If there’s one industry where it should be possible to make a decent case for renationalisation, it’s surely water. The water and sewerage utilities provide an essential service, have many features of a natural monopoly, and need high levels of investment that could, in principle, be financed more cheaply by government. Labour’s 2017 Manifesto claimed that ‘water bills have increased 40 per cent since privatisation’ and promised to ‘replace our dysfunctional water system with a network of regional publicly-owned water companies’. But there are also strong arguments in favour of keeping the current ownership structure and focusing instead on improving regulation further.
By way of background, the ten regional water and sewerage authorities in England and Wales were privatised in 1989, mainly because there was little appetite for public funding of the huge investment required to replace ageing Victorian infrastructure and meet new environmental standards. (As it happens, I was then a very junior economist in the Treasury working in this area.)
Privatisation was initially achieved by transferring assets into limited companies, which were then floated on the London Stock Exchange, supported by a one-off injection of public capital and the cancellation of a large amount of public debt.
Jumping forward to today, three of the nine regional water and sewerage companies in England are still listed on the stock market. The rest have been bought out by other businesses, including consortia of private equity and infrastructure funds, pension funds, sovereign wealth funds and foreign utility companies.
In contrast, Welsh Water reverted to not-for-profit status in 2001 (after its parent company ran into financial difficulties), and is now run on essentially the same basis as Scottish Water, which is a public corporation.
The upshot is that most households and businesses in England are now served by what are, in effect, regional privately-owned monopolies. However, they are all licensed and regulated by Ofwat, a non-ministerial government department, which is ‘responsible for making sure that the companies we regulate provide consumers with a good quality and efficient service at a fair price‘.
Ofwat’s main regulatory tool is a price review that takes place every five years. Currently Ofwat is in the process of completing PR19, which will cover the period from April 2020 to March 2025. This is expected to impose price cuts averaging around 5% in real terms, as well as further quality improvements.
Nonetheless, there are still many lobbying in favour of returning the English regional water companies to public ownership, including the GMB trade union and the Green Party, as well as Labour. The seven most common arguments can be summarised as follows:
- Water is, of course, one of life’s necessities, making price, quality and security of supply particularly critical;
- The supply of water is a ‘natural monopoly’, where high fixed costs and other barriers to entry make it much harder for private companies to compete against each other;
- The water industry is capital intensive, so there could be large savings from financing new investment at the relatively low cost of borrowing by government;
- The funding models of some privatised water companies involve unusually high levels of debt and are therefore unsustainable;
- Supporters of renationalisation have had some success in portraying the track record of the industry since privatisation as bad for consumers, taxpayers and the environment;
- The precedents appear to favour renationalisation. Water is already run on a not-for-profit basis in Scotland and Wales, and in most other countries;
- It has also been argued that renationalisation of the private water companies would be relatively cheap and easy to finance from future revenues.
Let’s review each of these in turn. First, there are the emotive points about water as a human right, and calls to make sure ‘water companies work for people not profit’. This doesn’t actually advance the debate very far. The same arguments could presumably be made about food, or shelter, or anything else that’s essential to life. However, very few (other than the hard left?) would argue that only the state could ever be trusted to provide these goods and services. It’s necessary instead to point to some sort of market failure.
Here the second argument – that the provision of water and sewerage is a ‘natural monopoly’ – carries a little more weight. There are indeed many barriers to entry, such as the high fixed costs of water infrastructure and networks, and the impracticality of running multiple pipes into a single building. These do make it hard for different private water companies to compete to offer customers a better service or lower prices.
However, this is a familiar problem for regulators, who have many ways to incentivise producers and promote the interests of consumers in these circumstances. Indeed, the water sector is already heavily regulated to prevent the abuse of monopoly power. Ofwat focuses mainly on economic and financial issues, including pricing. But in addition, English water companies have to meet quality and environmental standards set by Defra and (for now) the EU, and by other bodies such as the Environment Agency and the Drinking Water Inspectorate.
Ofwat is also strengthening its own oversight. For example, the regulator has run a service incentive mechanism (SIM) since 2010, which monitors customer service performance and applies rewards and penalties as part of its price review. This will be replaced as part of PR19 by a strengthened ‘customer measure of experience (C-MeX)’, effective from April 2020.
The terminology sounds ghastly, but these are presumably the same things that a publicly-owned water industry would prioritise too. The water industry itself has made a number of pledges to work in the public interest which cover essentially the same ground.
