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The affluent and the effluent: cleaning up failures in water and sewage regulation Contents

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Chapter 7: Debt, dividends, and financial resilience

Debt and dividends

268.Under its statutory duties, Ofwat must “secure that water companies can (in particular through securing reasonable returns on their capital) finance the proper carrying out of their statutory functions”.279

269.Professor David Hall of the University of Greenwich published a paper in January 2022 highlighting that between 2010 and 2021, English water and sewerage companies paid shareholders a total of £18.9 billion in dividends, an annual average of £1.6 billion. He suggested that the dividend payments have “significantly” reduced the money available for investment by companies and increased the cost of water and sewerage to consumers “by an average of £69 per household per year over the last 12 years”.280 Dr Kate Bayliss of SOAS University of London argued that water companies have used “financial engineering to create returns for shareholders”, including by restructuring company finances to accrue high debts while paying dividends to shareholders”.281

270.In July 2022, Ofwat published a consultation on proposals to improve financial resilience in the sector, which would give the regulator extra powers to stop water companies making dividend payments if their financial resilience is at risk. The proposals would also enable Ofwat to take enforcement action against companies that do not link dividend payments to performance, or those failing to be transparent about their dividend pay-outs.282

271.Ofwat Chief Executive David Black explained that the proposals would give Ofwat the power to “lock money into the company” if its credit rating fell to a level “deemed insufficient for a water company”. He said that the change “has been fiercely resisted by companies”, who may choose to refer the licence conditions to the Competition and Markets Authority (CMA).283

272.Jonson Cox, former Chair of Ofwat, said that a “very long-standing mantra” at Ofwat before his tenure was that capital structure was “for the companies to determine”. He argued that it was “unfortunate” that regulators had allowed companies to take ownership of capital structures, emphasising that if a public utility is owned privately then it should be “held to a higher standard than other businesses”. He explained that in the 2000s, investment banks began to realise their ability to acquire water companies and “put significantly more” debt onto their capital structures. He suggested that most water companies with highly leveraged structures had “run into real difficulties”, requiring action to “bring about significant reinvestment”284.

273.Emma Clancy, Chief Executive of the Consumer Council for Water, argued that the money put towards shareholder rewards and profits “could very much help” with the problems in the sector, but suggested that what customers “really want” is a level of transparency about what companies are being rewarded for.285

274.Peter Perry, Chief Executive of Dŵr Cymru Welsh Water, suggested that Dŵr Cymru Welsh Water, which operates on a non-profit basis, has “not had a problem raising finance” without paying dividends and is funded by debt on the bond market. He said that the company has “one of the best credit ratings in the utilities sector” and that it has been “oversubscribed” every time it has gone to the market. He argued that the retention of profits means Welsh Water has “very solid liquidity” which can be drawn on during shocks, which “works very well”286. However, other witnesses suggested that Welsh Water’s performance is not “significantly better” than its counterparts287 and that the non-profit model “is not a silver bullet”288.

275.On the other hand, Christine McGourty, Chief Executive of Water UK, argued that the model of companies raising a mix of debt and equity finance had delivered benefits, suggesting that “it is the dividends that enable the equity that funds the investment”. She also said that in the last year, three companies paid no dividends.289 Stuart Colville, Director of Policy at Water UK, said that the financial performance of companies over the last couple of years “does not quite match some of the stereotyping”, with a total return on regulated equity of 2.3 per cent in the 2020/21 financial year. He stressed that Ofwat has been “pushing down the cost of capital and effectively the assumed return for companies” during recent Price Reviews.290

276.Lawrence Slade, Chief Executive of the Global Infrastructure Investor Association, acknowledged that there have been disagreements between investors and the regulator over financial models, suggesting that investors have “the sense that the regulator has become too involved and too engaged” in regulating the funding models used by the sector. He argued that this element “should be one for company boards and not necessarily for the regulator”291, a point also raised by other investors292.

277.Lawrence Gosden, Chief Executive of Southern Water, and Sarah Bentley, Chief Executive of Thames Water, both emphasised that their companies had not paid dividends in recent years and that they were taking action to reduce debt levels. Mr Gosden suggested that in the long term it is “not sustainable” to have zero dividends.293

278.David Black, Chief Executive of Ofwat, said the regulator is “concerned” about debt and the financial resilience of water companies. He suggested that debt levels have “stabilised” rather than increased in recent years but that three companies in particular raise concerns: Thames Water, Southern Water and Yorkshire Water. He suggested that there has been progress with those companies but that Ofwat remains concerned that the licence is “still too permissive” and “does not set stringent enough standards of financial resilience”.294

279.Iain Coucher, Chair of Ofwat, said that the sector’s finances are currently “about 70 per cent” debt, explaining that Ofwat “would like to see it come down” to “about 60 per cent”, with Mr Black clarifying that Ofwat would like to see this reduction occur during the current Price Review period. Mr Black also pointed out that it is “important not just to look at the headline debt numbers”, as “other factors in the financial structure can add to the stresses”, including the use of derivatives.295

280.The Secretary of State said that Ofwat “thought there was an issue” in relation to dividends, “which is why, in the Environment Act [2021], powers were given on dividends” and related issues. She argued that “it is that unlocking of the private capital… that has led to investments” but recognised “some of the issues and dividends seeming to have been prioritised”. She stressed that the Government has responded to Ofwat’s concerns “and it is now over to Ofwat to deliver any changes that it thinks are necessary”.296

281.It is clear that in the past, a number of water companies have been overly focused on maximising financial returns, including by increasing debt levels, at the expense of operational performance and protecting the environment. We welcome that some companies have exercised more restraint in recent years, in part due to tougher regulatory settlements as well as wider economic conditions.

