Changing face of water utilities

Chris Webb reviews the likelihood of UK water industry reform, as regulatory constraints limit water companies' competitiveness in the global market and credit profiles weaken

Britain’s water utilities could fall into foreign hands in less than five years

due to unfair domestic regulatory constraints that are undermining competitiveness.

That is the verdict of a report by the Chartered Institute of Marketing, which

slams the haste with which the UK has deregulated its utility markets, exposing

domestic water businesses to overseas predators. At the same time, government

controls in France and Germany prevent any reciprocity which would allow British

utilities to expand into their continental markets.

No southern comfort

November was a nerve-racking month for Scottish Power, whose planned sale of

its Southern Water subsidiary hung by a thread. Italian power company Enel had

already withdrawn an offer to acquire Southern, which the firm had seen as an

alternative to the difficult acquisition of Acquedotto Pugliese, but said the

£1.8Bn deal was too big to swallow. The path is now clear for Centrica,

in alliance with Vivendi of France.

There were fears, however, the two may find it difficult to secure regulatory

clearances, while Scottish Power may have difficulty raising the £1.7Bn

it wants from the sale. It paid £1.68Bn for Southern in 1996.

There is generally anxiety and dismay among water companies who feel their

hands are tightly bound when it comes to any prospect of organic growth. As

a result, Standard & Poor’s (S&P) believe the UK water industry could

be entering its first major wave of reform since privatisation. S&P has

been reviewing a number of restructuring proposals, ranging from simply gearing

up balance sheets, to splitting assets ownership from operations, to a full

demerger of the asset company from operations. One of the main drivers for restructuring,

S&P believes, is that since privatisation, most operating and capital efficiencies

have been fully realised.

So what might the sector look like after the reforms are complete? The short

answer is that it may never be complete, although there are some likely outcomes.

It is not difficult to see why disaffection among shareholders is on the rise.

All ten water and sewerage companies started life after privatisation as stock

exchange listed holding companies owning 100% of shares in the regulated utility

company. Starting with virtually debt-free balance sheets they proceeded to

spend billions of Euros on capital investment, primarily owing to the water

and wastewater quality requirements imposed by various European Union directives.

While the quality of water and wastewater has generally improved, however, the

companies’ credit profiles have weakened, and credit ratings have suffered because

of higher debt and gearing levels.

Frustration prevails in Britain, where most water utilities feel they must

sit back and watch while giant utilities such as France’s Suez Lyonnaise des

Eaux and Germany’s RWE lead an accelerating global consolidation in the water

industry. RWE, which already owns Thames Water and considerable assets in the

USA, said last month it was to pay a premium of 36.5% to take over American

Water Works (AWW), paying $4.6Bn in cash and assuming $3.0Bn in debt, valuing

the company at $7.6Bn. AWW’s operations will be bundled with Thames’ existing

US assets. Although still the subject of regulatory clearances, RWE chief executive,

Dietmar Kuhnt, was confident the deal would cement the company’s position as

a global player in the industry. It is thought the deal will not affect the

company’s plans to acquire Azurix North America, or the wastewater assets of

Citizens Communications.

Meanwhile AWG, formerly Anglian Water, is putting the final touches to plans

that will see it pull out of selling water and become an environmental and infrastructure

support provider. The company already manages utility assets in China, Chile,

the Czech Republic and Thailand. It is believed a break-up of the group, through

a spin-off of its regulated water assets, could unlock capital worth £1.6Bn.

Both Centrica, the gas-to-credit cards group, and Innogy, the domestic power

utility formed by the break-up of National Power, are thought to be interested

in the water business.

Certainly Centrica would be a favourite. A rising star in the utility firmament,

it has emerged as one of the most successful implementers of the multi-utility

model. To date, it appears to be the company that has gained the best understanding

of what its customers value. Even so, there rem-ains a question mark over the

degree to which consumers are intersted in the multi-product concept.

Key to the AWG break-up will be regulatory approval, but insiders believe Philip

Fletcher’s stance may differ from his predecessor’s in the wake of clear and

growing indications that the existing equity-based funding structure of the

industry is simply unsustainable.

Mutual recognition

Ofwat blocked a bid by Kelda to set up a mutual structure last year. But there

is speculation that the AWG deal could be waved through in order to stimulate

restructuring of the industry in advance of the tariff review scheduled for

2005. Such a restructuring is likely to see water companies moving to reduce

their cost of capital by switching funding from the equity to the debt market.

British companies such as AWG must be envious of their French counterparts,

which enjoy relative freedom to expand. Utility group Suez Lyonnaise des Eaux,

for example, saw its net profits rise by 11% to ¤1.41Bn. The group’s

16% rise in operating profit reflected strong revenue growth from both energy

and water projects, particularly related to multi-utility contracts, the company

said. Multi-utility contracts for commercial customers are growing rapidly,

representing about half of group revenue by the end of the year. Suez said it

won no fewer than 30 major contracts with a variety of multinational clients

and foreign municipalities.

Only Credit Lyonnais, it seems, is upbeat about the UK water industry, having

upgraded its recommendations on several stocks, including AWG, Kelda and Pennon

from ‘add’ to ‘buy’. The move had an immediate, though small, effect on shares.

Yet the UK water industry is coming under increasing pressure from both shareholders

and regulatory bodies. Ofwat National

Consumer Council (ONCC) chairman Maurice Terry stressed his organisation intended

to underline the key criteria that companies should meet. Realism, stability,

affordability, value for money and ongoing service improvements were essential,

he said. At a recent Foresight Conference he told delegates he saw no reason

why further improvements should not be forthcoming.

But utilities such as Severn Trent have a different view. As a result of Ofwat-imposed

rate cuts Severn Trent says it is having difficulty maintaining its UK water

operations and has announced 1,100 job cuts to trim overheads. While its waste

businesses, such as Biffa and the recently acquired UK Waste, continue to do

well, water services are struggling.

There are also foreign would-be buyers that balk at the last hurdle, sending

a clear message that UK companies might not be the hot assets that they may

appear to some.

A new senior management team has bolstered United Utilities’ (UU) fortunes.

Aside from the provision of water and wastewater services, the company is involved

in electricity distribution, telecommunications services and business process

outsourcing. Like Centrica, UU is pressing ahead regardless with fine-tuning

its own multi-utility model in the belief that it will deliver increased shareholder

value. Recently, ratings’ analysts responded to the group’s improved strategic

focus by giving it a ‘positive’ rating. The move follows UU’s sale of Norweb

Energi and renewed focus on the monopoly regulated water businesses which analysts

say are subject to modest business risk and believe should deliver predictable

cashflows up to the end of the current price control period in March 2005. UU

plans to secure the combined Ofwat (£300M) and Ofgem (£100M) cost

savings targets by improving efficiency of the regulated businesses.

UU is actively participating in the current wave of operational outsourcing

contracts in the UK water sector, notably with Welsh Water, but management has

maintained its opposition to following the Glas Cymru capital model. The £1.9Bn

Glas Cymru Cyfyngedig bonds, issued to fund the acquisition of Dwr Cymru marked

the first highly geared water financing to reach UK shores.

Whatever restructuring option is chosen ultimately, however, S&P believes

the overall trend will be towards higher levels of debt financing in the water

sector. Whether this translates to lower credit ratings – and that, of course,

will filter through to share values – will depend on the ability of the companies

to mitigate the higher financing risk. But there is no magical formula that

will enable a highly geared entity to achieve a solid investment grade credit

rating. Restructuring, as S&P points out, cannot turn a bad business into

a good one. For a highly geared water company to achieve a solid investment

grade credit rating, genuine

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