Utility Week

UTILITY WEEK | MAY 2023 | 21 Water tion model that has enabled extremely high gearing. He says they are more comfortable with "complicated debt structures" and are able to exercise much greater control over the management of the companies, adding: "It's the private equity backed ones that are de• nitely more levered." But whether there is any correlation between • nancial structures and poor opera- tional performance is less clear. A 2018 report from Moody's which looked at a number of performance metrics during the period 2015 to 2018 suggested there was no systematic relationship between high gearing and operational performance, stat- ing: "While companies in highly covenanted structures have been accused of focusing on • nancial engineering rather than opera- tional performance, some have been con- sistently among the strongest performers in the†sector." Looking at leakage as an example, Moody's said these highly covenanted com- panies included Anglian Water, which exhib- ited the lowest leakage levels across the sector by a number of measures. It said their collective performance was dragged down by Thames Water and if this outlier is removed from the picture, then highly covenanted water and sewerage companies actually out- performed their peers on average. However, the Mason and Wright's report said that "more recent evidence gives a counterbalance to this view", noting the "well known" di‰ culties of highly geared Southern Water. Their own comparison of companies' credit ratings with their categorisation in Ofwat's annual service delivery reports from 2018 to 2021 found small to large correlations depending on the year. However, the paper also said the "fact of the matter" is there is "still relatively lit- tle data on which to base an assessment of whether there is a robust relationship between measures of • nancial resilience and operational performance". In its report on water regulation, the Industry and Regulators Committee said it was told by witnesses that the introduction of private equity ownership has been a driver in companies focusing on • nancial performance at the expense of service levels and resilience. It said Ofwat should require all water companies to "disclose information to the same standard as publicly listed companies" as this has "the poten- tial to improve their governance and increase scrutiny of their • nancial arrangements." Speaking to us shortly a' er appearing at a Utility Week event in November, former Ofwat chair Jonson Cox said it is "possibly di‰ cult to prove a theoretical causality here. But I can make a strong empirical observa- tion that, with only one exception – Anglian – those companies with the most aggres- sive • nancial structures sat low down in the performance league. And that set us really worrying." Cox said "across the infrastructure space globally, private capital has demonstrated it can run utilities well. "But", he added, "the model of the debt- led consortia of the 2006-10 period has, with only one exception, failed to create resilient performing water businesses. As a regulator we wanted investors to make money from operating the business well, not merely from being more leveraged." Ofwat is certainly making moves to ensure this is the case. Alongside its decision to strengthen cash lock-up conditions, the regulator also con• rmed plans in March to amend companies' licences to require them to link dividend policies and payments to their operational performance, including service levels for customers and the environ- ment, from 17 May 2023. To ensure this incentive applies to man- agers as well as shareholders, the regulator also announced plans at the beginning of April to regularly review executive bonuses to ensure they are re˜ ective of operational performance and introduce a mechanism to clawback revenues from companies at the end of the current regulatory period if they are not. Utility Week contacted a number of water com- panies and the trade body for reaction to this and other points in this report but none of them have provided a response. The way forward Although it has yet to make a decision on the matter, the return of the GOSM or some variation for PR24 seems highly doubtful, particularly given that the CMA has concerns over the fundamental design of the mecha- nism, which are unlikely to be assuaged by tweaks to the way it works or more evidence to back up its parameters. Bringing it back would give clear grounds for any water com- pany to appeal their • nal determinations. But Ofwat is pulling every other lever at hand to prevent companies earning excess returns through • nancial engineering, either by pushing companies to reduce the gear- ing levels that enable them to achieve these returns or preventing them from being paid out to shareholders through dividends. Water companies may dispute that they have generated excessive returns from higher debt, and insist that measures to limit their freedom will increase costs, but they have wholly failed to persuade Ofwat, which is pushing from multiple directions to make sure companies are le' with no room for • nancial engineering. Gearing levels are naturally falling and, amid growing public outrage over water companies' seeming ability to pro• t from polluting Britain's waters, Ofwat looks deter- mined to ensure they do not return to their recent highs. Tom Grimwood, insights editor

• Cover