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Environment analysis: As part of a series on the continued debate around renationalisation, we analyse the current sentiment in the water industry and the potential impact of renationalisation. Steve Gummer, partner at Sharpe Pritchard, considers the reasons for the recent discussion on nationalising the water industry, the arguments for and against it, and examines what legal avenues the government could take to renationalise the sector
Water industry must ‘up its game’ against climate change, politics and pollution, LNB News 14/05/2019 81
Sir James Bevan, Chief Executive of the Environment Agency, has named politics, operations and climate change as the ‘three big challenges’ for the future for water. Speaking at the Water Industry Forum, Bevan said that ‘we have to crack all three if the sector, and the country, is to thrive’. He urges companies to first and foremost address pollution, water leaks, drought and long-term approaches to climate change as a good place to start.
The most frequent arguments heard in favour of nationalisation are performance and payment-based. Namely some people hold the view that excessive returns have been made in the water sector, but that necessary investment has not been made sufficient to curb service failure and leakage.
It’s worth exploring each of those in turn.
In terms of payment, the amount water companies are allowed to charge is determined by the water regulator, Ofwat. Regulatory settlements determine what water companies will deliver for customers and what charges can be made. Water companies take performance and financing risk. The settlement regime works both ways—companies can achieve benefits if their costs are lower than the charges determined by Ofwat but can lose out if their costs exceed amounts set by Ofwat.
There are competing claims as to whether bills would be cheaper under a privatised or nationalised model. A figure often stated is that household water bills have risen by 40% since 1989. This rise is correct as expressed in real terms between 1989 and 2014/15. However, stating this position alone is slightly simplistic. A National Audit Office report from 2015 shows that the majority of this rise happened between 1990 and 1995 when privatised water was in its infancy. Bills fell in real terms between 2009/10 and 2014/15 and at the 2014 price review Ofwat determined that average bills should fall by 5% in real terms between 2014-15 and 2019-20. The counterfactual of what bills would be in a nationalised water scenario is difficult to establish.
In terms of performance, it is frequently stated that private water companies underperform. Underperformance can come in many forms—including loss of pressure, interruptions in supply, or leakage:
This is not to say that performance is perfect. There are obviously some instances where underperformance has arisen and been widely reported in respect of privatised water companies—most recently Southern Water was fined £126m following failures in the operation of its sewage treatment sites and for misreporting its performance. Ofwat’s investigation and the scale of the fine demonstrates that the role of the regulator is performing as it is supposed to.
In the recent price review, where Ofwat set prices and targets for the next five years through to 2025, Ofwat set significant targets for leakage, pollution and a requirement for a 12% reduction in average household bills before inflation. Targets for leakage and pollution will become more prevalent in future years reflecting the priority of the climate change agenda. It is difficult to know exactly how a nationalised water industry would compare.
It is difficult to say what shapes public opinion in respect of matters such as those in the survey. However, I have worked with a number of water companies over the years and each of them place a premium on communication with their customers.
The existence of a debate on nationalisation is certainly raising scrutiny of the performance of water companies. Whether or not to nationalise is a politically interesting story for obvious ideological reasons. However, there is concern that this debate distracts from the four biggest challenges the water industry currently faces:
I think it would be possible to focus on these issues in both a nationalised or privatised system.
The nationalisation debate is also shaping the terms of financing in the industry—it has been widely reported that at least one water company has recently issued bonds with a ‘nationalisation’ clause—this ensures lenders are paid back immediately on nationalisation.
It is difficult to say what the impact of any leaked document is. However, it is less difficult to consider some of the challenges if nationalisation of the water industry were to take place.
One challenge is the means by which nationalisation would be undertaken. I would expect an Act of Parliament to be passed that would pass equity and (in some cases) debt of the relevant companies to publicly owned entities. This approach has been used before. Such legislation would also set out relevant transition arrangements as well as the powers and scope of the new entities that would run our water networks. However, another approach may be an asset transfer or a part nationalisation where the government may purchase part of the relevant company. Some participants in the water industry have complex structures and so any approach that involved the transfer of equity and/or debt would need to consider the scope of what was being nationalised.
There is a huge challenge regarding the amount of compensation that should be paid for any company to be nationalised. I would expect this to be determined by Parliament, but figures reported in the press range from £86bn to as low as £15bn. There are a number of options as to how a government may go about valuing a water company—this could be done on the basis of the companies’ regulated asset bases (RAB)—this is a maintained notional regulatory value of the relevant company based on value of past investment and values determined as at privatisation. However, water companies currently trade and are sold on the basis of a mark-up against RAB.
Whatever approach is taken in respect of nationalisation, it is likely to be controversial and is likely to attract challenge. There are a number of options for challenging nationalisation, including:
The discussion regarding nationalisation stems from the political agenda and this seems to be the main cause for the discussion.
However, one interesting feature of the discussion to date is that—while the established regulatory system in the water industry is the subject of discussion for reform—it is being considered as a potential exemplar and a successor to Public Private Partnership or Public Finance Initiative 2 (PF2) contracts in the wider governmental sphere. As part of the on-going Infrastructure Finance Review consultation—the Infrastructure and Projects Authority is currently considering a number of options to replace PF2 and one such option being discussed is the use of a model akin to that used in regulated water and regulated electricity—namely an approach designed on the basis of a RAB. The UK government has also begun a consultation exploring use of this approach in respect of the nuclear industry.
A further interesting aspect of the discussion is that Ofwat (and indeed Ofgem in respect of electricity transmission) are increasingly trying to establish competition within areas that are historically regulated monopolies. Nowhere is this more apparent than in respect of Ofwat’s new flagship approach of direct procurement for customers. Under this policy, water companies will be required to procure a competitively appointed provider to design, build, operate and maintain major infrastructure assets. The competitively appointed entity will also be responsible for financing the project—as opposed to such financing being undertaken by the water company and returns being set by Ofwat. To date much of the discussion on nationalisation has been focussed on the water companies themselves but nationalisation may also present challenges for policies such as direct procurement.
This depends on a number of political realities. However, it seems likely that should a Labour government be appointed they would implement the policies which they have proposed. This includes nationalisation of the water industry.
Interviewed by Samantha Gilbert.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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