282.While financial structures are usually a matter for company boards, water companies’ monopoly role in providing an essential service means that a higher standard should be demanded, especially in a sector of such importance to households and the environment. We support Ofwat’s increased interest in the financial structures of water companies and wholly support its proposals to amend licenses to ensure that dividends are linked to performance and companies are financially resilient.

Executive pay

283.In February 2022, Ofwat Chief Executive David Black wrote to the chairs of water companies’ remuneration committees about performance-related executive pay. In the letter, Black explained that companies’ performance in some areas, and particularly the environment, “risks eroding trust and confidence in the sector”. He wrote that it is “essential that companies provide robust and clear explanations of performance related executive pay” and how this links to performance for customers, urging committees to give “particular consideration to the clarity of reasoning” for any awards made in relation to environmental performance, given the current concern in this area and ongoing investigations into compliance.297 In December 2022, Mr Black wrote a follow-up letter stressing that Ofwat’s board is “deeply concerned that, generally, companies have not taken sufficient action” to respond to the regulator’s measures. He wrote that Ofwat wants to be clear that it expects companies to “much better account for overall performance in making decisions on performance-related elements of executive pay.”298

284.The Rt Hon Philip Dunne MP, Chair of the House of Commons Environmental Audit Committee, said that there is a need to question whether some of the “very high” bonuses paid to executives of water companies that are in breach of their permits and licences “are appropriate for a public utility”.299 Wildlife and Countryside Link called on Ofwat to use powers under the Water Industry Act 1991 to limit payment of bonuses to water company executives who “consistently” breach their permits, arguing that this would disincentivise pollution.300

285.Mr Cox said that Ofwat has “intervened” with remuneration committees where it was not satisfied with their approach and would call in their Chairs to explain what is expected. He suggested that if he were still at Ofwat, he “would encourage it to think about going further on that”.301

286.Ms Bentley said that part of Thames Water’s turnaround plan is being “responsible” on executive pay, with a “substantial proportion” of the management team’s bonus relating to environmental and customer measures. Mr Gosden said that three-quarters of executive pay at Southern Water is linked to performance, including environmental and customer service performance.302

287.Mr Black said that it is “really concerning” given the current environment and criticism of water companies that they “have not yet been more responsible in linking executive pay to performance”. He stressed that Ofwat is “currently looking” at payments and engaging with companies.303 He said that Ofwat needs to act in this space and is looking at how it can “bolster arrangements”, noting that companies made a commitment at PR19 to align executive pay to performance.304 However, Mr Black argued that it is not the regulator’s role to “micromanage executive pay”, suggesting that company boards and remuneration committees “need to take responsibility for making those decisions”.305

288.Water company executives should not be able to receive substantial bonuses while their companies have missed performance targets and polluted the water environment, potentially in breach of their permits.

289.We support Ofwat’s increased interest in executive pay, including its expectation that companies set out their proposed policies for performance-related executive pay during the next Price Review period. These proposals should ensure performance-related pay is much more closely linked to performance, particularly in relation to the environment. Ofwat should set out further provisions to ban bonuses at companies who have been found to have caused serious pollution incidents as part of the conditions of water company licences.

Ownership models

290.Mr Dunne said that the nature of water companies’ capital structure is so variable that it is difficult to get a “clear picture” of each company’s activities, as while public companies have to make disclosures through annual reports, water companies that are owned by private equity companies are less transparent. He suggested that some water companies, particularly those owned by private equity, are more heavily indebted than others.306

291.Mr Cox said that in the 2000s, a “raft” of public listed water companies went private, leading to a “predisposition” for companies to look at water companies “as financial assets” rather than public service businesses.307 Water companies in England now consist of a mix of public listed and privately owned companies.

292.Asked whether water companies should be required to be publicly listed companies, Mr Gosden said that the water company licence already requires companies to act as if they are listed from a transparency point of view through an annual reporting process.308 Ms Bentley said that one can debate the pros and cons of different ownership models but argued that what is important is having “patient, long-term investors”.309

293.Mr Black argued that requiring water companies to trade at least some of their shares publicly would “have some benefits”, including minimum requirements for board governance and “the additional scrutiny that analysts bring when a company is listed”. He noted the regulator’s concerns around the highly indebted structures used by Thames Water, Southern Water and Yorkshire Water.310

294.Mr Black acknowledged that Ofwat has replicated “to a large extent” the governance benefits of public listing by introducing licence requirements for governance standards, and stressed that Ofwat has real concerns about the performance of some listed companies, including South West Water. He said that it would be “wrong to pretend that listed companies are the answer to the problem”, as being listed “does not guarantee good performance”.311

295.The Secretary of State said that she does not think that the Government “should force companies to be publicly traded”. She argued that private equity can work “in a variety of ways” and comprise of “different kinds of investors”, including pension funds. She emphasised that there are examples of private equity owned water companies that are performing well and public listed companies that are performing less impressively, suggesting that “there is a role for both approaches”.312

296.Some witnesses told us the introduction of private equity ownership to the water sector has been a driver in some companies focusing on financial performance rather than service delivery and securing resilience. This has led some privately owned companies to take on debt and introduce complex financial structures in order to pay out large returns, even where performance has been unacceptable. Requiring water companies to disclose information to the same standard as publicly listed companies has the potential to improve their governance and increase scrutiny of their financial arrangements.

297.Ofwat should ensure that water companies are subject to the same level of transparency as publicly listed companies, in order to improve transparency through the regular reporting cycle.

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