Water industry regulator Ofwat has published the final principles on Board leadership, transparency and governance it expects companies operating in the water sector in England and Wales to adhere to, together with a separate set of proposed principles for their ultimate holding company owners.

However, while the principles set out Ofwat’s minimum expectations, the regulator is looking to the water companies to adopt a self-regulatory approach where the companies’ Boards take the lead in setting out how they meet or exceed the principles. Ofwat’s expectation is that some Boards “will wish to adopt standards that exceed these principles.”

Introducing the principles, Ofwat said:

“We have adopted this approach as it means that ownership of Board leadership and governance rests where it should………We are giving companies greater ownership and accountability by placing less emphasis on simply meeting regulatory requirements and by moving to a less intrusive regulatory approach. Implicit in this is the expectation that companies are operating to high standards of Board leadership and governance.”

The existing conditions in the water companies’ licences which cover these issues have largely remained unchanged since they were put in place in the late 1990s.

Ofwat said that since the obligations were introduced the world of corporate governance has changed and the standards that apply have been tightened in the wake of significant failures in some markets. In addition, there is now greater focus in the media and elsewhere on the Board leadership and governance of individual companies.

The Ofwat principles for the water companies are:

• Transparency – reporting must meet or exceed the standards set out in the Disclosure and Transparency Rules
• The regulated company must act as if it is a separate public listed company
• An effective Board is fully focused on the regulated company’s obligations
• There must be significant independent representation on the Board Independent non-executive directors are essential to securing strong Board leadership and governance In line with best practice, boards should have the appropriate balance of skills, experience, independence and knowledge of the company
• The Chair must be independent of management and investors
• Board committees, including but not limited to audit and remuneration committees will operate at the regulated company level
• There should be a majority of independent members on the audit and remuneration committees
• The group structure must be explained in a way that is clear and simple to understand

Small companies – the new appointments created since privatisation and one pre-existing small company – are not currently expected to apply the principles. However, Ofwat said “it would be good practice for them to have regard to the principles where relevant.”

Following consultation in September 2013, the companies themselves have told the regulator that they will have codes covering the principles in place by April 2014 and will be meeting the principles by April 2015.

Timetable until 2017

Ofwat has set out the following timetable for adoption of the principles:

By 1 April 2014- all companies expected to share their codes with Ofwat, including any steps they need to take to fully meet the principles by 1 April 2015.

April 2014- Ofwat will examine companies’ codes - expected tofully meet the principles.

By 1 April 2015- all companies expected to have a code in place and be in compliance with their code.

July to September 2015 - Ofwat will consider approach taken to confirm that companies are implementing their codes – which could potentially be a statement from the Board, as part of the regulatoryaccounts.

2015-16- Review with companies whether the relevant licence obligations remain fit for purpose. Pursue modifications where necessary e.g. where a company is not meeting the principles.

January 2017- Review the content and coverage of the principles to make sure that they continue to be fit for purpose.

Transparency – left to Boards to consider how best to demonstrate

On transparency, Ofwat said it is for Boards to consider how best to demonstrate how they meet the principles. The regulator is also expect reporting to reflect material issues, typically including:

• group structure;
• company performance; and
• the key risks to the business.

Ofwat will expect the companies to ensure that the information is accessible to the appropriate audiences but says it will be for companies to determine the best means of making this information transparent.

Independent Chair is a pre-requisite

The principles also require an independent Chair – which should be independent of both investors and management – regarded by Ofwat as particularly important in a consortium where individual investors may be remote and where shareholder composition can change on an ongoing basis.

The regulator said there should be an explicit division of responsibilities between running the Board and executive responsibility for running the business and that consequently, the Chair should not be the CEO “as they would be unable to bring the same impartiality or lack of preconception as a truly independent Chair.”

In Ofwat’s view, an independent Chair will allow the company to demonstrate that the Board perceptibly acts "independently and exclusively" in the interests of the regulated company.

Regulated company to be in full control of business – not the holding company

On ownership, Ofwat expects the Board of the regulated company to have full control of the business, not its ultimate holding company and to have the powers necessary to make strategic and sustainable decisions in the interests of the company for the long term. The regulator wants it to be clear to stakeholders that the Board of the regulated company is leading the company, both in terms of accountability and legitimacy.

It also wants Boards that are equipped to balance the conflicting needs of customers, the environment, the business and shareholders. Independent directors (including the independent Chair) should be the largest single group on the Board, compared with executive directors and non-executive directors who are not independent.

While the regulator acknowledges that investors (who own the business) have a legitimate place on the Board of the regulated company, the principles also state that the number of investor representatives should be no greater than the number of independents.

