Something smells, and it’s not the flowers. In the last few weeks the UK water industry has come under intense scrutiny following the publication of the Industry and Regulators Committee most recent report into the state of the UK’s water and sewerage sector.
The report followed up by questions in the House of Parliament and a deluge of negative news stories prompted a rare attempt at dialogue from the water industry through trade body, Water UK, where in a joint communique bosses of the UK’s privatised water industry issued a mea culpa apologising for pumping raw sewage into Britain’s rivers and coastal seas.
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The joint communication unveiled a ‘National Overflows Plan’ which would invest GBP10bn in a modernisation of the country’s “Victorian” sewer system. Water UK said this was triple the current investment levels and “the most ambitious programme on sewage spills in the world.”
Under-investment
However, industry analysts believe that the actual cost of addressing the chronic under-investment in Britain’s sewage and waste-water system in order to meet the government’s spill reduction targets by 2050, would be around GBP56bn, which leaves the glass (of sewage) not even half-full; in fact, not even one-fifth full.
Ruth Kelly, former ‘Blair babe’ in the Labour administration of 1997-2010 and member of Opus Dei, who after her Parliamentary career segued seamlessly into business, first at HSBC and then took over as chair of Water UK this year said: “The message from the water and sewage industry today is clear: we are sorry. More should have been done to address the issue of spillages sooner and the public is right to be upset about the current quality of our rivers and beaches. We have listened and have an unprecedented plan to start to put it right. This problem cannot be fixed overnight, but we are determined to do everything we can to transform our rivers and seas in the way we all want to see.”
The water industry was privatised in 1989, and its firms have, on average, paid out dividends of GBP2bn per year since privatisation. Last year water companies paid shareholders dividends of GBP1.4bn; up from GBP540m the previous year. At the same time executive pay and pension contributions also climbed, with pay up 20% last year to an average of GBP1.1m for water bosses. Currently about 70% of the industry is owned by hedge funds, investment banks, foreign investment firms, sovereign wealth funds, private equity, pension funds and businesses based in tax havens. A large proportion of the dividends paid out by the water companies have been ‘internal dividends’ to holding companies that have lent money to them through shareholder loans or provided services to the water companies and are due ‘costs’.
Debt loading
At privatisation the water companies were sold with no debt. In the past 30 years, the companies have loaded over GBP60bn of debt onto their balance sheets, according to OfWat, the industry regulator. However, expenditure on wastewater infrastructure hasn’t kept apace with the rises in dividends (internal and external), executive pay or debt financing. In the 1990s, the top-10 water companies invested nearly GBP300m on wastewater treatment. Twenty years later this had fallen below the GBP300m mark, and in this decade has been less than GBP275m
The aim of water privatisation was to increase efficiency and improve service quality. This hasn’t been the case. High barriers to entry have excluded competition and the firms’ customers are captive, seeing their bills rise around 40% in real terms.
At the other end of the pipeline, the water companies have also raised public ire. Annually the industry preaches to its customers about using water sparingly, and often blanket hosepipe bans are imposed across large swathes of the country. However, investment into the cleanwater pipelines has followed a similar trajectory as wastewater, with similar results.
In 2021/22 UK water companies managed to lose nearly three million litres of water a day, with many water companies granted emergency drought orders last year, allowing them to take water from rivers and lakes, impacting the environment which was already stressed by low water flows.
A Water UK spokesperson said: “Bonuses and incentives for water company leaders are linked to their delivery for customers and the environment. If delivery falters, then levels of reward will, rightly, be lower.”
Customers forced to pay
And it seems that customers are going to see their bills rise substantially in the coming decades, as the proposed GBP10bn investment into wastewater will be passed onto bill-payers if OfWat greenlights the industry’s suggestions.
As the water industry fails, the call for more regulation and even nationalisation intensifies (although in the case of nationalisation, where a hard-pressed government is going to find GBP50bn to invest in sewers when it has competing calls for funding from a panoply of sources, not least the NHS, is a moot point) and shareholders – at least the ones holding the shares publicly – might see the flow of dividends dry up.