The third argument – that large savings could be made by financing investment at the lower cost of government borrowing – is also unconvincing. For one thing, this is another argument could be made about almost any sector. The water business is – perhaps – a relatively simple one where the gains from more efficient private sector management and allocation of resources might be limited. But there are few goods and services that the government could not provide more cheaply if (and it is a big if) borrowing costs were all that mattered.
What’s more, it was the lack of appetite for financing large investment that led to the privatisation of the water companies in the first place. It has been estimated that at least £100 billion will have to be invested in the industry in the coming decade, which would have to compete for limited public funds. In principle, this sort of capital investment should be ringfenced and protected under a sensible set of fiscal rules. But in practice, there is a clear risk that it is crowded out by other political priorities.
Here, supporters of renationalisation often draw attention to the large payments of dividends and debt interest that privatised water companies make to investors providing capital to run the business. But if these companies were brought back into public ownership, government debt and debt interest payments would increase, and future investment would still have to be financed in some way. (There’s more on the potential costs of renationalisation later in this piece.)
In addition, the cost of finance for private water companies is low compared to other industries. This can be seen as the flipside of the arguments about water being an essential service, a natural monopoly, and capital intensive with many tax reliefs, which makes it a relatively safe and attractive investment. The potential savings from replacing private with public borrowing might therefore be small.
This leads to the fourth argument – that the privatised water companies have blown these advantages by taking on too much debt and paying excessive dividends. The points here are well made by Kate Bayliss and David Hall in Bringing water into public ownership: costs and benefits, and by George Turner in Money Down the Drain.
However, to the extent that poor financial management is a problem, it is not clear that public ownership would be a better solution than more effective regulation, especially given the track record of the public sector itself. For example, the former regulator Ian Byatt (in the forward to Turner’s paper) has suggested some form of dividend control. Of course, there is only so much a regulator can do to limit potential returns without reducing the incentives for private managers to improve efficiency. But private companies are also still subject to market pressures.
Here, Turner has argued that the acquisition of some of the largest water firms by ‘private equity funds’ has ‘insulated them from the discipline of the equity market’ and reduced accountability to the public’. However, it seems at least as likely that tight control by a small number of investors will exert more discipline than a stock market listing, and that bondholders will be at least as alert to potential financial risks as holders of equity. Indeed, several water companies (notably Thames Water) have run into difficulties with credit rating agencies. And it was financial problems at Welsh Water’s previous parent company that forced its change of status.
There also appears to be an unjustifiable bias against foreign owners. In reality, having a larger pool of potential investors is good for customers, because it drives down the cost o borrowing. There may be advantages too in sharing expertise, especially if foreign utility companies are involved. Finally, it’s worth remembering that if the industry were renationalised and refinanced using UK government debt, much of this debt is also held by foreign investors.
It is still reasonable to ask whether the benefits of cost savings should sometimes have been shared more evenly with consumers.
For example, the NAO has estimated that water companies made net windfall gains of at least £800 million between 2010 and 2015 (£410 million from lower-than-expected corporation tax rates and £840 million from lower-than-expected interest rates, only partially offset by water bill discounts of £435 million). Some firms may also have engaged in dubious ‘financial engineering’ to deliver returns which were far greater than those justified by the risks of investing in the water business. But, if desired, these sorts of gains could be clawed back in future price reviews.
The fifth argument questions the track record of the privatised water companies in delivering a good service at a reasonable price. Supporters of renationalisation have had some success in portraying private ownership as bad for consumers, taxpayers and the environment – citing large price increases since privatisation, alarming data on water leakages, and so on.
Again, these arguments are unconvincing. On price, the claim that water bills have risen by 40% since privatisation is presumably taken from the NAO report published back in 2015. But this report also noted that most of the increase happened before 1995, when prices were allowed to rise significantly to finance investment. The 40% figure is also out of date. Bills have been flat or falling in real terms since 2015, with plans to reduce them by another 5% in real terms in PR19.
As for quality, the industry lobby group Water UK has noted that ‘leakage is down by a third since privatisation and is due to be cut by 16% by 2025 and by 50% by 2050. Water companies have spent around £25 billion on the environment since 1995, with 10,000 miles of rivers being protected and improved since then. Environmental work since privatisation has resulted in wildlife returning to rivers that had been biologically dead since the Industrial Revolution.’
