Steer for the deep waters only

Robert Day's thoughts on his photography, his writing and his business

On Water

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In a break from my usual policy, I’m going to comment on current UK politics in some level of detail. I’m not going to offer a firm opinion on the particular issue; instead, I’m going to set down what I know about the issue from first hand, so that anyone who is interested and wants to can have access to what I know and decide accordingly.

The topic is water re-nationalisation, as set out in the Labour Party’s manifesto. I will not get into arguments about how electable or not the Labour Party currently is, or about the merits or lack of merits of Jeremy Corbyn, the current leader. Any comments that I receive that ignore the rest of what I’m going to write here and go on about Corbyn this or Corbyn that or are specifically and blindly partisan will be moderated away. I’m trying to do my bit to restore some sort of rationality to political debate. I realise that’s probably a doomed enterprise from the start, but it’s where I come from.

I worked for the water regulator, Ofwat, from just after privatisation in 1989 to the end of the first year of the Coalition Government in December 2010. I was never very high up in the chain of command, but as Ofwat was and is a small organisation and I was working close to the top in a support role for the first five years, and then with key regulatory data for the following fifteen, I can claim to have been a fly on the wall at certain points.

The problem with the pledge to re-nationalise water in the Labour manifesto is that this is just one paragraph, with little in the way of detail. Water hasn’t been high on the political radar for some time, and up to the publication of the manifesto, little had been said by any political party on the subject. Opinions that have been expressed (on either side) have not generally been made from a position of knowledge. Wider utility issues have been a hot topic, though, with the Tory pledge to impose price cap regulation on the energy industry. On that topic, I would merely point out that there was price cap regulation on the energy industry in the years immediately following privatisation, only for it to be dropped because of the judgement that the competitive energy market was sufficiently mature to regulate prices. This has been challenged by the number of customers actually switching supplier. Meanwhile, water has continually been subject to price cap regulation and efforts to introduce competition have been slow, in part because of the sheer artificiality of any competitive water market in the absence of common carriage and a national water grid.

I make no apologies for the length of this post. Our modern life is complex; the recent trend amongst politicians for simple answers and mistrust of experts (because they tell you difficult stuff) is, in my view, at best misguided and at worst delusional, because in the real world, there are complex reasons for stuff happening, and if you ignore complex stuff happening, the end result is that it can blow up in your face.

Before privatisation

Before privatisation, there were ten water authorities for England and Wales (Scotland has always been separate) which covered water supply and sewage treatment. These were formed in 1973 from the nationalisation of a range of local water undertakings, either individual water companies or municipal undertakings.

By some clever lobbying and political manoeuvring, some nineteen water companies avoided nationalisation. These were established as “statutory water companies”; their shares, though tradable, were listed on the alternative securities market and their rates of return were capped.

Overall direction of the industry was limited. Water authority investment decisions were driven by the political agenda and budgets with water having to take its place amongst other priorities for public money, and so by the 1980s, the industry was seeing the effects of under-investment and falling standards. Meanwhile, overseas investors – especially French water companies – were making investments in the statutory companies.

Privatisation

The Thatcher government’s solution to these problems, as with so many others, was privatisation. The private sector would be able to raise money better than the public sector, investors would be guaranteed a rate of return because the consumer market was about as captive as it could be, water and sewage expenditure would come out of the public sector and investment decisions would be taken out of direct political control. A new regulatory regime would be put in place, applicable to the whole industry. The ten water authorities were therefore floated on the Stock Exchange from 1st August 1989 and the new regulator, the Office of Water Services (Ofwat) opened its doors for business on the same day.

Based wholly in Birmingham, Ofwat was headed by Ian (later Sir Ian) Byatt, a Treasury economist who earlier in his career had specialised in the economics of utility industries, and who, together with Steven Littlechild, the first electricity regulator, actually had written the book on the subject.

The ten privatised companies became known as “water and sewerage companies” (WaSCs) and the nineteen companies that had remained in the private sector became known as “water-only companies” (WoCs). The WoCs were given the freedom to list their shares on the open market and the rate of return cap was removed.

