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Thames Water’s business is simple even if its financial structure is fiendishly complicated. Remembering that is the first half of a fair solution to the troubled utility’s future. The second involves more difficult and political issues. If both halves are played skilfully, the company’s current woes present an opportunity to demonstrate that British authorities obey the rules, enhancing the safety and attractiveness of investment in the UK.
For all the talk about complexity, the business structures of private water companies are straight forward. Private owners of these utilities have a right to stable income flows from customers, with prices set periodically by regulators. In return, they need to meet the terms of their licences, providing safe drinking water and ensuring the treatment of sewage to standards agreed with regulators.
Higher profits come from efficient management, avoiding fines for pollution, efficient collection of bills and the diligent management of installed capital and effective investment in new assets. Every five years the regulator sets prices to ensure that a well-run company would make a reasonable return on equity.
If owners want to load their companies with debt (and they did), equity and debt holders should know they are gaining higher potential returns at the price of greater risk. These are decisions the private sector is well placed to make.
In the current regulatory period ending next April, the risks have dominated. The vast debt load on Thames along with higher interest rates, higher inflation, poor management and fines for breaching licence conditions appear to be pushing the company to the brink. Its parent company, Kemble Water Finance, this month defaulted on its debts.
These issues are simple in capitalism. Owners and managers got things wrong. They deserve to pay the price for these fully-known risks that Thames agreed to bear when it accepted the latest licence conditions in 2019.
The owners should now have a choice presented to them by regulators: put in sufficient money to repair the financial damage to their company and create a viable entity, or accept it is bust and needs to be placed in the special administration regime designed for these circumstances. Equity holders would probably be wiped out, with debt holders also taking a haircut. After that, there will be a viable company remaining. The assets, especially the right to levy and enforce water bills, are very valuable.
Veiled threats that the administration regime would set a terrible precedent that would kill the whole industry and ruin the UK’s reputation are entirely misplaced. Using it would demonstrate that the UK plays by the rules and foreign investors can be sure that if they evaluate a company’s worth accurately and manage it well, they can make a decent return. If they do not, they will bear the risk.
That way investors can evaluate projects sure in the knowledge that they do not also have to invest in capabilities such as striking murky deals with pliable regulators and ministers. These principles must be applied to deal with the past sins of Thames Water.
The future is more complicated. Negotiations for the next five years of price controls are ongoing between the water industry and regulators. It is clear what the public mood is: we want our rivers cleaner in future. Less clear is whether we recognise we will need to pay for greater water investment with higher bills.
It is a myth that private water companies do not like to invest. If the regulator allows them to do so, this is one way to increase their financial returns, so long as they do not make a mess of capital spending. In recent years, private water companies have asked to invest more than the regulator allows. It happened in 2019 and is happening again now.
The real cause for public concern is that the regulator or ministers might try to brush the sins of the past under a huge carpet labelled “new regulatory period”, resulting in customers in effect providing a bailout to private companies for their mistakes in the 2020 to 2025 period. Thames apparently wants such a solution. Meeting the company’s demands would be the worst form of crony capitalism.
It is vital therefore for regulators to demonstrate a strict separation of past and future. Private water companies need to accept losses for risks they knowingly took. If they do so, regulators can then make the case for higher bills to reduce pollution in rivers.
This is a big test of UK capitalism. Get Thames Water right and the case for private ownership of utilities will be enhanced. Any attempt to bail out private investors for their own mistakes with customers’ money will create an even greater stink than already exists.
chris.giles@ft.com