What’s more, ‘customers are now 5 times less likely to suffer from supply interruptions, 8 times less likely to suffer from sewer flooding, and 100 times less likely to have low water pressure than they were when the industry was in Government hands’. (This link contains some additional sources and data making similar points, and it is also worth reading the water industry’s briefing ’30 Years of Progress: Cleaner, Safer, Better Water’.)
Of course, statements from the industry lobby group may need to be taken with a pinch of salt. But the 2015 NAO report was also mostly positive about the performance of the privatised water companies (and rather more critical of the regulator).
The sixth argument concerns precedents from elsewhere both in the UK and further afield. International comparisons do suggest that water bills are sometimes lower when services are provided by public companies. However, like the railways, this partly reflects higher taxpayer subsidies.
There have also been cases when performance has improved after a failing private provider has been taken over by a municipal authority. Paris and Berlin are often cited as examples here. But this does not mean that similar improvements could not have been achieved by a better-managed and better-regulated private company.
Perhaps the most relevant comparison is with the performance of the not-for-profit companies in Scotland or Wales. Again, the evidence here is inconclusive. The average combined water and sewerage bill charged by Scottish Water is expected to be £369 in 2019/20, which is below the average in England and Wales of £415. However, Welsh Water’s average bill is relatively expensive, at £445. What’s more, Welsh Water’s customer satisfaction score is only mid-table. Scottish Water’s customer satisfaction metrics are not directly comparable, but the results also appear to be similar to those in England.
The final argument is about the cost of renationalisation. The Labour Party has suggested that the starting point for compensation should be the original value of the companies when they were privatised, perhaps based on the ‘book value’ of shareholders’ equity, or the ‘regulated capital value’ which includes the book value of debt. These two figures have recently been estimated by Moody’s at £14.5 billion and £18.3 billion respectively. Both would be much lower than the current value of the capital invested in the company, which is perhaps £40 billion for the equity (based on an average of recent market valuations) plus the same again for debt.
Starting with the equity, Labour has sought to justify a substantial discount on two grounds: that the lower figure better reflects what private investors have actually put into the company, and that the higher figure assumes the continued payment of dividends that will disappear after renationalisation. This approach is, to say the least, highly contentious.
Paying less than the current market value would inflict large losses on shareholders, especially those who have only bought recently at the higher prices (and not benefited from large dividend payments in the meantime).
Here, supporters of renationalisation like to portray investors as evil speculators, with foreign money being especially suspect. This seems a particularly harsh judgement on, for example, the Ontario Municipal Employees Retirement System, OMERS, which is the biggest shareholder in Thames Water. But research by the Global Infrastructure Investor Association (GIIA) also shows that more than four million UK public sector workers have pension funds invested in the English water industry.
Ironically, non-UK investors typically have more legal protections than UK ones, raising the possibility that a Labour government might have to pay more compensation to a foreign sovereign wealth fund than to a UK pensioner. But even if the government could get away with under-paying for water, this would send a very negative signal to other investors, driving up borrowing costs and undermining the prices of other assets, including sterling.
The Labour Party has also assumed away the cost of taking on the debt of the water companies, on the basis that the existing borrowings would simply be transferred to the government and financed, as now, from customer bills. In other words, the increase in debt is offset by the acquisition of an asset. This approach is not completely unreasonable. Indeed, it is arguably misleading to include the entire value of the debt as a potential cost of renationalisation (as the Social Market Foundation did when arriving at its estimate of £90 billion for the total price).
Nonetheless, the transfer to the government’s books will still increase gross public debt, and there is no guarantee that the assets will maintain their value under public management. What’s more, if the government is going to continue to pay the same interest to holders of existing water company debt, this significantly reduces the scope to reduce bills by refinancing current borrowing at lower rates.
In summary, there might be a decent case for public ownership of the water industry if England were setting one up from scratch. But in reality, the choice is between continuing to strengthen the regulation of a privately-owned industry whose performance is already clearly improving, or a potentially disruptive and costly renationalisation with no certain benefits. I’m for the former.
PS. Since I wrote this blog, Southern Water has been hit with a £126m penalty for wastewater spills and for deliberately misreporting its performance. But note the spills occurred between 2010 and 2017 under previous management, and the regulatory regime has since been strengthened. And while it would obviously have been much better if the record fines hadn’t been necessary in the first place, they at least show that the owners of privatised firms can’t get away with such poor performance. In contrast, financial penalties are unlikely to be much of a deterrent to nationalised companies, who would simply pass the cost on to taxpayers.