There was a requirement on companies to produce long-term costed investment plans (although at an early stage, Ian Byatt declared that Ofwat “was not GOSPLAN”, a reference to the Soviet Union’s office for planning of the centralised economy). These plans were reviewed and reported on. Early on, Ian Byatt visited all the companies to establish their opening position and to start making contacts, and something interesting emerged from this. It soon became clear that some of the smaller WoCs were in a shaky condition and did not have a good handle on their costs and expenditure. There were some which, it was estimated, were probably only 18 months or so from severe financial difficulties.

Meanwhile, the WaSCs were also getting to grips with the economic realities of the new regime. Many found that they did not have a good handle on their asset base, and in particular didn’t know the full extent of their networks.

These WaSCs were set up with a particular structure. The privatised companies that punters bought shares in were set up as parent group companies, which could diversify into any business area they saw fit. Water and sewerage services were in the hands of wholly-owned subsidiaries. This meant that if a WaSC made some really bad investment decisions and went bankrupt (I always used to say “Suppose Huge Water plc spent all its money on a boiled sweet factory and that gobbled up all their money…”), the water services company which actually ran the water and sewerage services could stand on its own and could be put in the hands of a special administrator until a buyer could be found for it.

Although the publicly-expressed aim of privatisation was to encourage small investors and turn Britain into a share-holding democracy, in practice large quantities of shares were bought by institutional investors, including private pension providers. One of my early jobs in Ofwat was to track publicly-disclosed share ownership (once a shareholding reaches 3%, it has to be so declared), and that told me a lot about the pensions and insurance industry, such as the underlying truth behind the supposedly poor performance of endowment policies. I saw what sort of return the big institutional investors were getting, and in the early years there was no under-performance. My endowment policy wasn’t under-performing, I surmised; rather, it performed rather well, in the form of some investment manager’s Porsche…

Regulation and company performance

Ofwat practised price cap control. We gathered information from water companies, reviewed their investment plans, looked at their costs and their outgoings, and set price limits beyond which companies could not charge. We also had the task of acting as a substitute for competition; so, if company A proposed spending £X on, say, mains renewals, we would use our oversight of the industry to say “But company B next door to you has similar issues and a similar programme of mains renewals, but their estimated cost for that work is half what you’re suggesting.” And so come price review time, we’d look at what company A proposed spending on mains renewals and if they’d not shown any improvement on their costs towards what company B was spending, we’d only allow company A roughly what company B’s comparative spend was.

A lot of water company spending was based on EU standards, especially on discharges to the environment. Another of my early jobs was to go down to Parliament and report back on the Committee stages of the adoption of the EU’s Urban Waste Water Treatment Directive (UWWTD) into UK law. One of the aims of our involvement in this was to understand what was being demanded of companies so that we could spot any attempts by the companies to gold-plate their solutions to the UWWTD, because (the economists’ opinion was) “that’s what engineers do”.

All this ended up in customer prices that (for the most part) rose rapidly in the first ten years, for very little visible improvement in water and sewerage services. After all, these things are fairly invisible; we only notice them when they go wrong. Meanwhile, companies were free to invest in any business that took their eye. Some, like the Homecare insurance business, were linked with the core water business; others, like my fictional boiled sweet factory, were not. The idea was that the privatised business could use external investment to generate profit for shareholders above and beyond a reasonable rate of return from the water and sewerage business and wholly independent of it.

This misfired in the case of Welsh Water (Dwr Cymru), whose parent company, Hyder, invested heavily in the leisure industry. This was all fine until the Blair government imposed a windfall tax on utility profits which hit them hard. The company went up for sale, various assets and businesses (including electricity generation) were sold off, and the water and sewerage business was sold for £1 to a not-for-profit company limited by guarantee, which ploughs its profits back into the business and has no shareholders. (Hence the reason why Labour’s manifesto only refers to water in England; Dwr Cymru has no profits, as well as falling to the Welsh Assembly to make governmental judgements on.) Dwr Cymru’s experience served to put nearly all other companies off the idea of large-scale diversification.

