklock
(DFWMB 26)
INTRODUCTION
The Environment, Food and Rural Affairs Committee
have requested comment with respect to the Draft Flood and Water
Management Bill. This paper represents my response to that Consultation.
I have been a consultant, banker and practitioner
in infrastructure and energy project finance,—PFI, PPP and
the like,—for the last 30 years or more, with both UK and
wide overseas experience. I also regularly give seminars on these
topics internationally.
With respect to water, in recent years I have focussed
at times on the operational; and financial performance of the
UK's water utilities, particularly Thames Water, my own water
supplier and the UK's largest.
COMMENTS:
1. Omission: Odour Management
The Draft Bill does not address the issue of
Odour Management. Yet, odour management is a "regulated activity",
ie part of the licence condition of a UK water company.
In short, Section 94 of the Water Industry Act of
1991 ("WIA91") states: "It will be the duty of
every sewerage undertaker to make provision ... for effectively
dealing, by means of sewage disposal works or otherwise, with
the contents of (those) sewers".
OFWAT have confirmed to me in writing (August 2008)
that ... "the composting of sewage sludge is a regulated
activity, where it is employed as the means of sludge treatment
and disposal".
However, experience has shown (see below) that
the current Act (WIA91) clearly does not work in this respect!!
Thames Water is the UK's largest water utility
(and private sector monopoly of public services) with 14 million
customers. By its own admission, the odour issues surrounding
their composting operations at the Little Marlow Sewage works
are the most complained-about activity in their region of operations,
followed closely by Mogden and Beckton. The problems raised by
local residents to the Little Marlow site have been recorded since
1995, albeit that the problem has become more acute since 2003.
Representations to OFWAT, CC Water, local and
County Councils, MPs, and the Environment Agency have proved fruitless.
It was only when it was pointed out to them that, prima facie,
Thames had been breaching their licence for the last 5-10 years
over this matter that the authorities have taken any notice.
At last Thames and OFWAT are moving towards
resolving the issues, but there is still some way to go before
locals residents can live odour-free.
Whilst the Committee is not able to consider
specific instances of abuse of the regulatory system, this one
example shows what can and does happen under the current regime
and why there is a need for a wholesale re-vamp of the Water Industry
Regulatory framework in respect of Odour Management.
2. Review of the Act: Relationship between
the Regulator and Customers
From the experience I have had over recent years
with the authorities in this sector, my impression is that those
charged with regulating and monitoring the system veer closer
to the industry, rather than the consumer/public, interest, which
is not the intention. The fact that OFWAT addresses publicly the
City twice a year, but not at all to customers, reflects the cosy
nature of the relationship between the regulators, the industry
and their financiers. There is no equivalent event for the public/consumers
to attend.
This feature partly arises as a result of the procedures
to be adopted under the Act for appointing CC Water representatives
(ref Ch III Cl 27, WIA91). (Water) industry experience is a requirement
of appointees, which results in "insiders being appointed
more often than not, whereas representatives with a broader industrial
and commercial background might result in more effective representation
of the public interest and the consumer.
A Review of this component of the Act is called
for.
3. Omission: Financial Oversight of Water
Utilities by OFWAT
OFWAT has a duty under the Water Industry Act
1991 to "safeguard the future" of the water utilities
for the benefit of customers.
Over the last five to eight years many UK water utilities
have changed hands so that many are now owned and controlled by
Private Equity investors. Often,—or even usually,—such
investor groups are domiciled in tax-havens, eg Thames Water,
whose owners reside in Luxemburg.
Is this to the benefit of consumers? Can OFWAT
safeguard the service in such circumstances? Has OFWAT any control
over the corporate and financial governance of such utilities?
I think, probably, not!
Five examples might suffice to prove these points:
(a) Increased Leverage in Water Utilities:
In the early 1990's, shortly after privatisation,
the rating, as defined by Standard & Poors, Fitch, etc, of
the average UK water utility was "AA-", ie they comprised
a "very strong capacity to repay debt".
Now, 15 years on, the majority of water utilities
have increased the proportion of debt ("leverage"),
in their funding, and as a result command only a "BBB"
rating or thereabouts, ie "protection of interest and principal
is moderate", just above the investment/sub-investment ("junk")
rating watershed.
[NB. Thames is currently rated "BBB+",
two grades from being sub-investment ("junk") level.)
When rating agencies express concern at the steady
decline of the investment grade status of the UK's private water
companies, as they have in recent times, the time has come to
worry!!
Accordingly, I expressed concerns to OFWAT (in
2006 and since) on their over-reliance on ratings in assessing
the financial health of UK's private water utilities. Ratings
are useful, but not the only tool available. They also change
over time! Secondly, it is somewhat alarming that OFWAT seemingly
has no "Plan B" for when a water utility does slip into
"junk" status.
