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Making the profits flow uphill

The privatisation of the water utilities aimed to bring private sector management expertise, resources and dynamism to a public sector infrastructure that had been starved of investment for decades. Those who opposed privatisation in this area did not, in general, argue that the utilities had prospered under public sector control. Instead, the arguments tended to focus on fears that handing water monopolies to private management would result in Joe Public getting fleeced over an essential-to-life commodity.

The solution, in both theory and practice, to monopolies being without the kinds of price controls usually exerted by competition and market forces, is a government-imposed regulatory regime. Regulating an artificial market is a tough game to get right, since there are at least three balls to juggle simultaneously, namely government interests, industry interests and, of course, the public interest. However, the general opinion seems to be that Ian Byatt, the director general of the Office of Water Services (Ofwat), is making a rather better fist of achieving a balance in all three directions than some of his regulatory colleagues.

In numerous speeches on the theme of regulation, Byatt has addressed the issues raised by such factors as the rise of multi-utilities, by the acquisition of water companies by groups with largely non-water interests, and by the successful diversification of water companies into other, larger areas of activity. As he himself puts it, “Many of the concerns about multi-utilities relate to the lack of transparency about inter-utility transactions, relative financial performance and how income from customers is used by the utilities.”

The problem, from the government’s standpoint, is that when you release utilities into the private sector, you have to expect the usual dynamics that drive businesses to apply. Company boards need to generate strategies for growth and in a regulated environment they will not get this to any really exciting degree, over the long term, from their UK water licences.

True, this sector has enjoyed significant profits in recent years, so much so that the government felt justified in clobbering it with its so-called “windfall tax”. However, that profit has come from short-term factors that few believe to be sustainable.

As Anglian Water Services managing director and former finance director Chris Mellor points out, the regulator is scheduled to deliver his report, Prospects for Prices, on 29 October, which will give the industry what Mellor calls “its first real signal” as to what the regulator sees as a ballpark figure for post-tax profit returns. The anticipation is that it will be between 5% and 6%. That might represent an excellent ROI by comparison with the motor manufacturing industry, which struggles to make 4%, but it is not exactly dynamite. It trails behind even the hard-pressed manufacturing sector by a few points in performance terms.

The industry’s gross margins, on the other hand, tend to be extremely handsome (in excess of 40%) and have been since privatisation. This, as Scottish Power FD Ian Russell points out, reflects the way the regulator has built a capital projects funding element into water pricing. It is designed to enable the water companies to carry out the massive investment programmes they require to bring their services up to the performance levels expected by government, by the regulator and by the European Union.

In fact, Russell stresses that from an FD’s perspective, managing and cost controlling billion dollar capital expenditure programmes, such as that undertaken by Scottish Power’s subsidiary Southern Water (acquired in 1996), is itself a very significant challenge. “Historically, the water industry has had much lower levels of spend and has not been accustomed to managing projects on this scale. Indeed, in recent years managing and completing really significant capital investment has been the major challenge for water and waste water companies,” he notes.

When Scottish Power acquired Southern Water one of the benefits it brought to its new subsidiary was precisely its track record, gained from major power construction projects, in managing and financially controlling large-scale investment projects. “This is an incentive-based regulatory regime.

You get rewarded for delivering good customer service and you are rewarded for lowering your operating costs and for effective project management of your capital program. As an FD, you can see a clear link between the operating side of the business delivering a service that meets the regulator’s performance criteria, and good financial results,” he says.

Russell argues that while there is a tendency to see water companies as not particularly commercial, once people look closely at the regulatory regime as a surrogate for competition, it becomes clear that Byatt has succeeded in incorporating into the regime most of the commercial factors faced by large private sector enterprises.

“Interestingly, in recent weeks both the deputy prime minister, John Prescott, and Ian Byatt have talked about rewarding water companies directly, with profit increases of between #5m and #10m, for success on service performance criteria. The regulator is also talking about introducing more competition among water companies for commercial clients. We would be very happy to see the next phase of the regulatory regime move in the direction of differentially rewarding the best performers in the sector,” he says.

Anglian’s Mellor agrees that the regime has succeeded in mimicking commercial life to some extent. However, while Russell is confident that the prospects for Southern Water are excellent in their own right, Mellor’s long-term view tends to stress the need for Anglian to exert itself in non-regulated markets. “The regime works much as the market would do as far as profits are concerned. Any company earning super profits in a competitive market has its capacity to earn at that level eroded by its competitors, and the regulator does the same thing with price adjustments. However, in the regulated market it is very hard to improve your market share,” he notes.