One of the big issues that exercises everyone is leakage. Ofwat looked at this dispassionately, as you might expect. The thing is that it costs pretty much the same to fix a leak whether it’s a pinhole or a major mains burst; so we evolved a measure called the “economic level of leakage” (ELL). This was the level of leakage where it was actually cheaper to bring a new water source into supply to compensate for leakage losses than it is to actually go out and track down and repair every leak. We commissioned some research into public perceptions on this matter, and it taught me something important about public opinions. We (well, the consultants we got to do this for us) put together a focus group and asked them “Should all leaks be fixed, irrespective of cost or size of leak?” and then looked at how many people agreed with that. They were then briefed about the ELL measure, with worked examples to explain the concept in terms that anyone could understand. The focus groups were even asked if they understood what they’d been told, and nearly everyone said “Yes”. And then they were asked the original question again – should all leaks be fixed regardless? And despite everything that had been done to explain it, almost exactly the same number of people as before said “Yes”. People prefer their firmly-held beliefs to clear and incontrovertible facts. (I’ve thought about this a lot since 2016.)

One of the other features of the industry since 1989 has been consolidation. Of the 19 WoCs, some of them were very small. Indeed, the smallest, Cholderton & District Water, still survives today. It serves two villages and seven farms on the edge of Salisbury Plain and was created in 1904 by a philanthropic landowner and MP (back in the days when MPs actually displayed integrity from time to time) who wanted to bring piped water to his tenants. This is a truly local water company; it has a staff of three, you are quite likely to find the MD going out on a tractor with a bag of tools to fix a pump, and it’s not that long since it stopped accepting produce in exchange for water bills.

But there were also a number of small companies, such as Hartlepool, York Waterworks, or East Worcestershire Water. These and others became targets for acquisition by larger companies and disappeared in the first ten years or so. There were also instances where companies were in common ownership, and over the years Ofwat pursued a policy of encouraging companies in common ownership to become single undertakings to achieve economies of scale. So by 2015 the number of companies of both types was down to eighteen (though since then there have been some new entrants). In cases of merger, in setting the prices for the new company Ofwat insisted on there being a direct dividend to customers in the form of lowered prices.

The flow of steady if unspectacular profits (in corporate terms) once the regulatory regime settled down into maturity meant that companies became targets for takeovers. This led to Wessex Water becoming part of the Enron empire; when Enron imploded, the company was bailed out by Malaysian investors. Thames became a wholly-owned subsidiary of the Australian bank Macquarie; and we saw the beginning of what the government of the day called “the Lilley Doctrine” (named for Peter Lilley MP, one-time Secretary of State for Social Security in the Major government), summed up as “we didn’t privatise these companies only to have them taken over by foreign nationalised industries”. The counter-argument is that under EU competition and open market rules, nationalised entities in Europe are structured as private companies anyway (even if the state, sometimes through a number of different players, remains the majority or even sole shareholder) and so through the Single Market are fully entitled to buy other companies in other lands. (How the Lilley Doctrine will fare during Brexit negotiations remains to be seen but could well be very interesting.) Meanwhile, companies have maintained their profitability but often through cutting jobs, outsourcing and offshoring, and adopting new technology, just like so many others.

Ian Byatt’s term as Director General of Water Services ended in 2000. The Labour Government had determined to review Ofwat because when in Opposition, they had criticised regulation for being too personality-driven. As a result, they introduced legislation that restructured Ofwat in a more corporate style. By 2004, Ofwat had a CEO and a Board; and attention turned back to attempts to bring in competition. The latest model for water industry competition is based around third-party water retailers, who compete to supply water in the most economic way. The same companies will put water into supply from the same sources and send it through the same pipes; but retail companies will buy it in bulk and compete amongst themselves to sell it on to end users (you and me). This is planned to be slowly rolled out, first to smaller business customers and eventually to domestic customers. But in trying to put a greater emphasis on competition, the role of Ofwat setting prices, analysing performance and acting as a substitute for competition has been downgraded. There is also evidence to suggest a level of company capture. One of my bosses once said that any proper private sector company would give its corporate right arm for a guaranteed income stream for the next five years in exchange for some form-filling; instead, although we kept regular oversight of how much and what information we collected, and strove to ensure that we only asked for the level of information that any prudent company would collect for its own uses, the companies were continually pushing back over the “burden of regulation” (despite the fact that many of them used Ofwat information internally for its own purposes, such as performance management).