Under the principles, Board committees will also be required to operate at the regulated company level to ensure that the focus is“fully aligned with the aims and needs of that company, not the holding company.” The water companies will also be expected to explain the structure of the group within which the company sits clearly and unambiguously. Under the principles,

“Customers can expect to know how the group which contains their company is structured, especially as the corporate structure for some groups is complex.”

Holding company principles kept to a minimum

Introducing the principles it has set out for holding companies, Ofwat said:

“ We have deliberately sought to limit the coverage of these principles to those areas where we consider that the activities of the holding company could impact on the regulated company’s ability to meet its obligations.”…”These principles are inter-linked and complement those we have set out for the regulated company. The latter have been accepted by all water companies and this has allowed us to keep the holding company principles to a minimum.”

The principles underline Ofwat’s expectation that the regulated company Board is composed in such a way that the directors are able to act independently of the parent company, emphasising that where potential conflicts exist between the interests of the regulated company and those of other group companies (including holding companies), the regulated company and its directors must ensure that they “should have regard exclusively to the interests of the regulated company.”

While Ofwat says the series of principles should apply as a minimum to any company operating in this sector, as with the regulated company principles, the holding companies will be expected to adopt a self-regulatory approach and meet the final principles by 1 April 2015. Ofwat said:

“The regulated company principles put the onus on the regulated company to demonstrate certain behaviours in relation to its interaction with its holding company.But we recognise that for the regulated company to operate to the highest standards, the holding company needs to do so too.”

Nevertheless, Ofwat acknowledges that “investors have a clear and legitimate role to play in running the business of the regulated company through the holding company.”

“ …a set of principles which each holding company may consider adopting voluntarily”

Ofwat describes the principles as “a set of principles which each holding company may consider adopting voluntarily in order to demonstrate that it is operating to the highest standards in relation to the interactions it has with the regulated company.”

However, Ofwat said that the new principles do not place requirements on a holding company that are “any more onerous than what is currently implied by the undertakings which a regulated company is required to secure from the ultimate controller.”

On transparency, risk and long-term decision making, again the regulator is looking for a self-regulatory approach, taking the view that the holding company, together with the regulated company, can decide how best to make the disclosures required by Ofwat. The principles state:

“a leading company may choose to set out clearly in a code how it meets our principles. Where a holding company does not meet a principle which we have set out, it may instead choose to provide an explanation of why that is the case and the approach that it has taken to meeting the spirit of the proposals.”

Holding company structure – must be transparent and identify ultimate owner

The proposed principles say that the holding company structure should be transparent, and explained in a way that is clear and simple to understand – including where ownership and accountability lies. It should also explain who has an economic interest in the business and make clear which company is the ultimate holding company. Any areas that lack clarity should be explained.

Ofwat also wants the role of each of the companies that have links or interests in the regulated company within the group structure to be explained clearly, including a description of the interaction between the holding company and the regulated company and  which country each company is registered in. There should also be no hidden beneficiaries of the regulated company within the structure – the investors in the holding company should be set outclearly.

The holding company should provide information on debt and equity structures in an accessible way to make its debt and equity structures transparent and explain where and why it has considered it necessary to exclude any information (for example, for reasons of commercial confidentiality). Ofwat also expects the holding company to manage its risks in such a way that the regulated company is protected from risk elsewhere in the group to ensure customers are not subject to service or cost issues as a result.

The regulated company should also have access to the information that it needs about the wider group to assure itself that it is not at risk from activities elsewhere within the group. This includes a clear understanding and visibility of matters such as the:

• shareholder agreement;
• financing, strategy and management of the wider group; and
• the potential for this to impact on the regulated company.

The principles also stipulate that the holding company should allow the Board of the regulated company to run the business as if it is a separate, public limited company.

Decisions should be made in interests of the regulated business for the long term

The holding company should also make sure that the Board of the regulated company is provided with the support necessary to make strategic and sustainable decisions in the interests of the regulated business for the long term – although no guidance is given on what this is likely to consist of.

The principles have thrown up some interesting pointers on how the regulator is developing its thinking on governance – of increasing importance in the run-up to competition. Ofwat is now treading a careful line in how it regulates the sector. On the one hand its stated aim is to adopt a light touch /hands-off approach. At the same time it is also under pressure to be seen to be tough on water companies who are perceived to not be acting in the best interest of consumers.

What is not clear at this stage is how Ofwat intends to monitor the effectiveness of the principles or  what sanctions it will bring to bear- beyond requiring self-verification via statements made by the Boards themselves.

Ofwat is now consulting on the principles it is proposing for the holding companies – deadline for submission of responses is 7^th March.

Whether Ofwat is correct in its assumption that the principles will “allow existing and potential investors to understand the expectations of those investing in a monopoly public service company” remains to be seen.

Click here to download Ofwat’s principles for the regulated water companies.

Click here to download Ofwat’s proposed principles for holding companies