Ofwat CEO David Black and Chair Iain Coucher have rejected suggestions by an influential Parliamentary Committee that since privatisation of the water sector, recent Price Reviews had focussed on keeping customer bills low at the expense of allowing sufficient investment in water and wastewater infrastructure.

The Ofwat Chiefs were appearing in person to answer questions from the House of Lords Business and Regulatory Committee which is currently conducting an inquiry into the work on the water sector’s economic regulator.

During the course of the lengthy and wide-ranging evidence session, they were repeatedly quizzed on whether Ofwat had focussed on keeping customers’ bills at the expense of investment in infrastructure, which may have been a contributory factor in the current problems relating to the use of Combined Sewer Overflows and excess sewage discharges.

Questions on investment, shareholder dividends, monitoring, sewage discharges were high on the peers’ agenda. The inquiry looked in some depth at the ability to take away a licence if there was persistent poor behaviour, including under- investment and pollution.

David Black explained that Ofwat had the power to invoke special administration which requires the approval of the Secretary of State and the High Court.. Despite the fact that the burden—or barrier—of proof is high, there is already a process in place and Ofwat had “come close to looking at the need to do that.” The power of special administration gave the right to change owners, which could lead to changes in management.

He told the peers it was “no secret that the case of Southern Water and its particularly poor performance on pollution and misreporting” had seen fines and penalties from Ofwat of over £127 million, together with £90 million from the courts from Environment Agency action.

When Ofwat had then looked to the company to turn itself around and to enter a transformation process, the then shareholders were “not willing or able to put in extra funding” and had ultimately exited as controlling shareholders and a new shareholder had entered.

In response to the Chair’s question of whether the powers currently in place were sufficient deterrent to the companies against persistent bad behaviour, David Black reiterated that there was now “very serious challenge to companies and their investors” from the penalties that are being imposed by both Ofwat and the Environment Agency and that it was now “getting very painful for shareholders.” Ofwat was seeing changes, and now arrangements, that imposed significant costs on shareholders, loss of value and, ultimately, the ability to exit shareholders and enter new investors.

He rejected a suggestion by Lord Reay that the Committee had heard “quite a bit of evidence” that, in the past, Ofwat had tended to prioritise keeping bills low, which had been achieved relatively successfully, but at “the expense of adequate investment in the sector’s infrastructure assets.”

Photo: Ofwat CEO David Black

Pointing to the 2019 price review, the Ofwat CEO said he did not think it was right to “characterise Ofwat’s focus as being on low bills” and “as holding back bill increases in previous price reviews”, adding that Ofwat had not rejected “a single scheme on the grounds of affordability.”

Acknowledging that bills had fallen in recent price reviews due to the fall in allowed returns, with lower returns for shareholders, he added:

“ We think that is absolutely right, but it was not at the expense of investment…”

“At recent price reviews, there has not been a need to constrain investment plans for affordability or other reasons. It may be that, looking ahead, significant increases in investment will be required.”

In the context of work being done by the Storm Overflows Taskforce, Black said “substantial new investment is required, which may well impact on bills.”

Ofwat Chair Ian Coucher supported this, saying Ofwat had not "refused any requests to fund” and had never said, “You should not invest”.

Photo: Ofwat Chair Ian Coucher 

The Committee went on to ask the Ofwat bosses what percentage increase in investment could be expected at the 2024 price review, relative to PR19, in order to “rectify the problems caused by lack of historical investment in infrastructure. “

Both David Black and Ian Coucher declined to comment on what the scale of investment would be, confining themselves to referring instead to the figure of £54 billion over 25 years mentioned in the Government’s storm overflows plan which would “in itself be a doubling, roughly, of the level of environmental spend.”

However, that would “certainly not the limit of environmental spend” and there would be “more on top of that because it is only one of the environmental issues facing the sector.”

Commenting on sewage discharges, Iain Coucher told the Committee that the water industry’s use of storm overflows was “clearly wrong” and the water companies had been allowed “to use this overflow mechanism for many years, polluting rivers.”

Lord Eatwell - this is an industry that has been characterised by significant underinvestment

Lord Eatwell intervened, describing David Black’s comment “we are not sure what the level of investment will be” as “a remarkably passive position” and asking whether Ofwat did not have a view on what the volume of investment should be.