And “light touch regulation” was the flavour of the month, though when the company headed by the doyen of deregulation, David Arculus (who also headed the Better Regulation Task Force), was found to have falsified its data returns to Ofwat, we were fully justified in fining them £35 million, and the Serious Fraud Office took very great interest in them. (By the way, fines cannot be passed on to customers. They have to come out of profits. And any company who tried hiding fines under other headings in the accounts in order to offload them onto the customer base would find its directors at risk of jail sentences and disqualification.)

One of Ofwat’s other duties, when setting prices, is to decide what a “reasonable” rate of return is. How much profit is “reasonable” from a regulated monopoly? The answer, of course, depends on your political viewpoint. In the case of Dwr Cymru, the answer is “zero” and all profits are ploughed back into more investment. For others, there are a number of viewpoints depending on how far up the list delivering shareholder value is. Whether you think regulation is a substitute for direct political control is going to determine how far you’re prepared to go along with privatisation.

Re-nationalisation?

A lot of different people have made good money out of privatisation. I suppose it’s possible to say that the privatisation process shifts the beneficiaries of the undertaking from employees and a wide proportion of the taxpaying public who use the service to a more focussed group of investors (who make a return on their investment) and contractors (who get paid for, and make a profit from, providing services to the undertaking that they might have handled internally in the past, or might not have done at all). The taxpaying public’s benefit becomes solely that of the recipient of the service that they pay directly for.

It is a feature of a nationalised undertaking that everyone pays for a service through taxation that not everyone will use. So, the argument runs, rail passengers should pay more for their tickets to finance the service that they use, whilst road users shouldn’t pay taxes for rail subsidies because they aren’t using rail. This argument ignores the additional impact on roads that rail passengers would represent if there were no trains for them to travel on, or the impact that increased heavy goods vehicles would inflict on the road network if there were no freight trains. And it’s not just a question of who pays for what; actual provision of capacity becomes an issue. Or to take another example; I have no children – why should I pay a share of the cost of educating the children of others? The answer is that I live in a society where old and young mix, in work, and commerce, and leisure. The education that I help pay for benefits me in the actions and knowledge and expertise that those younger than me use in their everyday lives when we interact.

(And it cuts both ways. The late Tony Benn had this to say about why the young should contribute towards the pensions of the retired:

What do the young get out of taking responsibility for the old? The answer is simple, for it is the sense of identity between the generations and the security that that sense of identity provides. I find it very comforting. But if older people are to be interesting to the young they have to be interested in the young and treat them with respect.

It seems to me that this is the very basis of any successful society.)

So it is with water. For example, take South West Water, who had a massive increase in bills, at the very limit of the ability of local inhabitants to cope with, to pay for a huge coastal clean-up along the longest section of coast of any water company to improve the aquatic environment, and compare them with Thames Water, who have possibly a similar outlay in putting in place systems to cope with the sewage output of their massive population, but equally have a far larger customer base to spread those costs across; and this resulted in South West having the biggest bills in the country and Thames having a far more reasonable rate of increase. In a nationalised scenario where the costs of necessary investment are met from centralised taxation and all contribute the same proportion of the tax take to water and sewerage services nationally, customers in the South West would be subsidised by customers in London and the south east.

(One of the arguments  put to the residents of the south west was that as a lot of the impact on the environment is caused by a seasonal influx of visitors, those in the hospitality industry could do their bit by raising prices to those visitors to reflect their impact on the environment and the pressure on water and sewerage bills. It could be argued, though, that placing the burden on centralised taxation would achieve the same ends.)