“To the extent that we cut costs and introduce efficiencies, we can grow our profits, but this is where the politics come in,” he comments. In the years since privatisation, the water companies have found considerable scope for cost reductions. Anglian, for example, has cut its workforce, over the last five years from 5,000 to 4,000. At the same time, service levels have gone up, he claims, to the highest they have ever been. “This is not to say that we cannot continue to improve, but some of those gains are not easily repeatable,” he stresses.

For this reason, Anglian has turned its attention to what Mellor describes as the $15bn global water and waste water business. “Unlike some other utilities that have diversified into different areas, we intend to stick to our knitting, but we are going to extend out into the unregulated markets that are emerging around the world,” he says.

“There is a huge potential market out there. All the bullets that the UK water industry has bitten, all the issues, are out there waiting to be resolved,” says Mellor. “The increased urbanisation of populations as a global trend and the recognition of water as a scarce and valuable resource all add to the pressure on foreign infrastructures knackered by under-investment. The UK is now looked to as the world leader in the effective management of water and waste water, which creates very exciting opportunities for us to internationalise our business,” he claims. Anglian has put together a strong bid team and intends to compete against the likes of the French giants Suez Lyonnaise and Vivendi. It is this same recognition of emerging global opportunities that is said to be behind the US oil, gas and power company Enron’s #1.4bn take-over of Wessex Water.

Ken Hill, financial director of the Pennon Group, which owns South West Water, agrees with Mellor that the regulated side of the industry will inevitably settle down to the point where water is seen as safe, steady stock, a good port in a storm, but nothing to write home about. Pennon, he says, is looking to its landfill business (it currently operates the biggest landfill operation in the UK) as its major growth factor. “We changed the name of the group last year in order to recognise that we are now about a great deal more than water and sewerage. Over half our revenues now come from our non-utility business,” he says.

The practicalities of managing the regulated business in such a manner as to keep the regulator happy that water consumers are not being asked to fund other parts of the group’s activities, are handled, he says, by effectively ring fencing the utility business. “We have to assume that our water business is essentially a stand-alone company in its own right.

Byatt has absolute leverage on how we account for the utility. We send in a separate set of regulated accounts, which give a particular meaning to the concept of profit that we use in this industry,” he says.

He makes the point that Byatt recognises the importance to the industry of focusing on current cost profits as well as historic profit. “The City has little interest in current cost profit, but in our industry this is a vital concept. The historic cost of acquiring our assets might be in the region of a billion pounds. In today’s terms that cost would be five to eight times higher. In order to come to a view on what constitutes a sensible return on assets, you have to take a current cost figure, so we base our calculations on modern equivalent assets,” he explains.

The difference is obvious. A return that might look handsome based on a 1950s construction value for a treatment plant would look pretty meagre when calculated against a modern equivalent asset value. However, this has meant that Pennon has to account differently for its water business as opposed to its landfill operations, which use conventional costing.

Although the landfill side of the operation is seen as offering far and away the most exciting opportunities for growth, Hill says that South West Water is luckier than most water companies in benefiting from a positive population migration into the area. “We get something like 6,000 to 9,000 new customers per annum from migration to the area, which gives us the opportunity to actually grow our customer base. A second growth factor, which all the companies enjoy, comes from people using more water as they move to modern appliances such as dishwashers,” he notes.

As Scottish Power’s Russell points out, multi-utility companies have yet another route to growing their business from water companies, namely by selling additional services to their captive customer base. Scottish Power has already sold gas services to 10% of the Southern Water customer base and as the electricity market opens up further over the next nine months, it hopes to win still further business. At the same time, the group is looking to expand its water business further by winning PFI contracts to manage Scottish water works. According to Russell it is already a preferred bidder in a couple of deals. “This shows the value of Scottish Power becoming a multi-utility. I am sure that we owe our success in the Scottish PFI bid process to the fact that we can call upon the experience we have gained from our acquisition of Southern Water,” he says.

Russell takes the view that there is still room to continue to make improvements, to drive down costs and to raise service levels still further in the industry.

“Water will continue to be a very good bet for shareholders for a long time to come,” he says. To those who would dismiss the water utilities as a star with just a decade or so of luminous life, he replies: “There is many a FTSE-100 company that would like to be able to point to a glittering decade …”.

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