The peer commented:

“After all, this is an industry that has been characterised by significant underinvestment. That has got us into the mess we are in right now. Is it that you do not have the powers to say what the level of investment should be, or is it that you are simply not doing that?”

David Black explained that at this stage Ofwat did not know what the level of investment would be and had not yet seen a business plan from a company.

Iain Coucher said Ofwat did in fact have “some very good ideas about what investment plans will be going forward” , but they were only estimates. Instead the regulator wanted the water companies to come forward and say, “This is what we believe the cost of a new reservoir or a new connection would be, or what the cost of addressing our share of the storm overflows will be”.

Lord Burns – “everyone we have seen has implied that there is a long-term problem of investment in the industry”

Lord Burns persisted with the question of under-investment, saying:

“You said that you have not turned down any investment projects, yet almost everybody thinks that, in hindsight, there has been underinvestment in the water industry. How can we put those two conflicting views together?….

“Everyone we have seen and who has come before us has implied that there is a long-term problem of investment in the industry and that, ideally, we would not be starting from where we are today. How do you get consistency between that view and your view that you have not turned down any projects?”

Referring to the storm overflows issue, Black said that setting it alongside other environmental issues, it will mean “a significant step-up in investment.”

He continued:

“The question is whether those investments should have been made before. There were no proposals to make that level of investment historically. The focus was on targeted improvements, and improvements were made.”

The Ofwat Chief went on to suggest that lack of available data was the key missing information, saying that the sector had been “very slow to identify the early signs that more investment needs to be made” and “did not have information on the extent of the use of overflows.” The new data had now revealed that “there is a need for a major step-up in investments, which will now take place.”

He commented:

“…We agree that there needs to be a major step-up in investment and that that was not scoped in the past, but it was not because Ofwat looked at an investment proposition and said, “No, don’t do that”. It was because the investment proposition was not sent.”

David Black said investment post privatisation was very much about reducing nutrients going into rivers from wastewater treatment works, where quite major reductions were made, and about bathing waters, with a focus on beaches. There was relatively little focus on rivers – which is “very clearly where the focus is now.”

Ofwat CEO – “where water companies have fallen short, it should be their shareholders who fund the improvements”

Lord Cromwell pressed home the question of whether the water companies and Ofwat were “really not aware that there were pollution issues before the monitoring was put in place.”

“The issue of storm overflows was known about, but the extent of the issue was not known. Clearly, there were concerns about it,” Black said.

Describing himself as “very keen” that Ofwat should push companies to address the issues, the Ofwat CEO said that “where they have fallen short, it should be their shareholders who fund the improvements” and that “where they go above and beyond what are industry standards now, that should fall to the customers.”

Iain Coucher commented that the water sector “absolutely needs longer-term planning” and that for some of the large-scale investment schemes tackling storm overflows, which are multi-billion pound and multi-AMP and multi-periodic reviews and timescales, the investment in new reservoirs, water management schemes and drainage plans are all things that would take more than five years and cover multiple control periods.

In reply to Baroness Bowles of Berkhamsted’s query whether this meant that the strategic significant infrastructure project should run on a timeline that is outside the price review process. David Black said that might well be the approach, citing the 10-year price control for the new Havant Thicket reservoir Ofwat set at the last price review.

Step-up in major infrastructure projects would impact Ofwat’s own workload

He went on to explain that the water sector was going to see a major step-up in major infrastructure projects.

In contrast to investments made in previous price reviews in relatively smaller-scale projects: £10 million, £20 million or £50 million, looking ahead, there would be projects that are billions of pounds, which would require new skills and new capacity to manage.

They would also raise different issues as a regulator which would be a step-up in scale and volume which would impact on Ofwat’s own work, requiring Ofwat to be resourced to deliver against that.

Special purpose vehicles and direct procurement model are the way forward

Baroness McGregor-Smith raised the issue of how any of the water companies could take on huge, major projects over the next few years if their entire focus was on basic turnaround.

David Black replied that in Ofwat’s view special purpose vehicles were the right way to go and the reason Ofwat had developed the direct procurement model. Ofwat was also keen to see the expansion of the Thames Tideway model, which has a licence that could then be applied to the new investment.

