Will regulation threaten future investment?

The withdrawal of a big player from the regulated UK market and warnings by analysts of the negative effect on investment of over-regulation have added to the uncertainty within the UK water industry. Dean Stiles reports.

Biwater Holdings is exiting the regulated UK water market selling its UK-based subsidiary Biwater Services to MWH Constructors, the UK construction arm of MWH Global.

MWH Global, a private, employee-owned company that provides environmental engineering, construction and strategic consulting services, has signed a definitive agreement with Biwater Holdings to acquire its UK-based subsidiary Biwater Services.

Biwater Services, with 675 employees, is a UK water construction and engineering firm, acting as the holding company for Biwater Treatment, Farrer Consulting and BiProduct Recovery.

As WET News went to press, Biwater and MWH remained tight-lipped about the deal but in a statement, Larry Magor, chief executive of Biwater Holdings, said the sale of Biwater Services to MWH Global “completes Biwater Holding’s period of strategic realignment”.

The sale will enable Biwater Holdings to focus on its core international business in the water and wastewater markets, and follows the disposal in July 2010 of its interest in Cascal NV, the New York stock exchange-listed operator of water and wastewater treatment plants.

“The company will continue with its successful core strategy of securing export and project financed projects in the international water and wastewater market,” Magor said. He expects Biwater to maintain its relationship with Biwater Services’ team and to work jointly with MWH on future projects.

The acquisition of Biwater Services expands MWH’s existing UK presence. Bernard Armstrong, chairman of Biwater Services, says: “We believe that a combination with MWH Global enhances our strong position in the UK water market and strengthens our service offering to our clients. We believe this combination will significantly benefit our long-standing clients during the current and future AMP cycles.”

MWH and Biwater Services have the ability to provide program and asset management led frameworks, enabling MWH to benefit from expected market changes and be responsive to future challenges.

Robert Uhler, chairman and chief executive officer of MWH Global adds: “Together, we provide a broader range of skills to address the creation, management and optimisation of existing wet infrastructure assets. This is especially relevant recognising changing, and sometimes conflicting, demands of energy, infrastructure rehabilitation, refurbishment, efficiency and carbon reduction.

“We have enhanced our ability to service the full asset life cycle of our clients from feasibility through commissioning and operation.”

Biwater’s withdrawal from the regulated UK market comes as analysts warn of the dangers to investor returns from over-regulation in the UK water sector. Dividend payments are essential for the sector to attract investors as firms look to raise the billions of pounds needed to pay for spending on the network.

Dominic Nash, utilities analyst at Liberum Capital, believes the whole sector is facing continued uncertainty until the government White Paper setting out reforms is published next summer along with the Government’s review of Ofwat.

An additional complication for investors comes next year when water companies will have to adopt private sewers into their asset bases, potentially creating an 11% hit on earnings per share. “At best this cost will be recouped at a later date; at worst it will only be partially recovered,” Nash says.

Philip Green, the outgoing boss of United Utilities, supported Invesco Perpetual fund manager Neil Woodford after he said regulation might cause inadequate investor returns. Woodford, who owns about 7% of United, sold his £100M stake in rival Severn Trent in October.

Green describes the last regulatory review as “tough but fair”, but he says investors were needed to help the industry invest in the next few years. “I would support Neil Woodford in saying it’s important that the regulator makes sure the equity markets get an adequate return: we’ll continue to need high levels of capital,” he says.

There is no need to overhaul the regulation of water companies because consumers and investors alike do well out of the current system, says Green. United blames regulatory price cuts and higher interest charges for a 24% fall in core pre-tax profit to £196.2M in the six months to September 30.

Despite regulators telling the group to cut prices by 4.3% in the current year, Green says the present model of privatisation “works really well”. The group says it is on track to hit its 2015 targets, and has announced an interim dividend of 10p per share.

In June, Woodford told utility regulators they were not paying enough attention to the needs of investors warning that Ofwat was taking investors “for granted” following a tough settlement at the five-year pricing review.

Woodford said in a letter to Ofgem: “We have to shoulder an increasingly anti-equity culture at Ofgem and Ofwat, whose public stance along with that of the Government seems to be predicated on the achievement of the impossible more investment with lower prices.”

Severn Trent also reported a drop in profits at its water business, despite seeing a turnaround in water consumption and lower rate of bad debts. Turnover at Severn Trent Water rose 1% to £702.3M in the six months to September 30 after a cut of 0.7% in prices from April was offset by higher household usage and a lower level of corporate failures.

Severn, which had been braced for further pressure on consumption, added that it had worked hard on its collections performance as its bad debt charge in the first half of the year fell to 2.3% of turnover, from 2.5% the previous year.

Wages and salaries were £5.8M lower due to efficiency programmes, but there was an increase in depreciation of £15.8M as underlying pre-tax profit in the regulated water arm fell 2.4% to £272.7M.

Across the group underlying profits fell 16% to £158M. The drop reflected the impact of higher inflation on its borrowing costs. Severn also announced a 2.5% cut in its half-year dividend as part of a 10% reduction planned for this financial year due to Ofwat’s latest price controls.

Severn announced a new dividend policy for the following four years to 2015 that will see annual growth of RPI inflation plus 3%.

Dividend payments are essential for the sector to attract investors as firms look to raise the billions of pounds needed to pay for spending on the network.

Severn said its water business invested £164.5M in fixed assets and maintaining and improving its infrastructure during the half year. Severn was required to cut average household bills by 4% in real terms by 2015 in a ruling labelled “tough” by the water firm.

Despite this, shares in Severn and the UK’s three other listed water stocks have risen by around 25% this year, compared with a 9% fall for the broader utility sector.

The profits falls at Severn Trent and United are no surprise given the scale of required price cuts. But United is one of the best performing utility stocks in Europe.

The Financial Times says of United’s performance: “As with the wider sector, the shares now trade at a premium to the regulated asset base and bears fret that further upside is limited. Still, the prospective dividend yield of 4.9% is competitive.”

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