Water, water ...

One of the motivations for setting up this blog eight years ago was to highlight that continued reliance on the private sector for solutions to economic problems is a far from optimal strategy (see my June 2016 post, here). The recent furore regarding the failings of the UK water industry, along with the vexed problem of how to organise the rail network, are examples in a long line of businesses which have failed to live up to post-privatisation expectations. At a time when government is vexed by the problem of persistently low productivity, this makes it all the more important that infrastructure works efficiently.

Looking back to the 1980s and 1990s, you might recall that one of the main arguments advanced by the Conservative governments of the time was that the private sector would run businesses more efficiently and productively than the public sector. By introducing market discipline, competition, and incentives for innovation, this would lead to cost reductions and improved performance. In addition, private companies would have stronger incentives to improve service quality and customer satisfaction in order to attract and retain customers. While there were examples of industries which did benefit from a return to the private sector – telecoms being the prime candidate, which gained from a technological revolution – in many instances, privatisation simply meant swapping a public sector monopoly for one in the private sector. As a result, they had little incentive to innovate and could rely on a captive market to sustain revenues.

Where did it all go wrong?

Evidence to suggest that the water industry has not generated the post-privatisation efficiency gains that were claimed for it comes from a study by the consultancy Frontier Economics published in 2017 (chart below). Their analysis suggests that total factor productivity in the water industry did pick up immediately after privatisation but that it quickly slowed thereafter, doing nothing to dispel the suggestion that the industry has lived off the assets it inherited at the time of privatisation in 1989.

Yet the failings of the privatisation model introduced in the UK over the last thirty-odd years go far beyond the shoddy way in which customers are treated (overpriced train journeys, effluent being dumped in rivers, electricity companies that went bust at the first sign of trouble in global energy markets). One of the issues that privatisation was meant to tackle was reduced reliance on a pay-as-you-go model, in which the current generation of taxpayers stumped up for investment from which the next generation would benefit. Under a pay-when-delivered model, it was planned that balance sheets be used to pay for the initial cost of investment and future customers pay for the services they consume and so long as prices were set appropriately, the business would generate a decent rate of return. In addition to this being a sound economic basis, there was also a political motive for doing this as far as water was concerned. Planned EU legislation in the 1980s and 1990s required a significant rise in future investment which the government did not want to pay for, nor did it want customers (aka voters) to have to pay for it either. Getting private companies to use their debt-free balance sheet to pay for investment seemed like an expedient solution (water companies were debt free on privatisation).

But as the Thames Water debacle shows, that is not what happened. Newly privatised companies resorted to borrowing against assets on the balance sheet, much of which was ultimately used to pay shareholder dividends. As a result, Thames Water now has huge debts which threaten it with bankruptcy. This has forced a return to a pay-as-you-go model with today’s customers being asked to fund investment while servicing today’s debt.

Regulatory failure

While the public rightly puts most of the blame for the failures of privatised utilities on its managers, we should not ignore the fact that in many cases regulators have been remarkably complacent. First off, regulators in the electricity and water industries failed to stop companies from leveraging up their balance sheet from the 1990s. The companies perhaps ought to have behaved more responsibly but it is the duty of regulators to step in when irresponsible behaviour occurs.

Second, regulators did what they often do, and conduct regulation by rule book. As the economist Dieter Helm points out, the periodic reviews they conducted generated huge amounts of admin which companies struggled to process. As Helm notes: “company boards find that they are essentially asking the regulators to make decisions for them. In recognition that the “customer” is Ofwat rather than the household and business users, utilities engage in lots of lobbying, and try to work out what answer the regulator wants, rather than what their customers want and the wider environment needs ... Utilities start by trying to guess the answer the regulator (and the government of the day) might want, and then shape their business plans around them.” Both these elements chime with the situation in the financial services industry pre-2008 when regulators failed to rein in the (dubious) actions of many banks and issued vague directives without giving clear guidance as to whether institutions were compliant. And as we know, the UK regulator ended up being abolished and a large part of its responsibilities transferred to the BoE.

A final problem, though one which is perhaps only recognisable in hindsight, was that regulators applied the wrong cost of capital – a key metric used in determining the allowed rate of return and thus the appropriate prices for consumers. They applied a weighted average cost of capital (WACC) averaged across all areas of the business, rather than looking at each individual area separately. As a result, for each individual business WACC turned out to be too high for the cost of debt and too low for the cost of equity, providing an incentive for privatised utilities to switch from equity to debt and encouraging the gearing that proved to be so problematic for Thames Water (for more detail, see the work by Helm here or here). Here too, there are echoes of the failures of the VaR models which so underpriced financial risks prior to 2008.

 

Nationalisation is not (necessarily) the answer

Not surprisingly, this has caused a political uproar which threatens to rebound on the Conservative government which has long been an advocate of privatisation, while giving ammunition to those at the other end of the political spectrum who advocate taking assets into public ownership. However, nationalisation is not necessarily the best solution (it might be for rail, but that is a subject for another time). The arguments continue to rage as to whether renationalisation would result in an industry which is better aligned with customer interests. But the biggest argument against it is the fact that the state currently does not have the funds available to buy the utilities without issuing significant amounts of additional debt, and certainly does not have the cash available to fund the necessary investment. Many utilities are foreign owned (over the last 20 years Thames Water has had German, Australian and Canadian owners) and nationalisation would sit uncomfortably with efforts to attract foreign investment. As Helm has consistently pointed out, the UK suffers from a sizeable savings deficit – the current account deficit is a measure of the excess of domestic investment over savings – which implies that it is already reliant on the kindness of strangers to fund investment.

What to do?

Since we cannot easily nationalise Thames Water, and imposing yet more red tape would not seem to be a viable option, we may be left with little option other than to place it in administration. This is effectively what happened to the privatised rail operator Railtrack in 2001. Rather than nationalise the whole operation, however, there is a strong case for splitting it into smaller parts with different regional responsibilities and maybe with different functional responsibilities (e.g. one for water supply and one for treating sewage), selling off the good bits and putting the bad bits into special administration.

Either way, it seems socially irresponsible to allow a company that has failed to properly manage the largest water company in Europe to be allowed another go at getting it right. This may be the right time to redraw the contract between the state and the market, and learn some of the lessons of the last thirty years. In short, the companies must strike a better balance between serving their shareholders and their customers, entailing effective regulation (not simply more of it, but better targeted regulation); breaking up private sector monopolies; more strict controls over pricing and more effective sanctions against those who transgress. On the assumption that a new government will have to pick up the pieces of this problem in the not-too-distant future, the Thames Water problem could provide a good opportunity to reimagine how utilities should be run in the twenty first century.