Unloved but worth holding
Consumers may be irritated by the performance of water utilities, says Alex Brummer, but their solidity and growth potential make them sound investments
A couple of years ago, while on holiday in Mallorca, I was disturbed to find that NatWest had decided that my credit risk was so great that no more euros would be allowed from the Spanish hole in the wall. When I contacted the bank, it was revealed that during our three-week absence from Blighty, the utility Thames Water had decided, without consultation, to remove more than £6,000 from my account by direct debit.
This might have seemed reasonable if I ran a car wash, a market garden or a brewery, but for your average suburban home in Richmond it seemed a trifle excessive. Had I been a pensioner or someone with a weak heart, receipt of the world’s largest private water bill might have been enough to send me to A&E. As a financial journalist, I was able to go straight to the top at Thames Water (then being sold by the German utility RWE) to uncover the source of the mystery bill – a leak between the road and our metered house – and the cash and my credit rating were restored.
As a consumer, it is difficult to have much sympathy with the British water industry. In a country where the rain never seems to stop, at the first sign of a heat wave we are asked not to flush the toilets and to drink bath water, or some other nonsense. To add insult to industry, we learn that the very same Thames Water, which is currently in overdrive replacing Victorian pipes across London, has an appalling leakage record. Meanwhile, a publicly quoted utility, Severn Trent, is ordered by its regulator Ofwat to pay a fine of £35.8 million for providing false returns for leakage to the authorities and offering poor customer service.
Yet despite the terrible reputation with the consumer and the clampdown on leakages and billing errors by the regulator, investment in water remains an attractive proposition both here in Britain and around the world. In Britain’s sophisticated privatised water industry the four main UK-quoted firms United Utilities, Northumbrian Water, Pennon Group and Severn Trent, have remained a sea of calm amid the stock-market carnage associated with the credit crunch. They are particularly attractive defensive stocks in the current climate because of the regular and predictable cash flow. This has also made private water companies attractive to private equity. The Australian bank Macquarie snapped up troubled Thames Water for £8 billion in 2006, after the German electricity utility RWE decided the poor publicity associated with running Thames made it an investment too far.
However, the difficulties of the regulatory environment for Britain’s water utilities (of which more later) should not be allowed to distract interest from the potential of the industry both in the Western economies and worldwide. Population growth in the emerging markets (and nations like Britain which have been boosted by immigration) means that water is an expanding and undeveloped industry, with the demand for clean, pure water growing all the time.
Steven Goldin, a vice-president at Standard & Poor’s, recently noted: ‘What infrastructure and water have in common is that both participate in global growth and an underlying demand for natural resources. These are long-term assets generating lots of cash flow, so are very stable from that perspective.’
Britain, as in many other areas, has been among the pioneers in water privatisation. But, as Katrina Manson writes on page 30, it is still in its infancy globally. It is estimated that at present, only 10 per cent of the world’s population is serviced by private companies, which gives some idea of the potential scope for the industry including those – like some of the UK companies – which have the skills to bolster income by selling their expertise overseas.
In the immediate future, Europe would seem to have great potential with just 34 per cent of the population currently served by the private sector. Pressures on domestic budgets mean that governments and municipalities can be expected to offload water assets as they seek to shrink the size of the public sector and raise money to pay down debt at the same time.
Macquarie, whose infrastructure funds have shown how assets of all kinds, from toll roads in France to bridges, can be turned into milch cows, is one of the more enthusiastic investors in water assets. Investment can be accessed through the CF Macquarie Global Infrastructure Securities Fund. At the moment it believes the best opportunities are in Western economies because of the tendency of emerging markets to hold tariffs low through subsidisation.
In the Western economies, water can be a good hedge against inflation, since tariffs respond to overall price levels. Water is a secure investment during economic hard times and also a necessity. For those investors concerned about the degree of government interference and regulatory risk, Britain’s water sector provides insight into the potential pitfalls of the industry as an investment. Among the main reasons for cutting water free from government budgets was to remove responsibility from government for a huge investment programme in modernising Victorian drains, cleaning up polluted beaches and rivers and developing a more sophisticated water grid. The idea was to switch infrastructure investment from the public to the private sector. It is the requirement for capital expenditure to meet leakage and pollution targets which creates concern about regulatory risk.
The prospects for British water investors over the next few years will be decided between now and next year when the 2010-15 settlement will be reached. The regulator Ofwat has made it clear that the allowed returns will be considerably below the 5.1 per cent granted in the last price review. The companies have submitted their requests. Dwr Cymru, the former Welsh water company, now a mutual funded by debt, argues it will be possible to improve water supply to their customers at the same time as lowering average bills in real terms.
Severn Trent claims that it will be able to reduce the cost of waste water services. Other suppliers have asked the regulator for price caps that give them flexibility in the early years, allowing them to raise prices to twice the level of the retail prices index. Given, however, what has been happening among the energy utilities – where prices have been climbing by 30 to 40 per cent – the rises in water prices could seem modest.
Certainly, the regulator Ofwat, which itself has been the subject of extensive criticism for being too soft on its charges, is likely to be more aggressive with the companies in the current price round. In the submissions made, Pennon, owner of South West Water, has come in lowest, asking for a rate of return of 4.6 per cent. At the other end of the scale, Severn Trent is demanding 4.94 per cent. In their submissions, all of the companies have cited the need for a generous settlement because of higher energy costs and the need to increase maintenance and capital expenditure. Overall, the industry estimates capital costs of £25.5 billion in the five years from 2010-15, against £20 billion in the current period.
Under the draft business plans submitted by the industry, aggregate bills for consumers would likely rise by 1.6 per cent, after inflation, for most of the companies. Thames and Southern, with their need to cure leakages, are asking for more. The quoted water companies are projecting more modest rises.
Ofwat is certain to tighten up the plans. But it will be anxious not to decrease the scope for more capital investment. So there will be a focus on lower unit costs, more efficiency and reducing the cost of capital. It is even possible for those companies with lesser capital expenditure needs that there could even be real price cuts ahead. The review will also have to take note of the green agenda demanded in Whitehall and by the consumer too.
Ofwat has been told by Government that it must reduce its greenhouse emissions, which are estimated at around one per cent of the national total. In particular, this will have to be taken into account when setting leakage targets.
The industry is also under pressure to encourage greater water conservation. This is particularly true in the south east of England, which despite two drenching summers, is still classified by the OECD as being in the same bracket as the Sahara. As far as the companies are concerned, metering is not necessarily to the advantage of their bottom line. Evidence suggests that when people control their own water consumption through metering, they are much more cautious about wasting a valuable commodity.
Clearly, direct investment in UK water companies faces a variety of regulatory risks. But as unpopular as price increases are, Ofwat does recognise the need for balance between the green and leakage agenda and the requirement that companies make reasonable returns.
Water investment has been deeply unfashionable in Britain because of the consumer backlash from the drought years. Yet a time when banks and consumer companies are being rocked by the crunch and economic recession, water – an essential not easily cut back on – looks like a relatively safe and reliable investment at home. Internationally, it could even become a growth industry. As a saver, the best way to access the upside could be through infrastructure funds with a decent water weighting. But it may be a long haul.
Alex Brummer is City editor of the Daily Mail