(b) The Lack of Transparent Corporate Structures
for UK Water Utilities
In December 2006, Thames Water, at the time a
subsidiary of the German energy utility, RWE, was sold to a consortium
controlled (52%) by Macquarie Private Equity funds, the balance
coming from pension funds, etc. Overall, Macquarie controlled
the strategic development and management of Thames.
["MEIF", etc are Macquarie Bank Infrastructure
Funds; "Non-Macquarie Investors" represent offshore
pension funds, etc.]
[source: OFWAT Feb 2008 Consultation Doc]
In the resultant corporate structure shown overleaf,
Thames Water Utilities Limited (at the bottom) is the water utility
licenced by OFWAT, 5 or 6 levels removed from the controlling
offshore Macquarie Funds (at the top).
Rightly, one might question whether this is an
appropriately "transparent" corporate structure for
a UK monopoly public service provider??
(c) Excessive Dividend Payments (1):
In June 2007, Thames Water,—by that time
controlled by Macquarie Funds,— reported (to OFWAT) that
in the financial year to 31 March 2007 they recorded a profit
after tax of £190.5 million. This was slightly less than
the previous year, but not far out of line for the industry.
In June 2007, Thames distributed dividends of
£535.3 million to its shareholders for the financial year
2006-07. In fact, this payment was made to RWE, not Macquarie
Funds, just prior to the change of ownership.
The only source of funds to pay such dividends,
apart from after tax profits, was the Balance Sheet Capital of
Thames.
As a result, the recorded reduction in the capital
of Thames, as per the published Accounts, for this period was
£310 million (= £1,628.5 million minus £1,318.6
million). This represents a reduction in the capital of Thames
of around 20%.
This reduction increased the leverage, or indebtedness,
of Thames from 57% to 72%.
Seemingly, OFWAT took no action to prevent such
payment. It is also arguable in their defence that they were powerless
to do so under the current Act.
[Note: to constrain such activities in future,
OFWAT on occasion imposes "ring-fencing" on dividend
payments. However, it is not beyond the accounting profession
to devise methods (eg shareholder loans, consultancy fees, etc.)
to circumvent such constraints and to minimise taxation for the
Exchequer. Many such private public service/PPP companies inject
their equity as shareholder loans at inflated (eg 15-20%) shareholder
loans, thereby avoiding corporation tax.]
(d) Water Effluent Disaster (Edinburgh), 2007:
In April 2007 a faulty pump at a waste water
treatment plant at Seafield near Edinburgh, serving 800,000 people
and operated/controlled by Thames Water, failed. The accident
could have caused an environmental disaster in the Firth of Forth,
and given rise to serious local health concerns over a wide section
of Edinburgh's population.
As mentioned earlier, Thames is owned by offshore
Macquarie Funds based in Luxemburg. Further, Seafield, like many
such PFI projects, will be set up as a special-purpose limited
liability company. When Thames won the PFI concession to build
and operate the treatment plant at Seafield in 1999, it financed
Seafield with £5 million of equity and £95 million of
debt, a highly geared financial structure.
In this scenario of pending environmental disaster
and assuming that insurance monies were inadequate to meet claims,
there would be minimal capital in the Seafield company available
to cover shortfalls. Secondly, the owners and directors of Thames'
Macquarie Funds will be largely unaccountable and offshore, so
outside UK jurisdiction. Thirdly, the Fund managers will, under
the financial arrangements made with their Fund investors, carry
no responsibility or liability.
Is this scenario desirable? I think not ...
(e) Excessive Dividends Payments (2):
In the periods 2001-02, 2002-03 and 2003-04,
before the takeover of South East Water by Macquarie Investment
Funds, some 60% of profits on average were distributed as dividends,
the balance retained in the company boosting internal capital.
After the takeover, the dividends in 2004-05
and 2005-06 represented 150% and 250% of funds available for distribution,
ie the company was distributing dividends to its shareholders
(in the tax-haven of Luxemburg) more money than the utility was
generating as profit, ie the company was eroding its capital base.
Some might call this "asset stripping".
In 2005-06 this erosion of shareholder capital
amounted to £26 million. This constrained South East's ability
to raise funds for new investment in the future.
[Note: currently South East Water is owned by
a Hastings Private Equity Fund and the unlisted Utilities Fund,
Australia. Also, in April 2009, the Sunday Times reported
that South East Water along with two other UK water companies
had had to receive cash injections from shareholders to avoid
breaches of loan covenants.]
OVERALL CONCLUSION
The overall conclusion is that the Draft Flood
and Water Management Bill should also address:
(c) clarifying the role of OFWAT with respect
to intervention on financial issues within utility companies.
T M Blaiklock
May 2009
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