It is possible for the state to run a business as a business (as long as the managerial expertise is in place). Nils Pratley, writing in The Guardian shortly after the Labour Manifesto was published, commented that as the Government can borrow money at preferential rates, borrowing at 1.5% to purchase an industry with a current rate of return of 3.4% is actually quite sensible. But, he points out, that isn’t the point of the policy. The Labour argument isn’t that the Government could make a better deal; instead, it’s a democratic argument. It’s about governance, and whether there are certain services which should be provided by the state to ensure equality of access  and equality of standards, and that the undertaking itself serves broader national objectives as opposed to narrow, self-interested ones. Many who voted for British exit from the EU were motivated by the democratic imperative; “taking back control”. It’s possible to see the argument for re-nationalisation in the same light. And just as there are those who say that Brexit is worth any price, there are those who say that money is not the primary consideration in re-nationalisation.

It is true to say that average bills (and please try to understand what average means; so many seemingly intelligent people don’t seem to understand this) are 40% higher than they were at the time of privatisation. However, recent price cap settlements have begun rolling those increases back as the initial investment programmes have been fulfilled (Thames Tideway notwithstanding). Some are currently saying that bills would (again on average) be some £150/year higher were it not for privatisation, but we’re talking pure speculation on hypothetical cases here. Had regulation been more light touch in the earlier years and companies allowed to pass all enhanced costs through to the customer, we might have been looking at far higher bills. The first reset of price limits that Ofwat did in 1994 was estimated to have taken some £60/year off future bills in the following five years compared with what the companies initially asked for. And there have been another three price reviews since then.

Previous Labour governments and manifestoes proposed increasing state oversight of the water industry through strengthening Ofwat’s powers or changing their remit; and certainly, Ofwat would still have a function even in a future nationalised scenario. When the Thatcher administration was thinking about extending water privatisation to Scotland (as they tried roughly once per Parliament), a lady wrote to the newspaper The Scotsman with the often heard argument against privatisation, “Why should we pay for water? God sends the rain to fall on our land for free.” The next day, a response appeared in the form of another letter which said “God may send the rain to fall for free, but he disnae pay the wages of my mate Hamish who lays the pipes.”

Mad and costly political decisions can impact an industry whether it is in the public or the private sector; I recollect this story from the time when Chris Patten was Secretary of State for the Environment. He went to a conference on the environmental state of the North Sea and shocked his officials by standing up and without warning declaring that the UK would cease discharging raw sewage to the North Sea within the next five years, to which his officials, in best Sir Humphrey Appleby style, said “You said what, Secretary of State?” as of course, this sudden bright idea of his had not been discussed with anyone before that day and hadn’t figured in any legal obligations placed on companies up to then and included in forward investment plans. (They stopped short of calling it “courageous”, though.)

At only a single paragraph in the manifesto, Labour is not strong on the detail of renationalisation. Does it include the WoCs as well? I hope that the issues I’ve explored from the history of privatised water show that the sector has a range of issues which do not allow simple answers (quite apart from the ones I’ve not covered, such as metering or ability to pay). I’m not saying that it’s either a bad idea or a good one; I’m sure that a nationalised water industry could be made to work, just as when East Coast Trains were taken back into public ownership when the franchise holder walked away from the contract, the railway was actually run better and more profitably than when it was in private hands.

But I am saying that the sector has a lot of expertise to hand; and it has that expertise because it needs it. There are no simple answers. And any politician who looks for simple answers and ignores experts is storing up trouble for themselves.

 

 

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Written by robertday154

May 18, 2017 at 3:48 pm

Posted in Uncategorized

One Response

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  1. An excellent post Rob, I had some exposure to this working for a contractor to some of those companies a few years ago, and whilst they have taken time to change from rather inefficient public sector organisations they may now be ripe for taking back into the fold…

    ChrisWeston

    May 19, 2017 at 6:58 pm


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