Making the most of liquid assets

While they consider re-structuring, diversification and overseas investment to arrest falling profits, British water companies are vulnerable to international takeovers says Chris Webb

Water chiefs are worried. A crisis on the scale of that affecting the rail network is inevitable unless both government and regulator heed calls for an immediate strategic review. That was the message from Kelda's chief executive John Napier late last year. The comments came as he announced interim results which have seen pre-tax profits fall by a third on generally flat sales of £349M, to £81M.

Tough conditions
Kelda is not alone. In addition to an investment regime which prevents inter-regional consolidation, water companies have had to shoulder the capital cost burden associated with automatic meter take-up - coupled with lower than expected income as a result - and major flooding which has highlighted the state of much of the nation's sewerage. Faced with falling domestic profits, some UK firms are seeking to bolster performance with international acquisitions. Towards the end of 2000 for example, Thames Water announced the acquisition of E'town Corporation, marking the beginning of its water supply operations in the US. The deal will take the form of a merger, with E'town becoming an indirect wholly-owned subsidiary of Thames.

Many in the water industry saw the November 1999 price determination, which reduced prices by 14.5%, as the final straw; a further plunge in the downward profit spiral. Add to this the aforementioned problems and it is easy to see why the boardrooms are pessimistic. The situation has led Napier to speculate: "What sort of industry will we have at the end [of the regulatory period]? A business driven into the ground where we are close to breaking our banking and borrowing covenants?" The need for major restructuring is clearly high on the agenda.

The fear is that denied the freedom to consolidate, UK firms will be easy prey to foreign investors. RWE has snapped up Thames, the German company's biggest rival E.On - formed from the merger of German utility giants Viag and Veba - has indicated its intention to buy foreign water assets, and Suez Lyonnaise des Eaux is similarly acquisitive.

Kelda has been trying as hard as most other UK groups with water interests to remain profitable. The company has acted fast to cut costs, shedding 500 jobs in the process. Kelda also expects to raise up to £130M from the sale of its non-regulated businesses. US water acquisition, Aquarion, and better performance from Waste Recycling Group, its associated company, helped boost interim figures.

Although Kelda's first proposals for restructuring its water business into separate asset and operating companies did not meet with regulatory approval, they helped to focus both government and regulator on the long-term issues facing the water industry, particularly the need to raise the significant capital sums required at the lowest cost of borrowing. In the wake of the 'not for profit' ownership structure proposed for Welsh Water there seems to be more regulatory sensitivity to and acceptance of the links between capital and equity markets in the UK.

Further evidence of the need for change was signalled by Thames' decision to go ahead with the RWE deal. Such companies enjoy a more stable long-term commercial environment, are allowed more attractive rates of return, can more easily finance investment and have the financial muscle to take the longer-term view.

According to Napier: "There is increasing recognition that the combination of historic privatisation structures, inappropriate 'one size fits all' models of competition and a punitive interventionist regulatory approach does not, in the long-term, best serve the interests of the consumer, the industry or the wider environment." His belief is that there is an imperative for an agreed long-term strategic view of the water industry with acceptance of the need for more commercial, stable, balanced and cohesive relations with all stakeholders.

In July 2000, when Kelda announced its mutuality plan Napier said: "We believe that a new structure is required if the industry is to be able to fund its long term capital investment programmes at the lowest cost whilst delivering upon its commitment to improved customer service."

Alternative proposals
Despite Napier's enthusiasm, mutuality was not universally welcomed. At the time, Lehman Brothers analyst Rebecca Reehal commented: "There are other ways of doing this, there may be some equity solutions. It is not clear that to bring about goals such as asset value transparency and shareholder flexibility you have to go for a mutual solution for the asset company." And Water Watch's Peter Bowler warned that having realised they could not match former profits Kelda had decided to: "Keep the operational business, while the client takes the risk and hassle, and they dress it up to look like they are doing the client a favour."

Pamela Taylor, Water UK's chief executive, said she did not believe mutuality was the way forward for the industry as a whole, saying it was "Okay for a few." A more critical line was taken by Enviro-Logic's Jeremy Bryan, who said Kelda was: "throwing in the towel, saying it is too difficult to make money."

More recently Severn Trent and United Utilities, which owns North West Water, announced that despite falling profits they would not pursue the mutual option. Respectively, they cited expansion into international environmental services and a multi-utility approach as the way forward.

Former regulator, Sir Ian Byatt, blocked Kelda's plans to sell Yorkshire Water's assets to a debt-financed mutual company owned by customers. His successor, Philip Fletcher, has largely supported the decision, but industry chiefs are beginning to see a softening of Mr Fletcher's stance.

Fletcher has not ruled out, in principle, the proposal by Glas Cymru to turn Dwr Cymru (Welsh Water) into a mutual company. The plan would see Dwr Cymru pass to a company limited by guarantee, owned and controlled by members. The members would not receive dividends or have any other financial interest in the company and there would be no shareholders. Glas Cymru would own the assets of Dwr Cymru but employ contractors to run them.

Fletcher has said: "My preliminary view is that the Glas ownership model does not, on balance, give rise to any insurmountable issues," although he added: "The current shareholder-owned model has worked well. It is delivering efficiency gains for the benefit of customers and shareholders whilst the water companies have been carrying out a massive capital expenditure programme."

Whether or not the regulator will open the gates for water companies to 'go mutual', may well depend on the government, and this is where the rail analogy comes in again. It is a matter of debate as to whether splitting the railway into the track owners and train operators has been the cause of its present woes, but the wisdom of rail privatisation has come under renewed scrutiny and deputy prime minister John Prescott, is unlikely to rush to endorse what is essentially a similar restructuring of the water industry.

Seeking mutual approval

During the consultation process on the Kelda proposal Ofwat set out a framework for assessing new structures for water companies. This led to stakeholder's opinions being sought on the following during the Glas Cymru consultation:

  • without sharholder pressure, do the proposals provide enough incentives for efficiency?
  • what benefits are offered to customers and are they protected from any new risks should the company run into difficulties?
  • can Dwr Cymru's management ensure environmental protection and drinking water quality in the light of its proposals to out-source the operations?
  • do the plans ensure the Drinking Water Inspectorate and Environment Agency can still regulate the company effectively if it fails to meet its obligations?
  • will the members of Glas Cymru have sufficient incentives to hold the board of Dwr Cymru to account, and not be "captured" by particular interest groups?
  • do the proposals include adequate consumer consultation given the new model of company proposed?
  • is the board of Glas Cymru fully independent of Hyder plc and WPD?


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