One aspect of the Thames Water saga has been relatively unexplored in the political and media commentary. How did the water companies get away with taking on so much debt over the years?
At the time of privatisation the water companies’ debts were all written off and they were even given cash ‘dowries’ to fund investment. But today most of them have gearing levels above the Ofwat benchmark of 60 per cent; several are above 70 per cent; and Thames is at over 85 per cent.
To understand what happened and why, we need to look back at the political bargain that was struck at the time of privatisation, why rising debt was a feature not a bug, and how path dependency prevented a change of course.
At the time of privatisation, the then government recognised that the water sector would develop differently from telecoms or gas. Water was the ultimate natural monopoly so there could be little hope of price cuts being driven by competition or new entrants. Nor could a regulator extract price cuts from existing operators on the basis of potential efficiency savings, because the companies were going to have to invest more money to meet new environmental obligations. (Indeed, a large part of the rationale for water privatisation was that it would be easier to finance this new investment through the capital markets than from the public purse.) The companies would ultimately have to pass these costs through to consumers and so bills after privatisation would go up, not down. As a result it was recognised from the start that the privatised water companies would become very unpopular.
This created a challenge for the government. It would only get the privatisation off the ground if investors were confident that having parted with their cash they would be allowed to put bills up in order to earn a return. But the government, and Mrs Thatcher personally, wanted to keep price rises for consumers as low as possible, certainly in the year or two after privatisation.
Debt played a role in solving this problem, as explained in the Official History of Privatisation by David Parker, who had access to the records of the government of the time. Ministers and officials concluded that if the companies were privatised debt-free, investment could then be financed by raising new debt. This also helped reassure potential shareholders that the companies would not have to tap equity markets and thereby dilute their holdings. Meanwhile the lower cost of debt could at least theoretically help keep a lid on price rises to consumers. As a result, the government and its financial advisors, Schroders, anticipated that the level of net debt in the sector “will rise fairly fast” (1).
But what of the risk that the companies would borrow more than was strictly needed to finance the investment, and engage in financial engineering to boost their returns even further?
Interestingly, the government was not blind to some of the likely incentives on the companies. It suspected they would engage in mergers and acquisitions – so the Water Act included a duty on the Secretary of State to refer to the Monopolies and Mergers Commission any water mergers above a certain size (2). And it suspected they would diversify into non-regulated activities or overseas ventures, given that the water companies could not expect to grow fast in their core business – so the Act required the regulated activities to be ring-fenced in order to prevent cross-subsidisation of other enterprises (3).
However, the government did not put in place similar guardrails against excessive borrowing. Perhaps this was due to their unfamiliarity at the time with the highly leveraged private equity model, given that it was assumed that most of the companies would be publicly listed. Or maybe given that the government was “desperate to reach an agreement with the industry” on privatisation, it was happy to leave a little scope for investors to extract further value afterwards, without realising how far this would eventually be taken (4).
But either way, this still leaves unanswered the question of why Ofwat and the government did not then change course once they realised that gearing was rising so significantly.
Here, it is instructive to read a report that Defra and Ofwat commissioned and published back in 2004, ‘Structure of the Water Industry in England: Does it Remain Fit for Purpose?’ By that time, it was already clear that the water companies were becoming much more highly geared. The key development that the report highlighted was the “much greater reliance on debt finance” with the average level of gearing in the industry having “risen from 41% in 1998/99 to 57% in 2002/03”.
But the authors of the report – who, curiously, do not appear to have been named – were relaxed about this development. They found no “immediate cause for concern”, pointing to the fact that shareholders retained corporate governance controls and that the risks associated with financial failure were mitigated by the ringfencing of the regulated businesses from their parent groups and by their debt maturity profiles.
As well as rebutting the arguments against higher gearing, the report also set out the positive case for debt finance – but it was not the same case that the government had relied on at the time of privatisation. At privatisation, the idea was that debt would finance investment. But by 2004, the report found “no correlation between the levels of preferred investment strategies and financial structure”. Instead, the benefits of debt finance were to “strengthen the low risk business properties of water companies” on the basis that debt finance was appropriate for the low risk businesses that water companies were thought to be. In addition, leverage was thought to lead to “increased accountability and focus for the performance of the appointed business” since “as its risks and returns [were] now leveraged it might be expected to put more pressure on managers to perform”. The report conceded that it would be undesirable for all companies in the sector to become very highly leveraged but it neither suggested what the cut-off point should be nor what action should taken in the event such a point was reached. As a basis for policy, therefore, the report justified continued inaction.
There are a number of lessons that I think flow from all this.
First, it is hard to pin the blame on profit-maximising companies for acting in their own commercial interests. When water was privatised, the incentives on the companies were not hard to identify. In some cases, the government and the regulator chose to put appropriate guardrails in place, but in others they chose not to.
This leads to the second lesson, which is that economic regulation is not a purely technical economic exercise. It is underpinned by political bargains, and if you want to understand how and why regulation is developing in a particular way you need to understand what those bargains are.
Third, when the rationale for a policy no longer makes sense, it can be a lot more convenient to change the rationale than to change the policy. Spotting such a change in rationale can be a good early warning sign of likely policy failure.
REFERENCES
(1) Parker, D., The Official History of Privatisation, Volume II: Popular Capitalism, 1987-1997. London: Routledge, p. 211
(2) Ibid., p. 198
(3) Ibid., p. 194
(4) Ibid., p. 216