Pennon Group LON:PNN, which owns South West Water is the second-smallest water company in the country by revenue. A FTSE250 constituent, the firm expects to publish its final results on Thursday (1st June). Given the (low bar set by) competition, Pennon has been on par in terms of operational and financial performance. South West Water operates in Devon, Dorset, Somerset and Cornwall and following the acquisition of Bristol Water, one of the last-surviving privately-held water companies in England and Wales, Bristol as well as Bournemouth.
However, last week OfWat launched an investigation into South West Water’s reporting of its performance on leakage and per capita consumption (PCC), primarily focussed on the way South West Water calculated its leakage performance target in 2021/22.
Regulator investigations
Pennon only commented: “We will work openly and constructively with OfWat to comply with the formal notice issued to South West Water as part of this investigation.” OfWat on its own part said: “OfWat will not provide further information on the investigation until it reaches a conclusion.” However, the regulator has the right to fine any water companies breaching regulations up to 10% of its annual turnover.
South West Water was also dragged into OfWat’s 2022 investigation into the illegal dumping of sewage into waterways, resulting in a GBP2.1m fine issued by the Environment Agency in April for pollution breaches. The Environment Agency also gave South West Water a one-star rating.
As reported in the company’s last financial statement in November 2022, covering the half-year to the end of September 2022 the company saw its revenues rise around 9.4% to GBP425.5m year-on-year, but also saw its profits evaporate by nearly 74%, as dry spells caused issues and prompted regulatory investigation. That said Pennon declared the interim dividends were up 10.8%.
As reported, one of the most-significant drags on performance was Pennon’s overhanging debt, which increased 13% from the prior year, to GBP2.9bn. As inflation rose in 2022, so did interest rates and Pennon found itself paying GBP37m more on non-cash interest charges than in 2021. And just like a burst water main, Pennon haemorrhaged cash in the period with free cash flow outflow of GBP41.1m for the half-year, compared to an outflow of GBP24.9m last year. The company warned that its second half would likely be worse than 1H22.
Stop the Drop
The company updated the market in March with the positive news that its protracted acquisition of Bristol Water had completed, after an investigation by the Competitions and Market Authority and was expecting: “the delivery of double base returns on regulated equity in 2022/23, driven by our strategically positioned financing portfolio.” Despite a wet spring, the company was still enforcing drought emergency status and was berating its customers through its ‘Stop the Drop’ campaign to conserve water supplies.
The company’s CEO, Susan Davy announced that she was forgoing her 2022/23 performance-related bonus this year (after receiving over GBP500,000 in 2021/22), saying: ““[…] this is the right thing to do. We’re listening to our customers, we get it.”
In March, broker RBC Capital Markets downgraded Pennon to ‘sector perform’ from ‘outperform’ but maintained a target price of 975p. Credit Suisse said in a brokers note that the company’s investor presentation next week would be the “most critical that the current management team has undertaken yet.”
The company’ shares have suffered over the last few years, and was targeted by short-sellers at the close of last year, but with generous dividends, the company’s Total Returns have kept shareholders happy. The Exeter-based utility company’s shares opened trading today (30th May) at 776p and has offered a year-to-date return of -12.3% and a one-year return of -23% with shares ranging between 735.00p and 1,076p over a 52-week period. The company has a market cap of GBP2bn.Bridgewise rates Pennon as a ‘Hold.’ The analyst said: “Pennon’s financial results from Q3 demonstrated decent performance, but will likely only help Pennon remain on par with its peers. We do believe, though, that macro-related market conditions will influence their performance more significantly than its individual results. Therefore, Pennon received an overall score of 65./100”
As indicated, Pennon, like most utility companies, is a fairly steady and predictable investment. The shares are never going to go great guns, but shareholders are adequately compensated with a reliable dividend stream. Prices have fallen over 20% from this time last year creating a buying opportunity.
However, given the heightened public scrutiny and a government and regulator wanting to be seen to be doing something about the water companies’ performance, regulation and a more critical approach to the sector might be down the line, which may blunt that dividend stream. With profits seemingly on the decline and the vast sums needed across the industry in terms of infrastructure investment, there is going to be a lot less money going around at Peninsula House. Thursday’s results will be watched closely.
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