“You are quite right that a lot of this will probably happen outside the existing company boundaries,” he added.

Iain Coucher said that under direct procurement for customers a package of work would be put out which would have to be significant—e.g. a new reservoir or a new connection. He explained:

“They are billions of pounds and we will create SPVs to create and own those, and to fund them. That is a big part of our programme going forward. We will get new entrants and new competition in there.”

Ofwat would like to see greater powers to deal with under-performing companies

Baroness Donaghy referred to a suggestion by some witnesses that “criminal fines are seen by water companies as a normal part of their business rather than a real disincentive.”

Iain Coucher said that Ofwat’s view was that it would like to see greater powers to “debar directors from companies that are egregiously and continually poorly performing” and “not allow them to be company directors any more.”

Commenting on whether Ofwat should be more proactive in using special administration powers to change the ownership of water companies that fail the environment, David Black said Ofwat had “certainly used the threat of those powers to achieve changes at companies” and would use the powers if it saw the need to do so.

Black also said the proposal that water companies should have to compete for licences over a certain period in order to drive improved performance was “certainly an idea worth considering” although there were both upsides and downsides. There was a problem with monopoly companies not facing sufficient challenge and it was “very hard to replicate some of the disciplines that a competitive market would bring to the behaviour of companies.”

Questions over water company ownership

Lord Sharkey referred to the issue of ownership of the water companies, commenting:

“Macquarie was a highly unsatisfactory owner of Thames Water and is now a dramatically underperforming owner of Southern. Can you explain why Macquarie was awarded the Southern franchise?”

David Black said the reason why Ofwat was “not uncomfortable with the proposal” was that Ofwat had changed the regime since Macquarie owned Thames. “We think we have built additional protections into the regime to stop the kind of behaviour that we saw at Thames and the poor performance there”, he added.

With regard to the £1 billion Macquarie had injected into Southern Water, Lord Sharkey asked how much of that was used for investment and how much was used to repay debt throughout the financial structure. Baroness Bowles of Berkhamsted separately suggested that of the £1 billion Macquarie had put into Southern Water, “three-quarters of that seemed to disappear out again in dividends.”

“How can high levels of dividends and executive pay be justified when the environmental performance is so poor?” she asked.

David Black said that of the £1 billion, £500 million went into the regulated company and £500 million into the holding company to restructure its finances, with around £280 million used in the company’s transformation plan. Saying that Macquarie is “up for whatever it takes” to turn round the organisation, which requires serious transformation, Black added:

“It is no secret that we are very unhappy with the performance of Southern. It is failing on most of its performance commitments. It is also failing to invest at the pace that we would like to see to provide for the future. It is a company in serious difficulties, and it requires very serious work to turn that organisation round.”

Lord Sharkey told the Ofwat Chief:

“You probably understand that it seems very strange that such a dramatically underperforming owner of Thames Water can arrange things so that it becomes a dramatically underperforming owner of Southern Water.”

Lord Cromwell - huge scale of investment needed – will the public purse be involved?

Returning to investment, Lord Cromwell said that to maintain and increase the water supply and deal with the more overt environmental aspects would “clearly require a huge scale of investment” and that he was “still groping for a date when it all comes together.”

He inquired whether the private sector would be able to raise “these sorts of eye-watering sums”, or would the public purse be involved and, if so, in what proportion.

David Black explained that ultimately, the costs would be be financed by investors paid for by customers over the next 30 to 50 years and the sector was “seen as attractive for investors.”

There had been no problem to date in raising capital, and he did not think there is an issue with the level of capital that needs to be raised. Ofwat was seeing “strong signs of keenness for people to invest” and from their perspective, investors were “looking at the prospects for return and certainty about the level of return.”

“What comes across, maybe unfairly, is that Ofwat is a much more passive regulator”

Lord Blackwell made the point that a number of the Committee had experience working with or on the boards of other regulators, saying:

“What comes across, maybe unfairly, is that Ofwat is a much more passive regulator in the way you describe the investment process. The businesses put forward their plans; you review them, and you have not stopped them investing in anything. What I am missing is the notion that you have a vision of what is required to take the industry forward and that you are pressurising, compelling or requiring the companies to come up with that investment.”

David Black commented:

“We have been willing to play a more active role. I have pointed to the water resource situation, where we stepped in to require companies to develop 18 new strategic resources.”

However, he accepted that Ofwat had been “less active in the environmental space”, partly because it had been a working arrangement with the Environment Agency and that Ofwat’s approach had been more about requiring companies to meet the standards as set by the Environment Agency.

In hindsight, he conceded that Ofwat could have been more actively involved, which is why the regulator was now looking at how it could further deploy the RAPID model. He categorised PR19 as having reached and set challenging performance targets right across the business for water supply interruptions, leakage and reducing pollution incidents which had had an effect.

In the last five-year control period, pollution incidents were reduced by 36% as a result of challenging companies and incentivising them to do that, something Black said he was “very keen” to do more of.

Iain Coucher - "we do not want to shift the industry from an underperforming level to a new level of mediocrity"

Referring to the publication of Ofwat’s final PR24 methodology for the water companies which will go out in December, Iain Coucher commented:

“We do not want to miss this opportunity to make a step change in performance. Whatever we do now affects the delivery of water companies into 2030. Let’s get it right now. We really do not want to shift the industry from an underperforming level to a new level of mediocrity; we have to be more ambitious than that.”

Baroness Bowles raised the issue of companies’ poor performance and linkage to water companies’ finance, saying “we have heard that they are becoming increasingly leveraged in order to pay out dividends to shareholders.”

David Black told the Committee that Ofwat was concerned about financial resilience — the level of gearing in companies. While progress has been made, Ofwat was none the less concerned that the licence in the sector is still too permissive and that it does not set stringent enough standards of financial resilience.

He explained that the regulator had consulted on a set of licence changes that would basically give Ofwat power to lock money into a company if its credit rating fell to a level deemed insufficient for a water company.

Ofwat also has the power to take enforcement action when companies do not align dividends to their performance – which he described as a change which “has been fiercely resisted by companies.” The regulator would “see whether they choose to refer those licence conditions to the CMA” he said and Ofwat was “in that process with them at present.”

Responding on executive pay, Black said he “could not agree more” adding:

“It is really concerning, given the current environment and the storm of criticism that companies faced over the summer, that they have not yet been more responsible in linking executive pay to performance…

“As as a regulator we are quite clear that it is company boards and remuneration committees that need to take responsibility for making those decisions. It is not for us, as a regulator, to micromanage executive pay, but they ought to be able to demonstrate that it is linked to their performance and, to date, they have not done so.”

Baroness Bowles said the Committee had been told that private equity was often behind the increasing debt and dividends. “Some people have suggested that one way around that would be to make the licence conditional on all water companies being listed on the Stock Exchange, with at least 25% of shares traded publicly,” she said.

David Black agreed that this would have twofold benefits - minimum requirements about Board governance and the additional scrutiny that analysts bring when a company is listed.

However, he cautioned that it would be “wrong to pretend that listed companies” are the answer to the problem. Pointing out that South West Water is listed by the Pennon Group, he said Ofwat had “real concerns about their poor environmental performance, so being listed does not guarantee good performance.”

Lord Reay referred to an article in the Financial Times about Yorkshire Water which suggested that if pension liabilities and derivatives in the water company’s were included its gearing ratio, this reached over 100%, “which seems very high.”

The Ofwat CEO said there were particular issues with derivatives that Yorkshire Water had entered into and “a very unwise— at least in hindsight—set of swaps back in 2011 which turned out very badly for it.” This had led to the additional 30% of gearing.

“I am pleased with the resolution of the enforcement action that we took against it and that it is injecting £900 million into the company,” he added.

The Committee Chair asked whether Ofwat was in the uncomfortable position of having to take what is essentially a political decision about a trade-off between price and investment levels.

Iain Coucher said Ofwat’s role was to make sure that schemes which had been signed off by the EA and the Government, are delivered cost effectively and efficiently by the organisations, adding, “it is not our role to challenge whether they are necessarily the right or wrong things to do.”

However, he cautioned that the future will see significantly more investment in the environment which “may well cause the Government to get involved in decision-making or balancing between investment and bill payers.”