Ofwat's 'price review' is just PR – but investors should still take note

The Great British public hates nationalised industries. The public hates privatised industries. Contradictory though those two statements may be – and allowing for a little exaggeration – they both hold good, sometimes simultaneously. It is against this hate-hate backdrop that the grandest performance of all in the UK’s stable of privatised industries is about to be conducted – the spectacle of the five-year price review for the 10 privatised water companies of England and Wales.

Performance though it is, the review has a succinct and rather boring title, PR24. That said, it is somehow appropriate that ‘PR’ should be in the acronym since the price review, which will decide how much the water companies can charge their customers in the period 2025 to the end of 2029, is almost as much a public relations exercise as it is a price-fixing one.

And the production is as much about the conductor, the water regulator Ofwat, as it is about the players. After all, why else would Ofwat produce a 164-page book that supposedly does nothing more than tell the water company chiefs what to include in their pricing submissions? If the book’s contents were as dull as the title, Our final methodology for PR24, an email with appropriate attachments sent to the respective finance directors would do the job nicely. As it is, the details for the finance chiefs are mostly contained in the 14 appendices that are in addition to the book. That leaves the 164-pager as much as anything a glossy exercise about the importance of water (“central to our daily lives” etc), the duties of the water companies (they must rebuild the public’s trust) and the square-jawed, hand-on-heart sincerity of Ofwat (“we will drive companies to deliver more for customers and the environment” etc).

No surprise that the water companies have responded in kind. United Utilities (UU.), the operator in north-west England, submitted 90 documents whose aggregate page count easily runs to several thousand. Small wonder that the regulator demands that all the documents be submitted in a searchable PDF format. That’s tantamount to admitting many documents will, at best, be skimmed. But it also implies what, intuitively, we already know – that the price-setting exercise is as much about show as it is about rigour. Implicitly, the water companies are saying: “Don’t worry, dear customers, if the quality is lacking we’ll make up for it with quantity. Roughly speaking, that’s what we do in our day-to-day business anyway”.

Then again, this is what happens when natural monopoly operators are bent and squeezed into shapes that are supposed to resemble competitors in a proper marketplace. They try to look like something they are not. Small wonder the public is sceptical. You can always spot a phoney.

And it was ever thus. Back in the 1940s, the public was sceptical about the benefits of nationalisation as the post-war Labour government took, first, the health service and then coal mining into state ownership. Granted, people took to free medical care, although that was seasoned with complaints about the sudden unfriendliness of GPs – “now it’s nationalised, doctors are just like the rest of the civil servants”, an interviewee told the Mass-Observation social research project.

Among coal miners, scepticism was soon replaced by indifference spilling into hostility once nationalisation became a fact. In Coal is our Life, a study of the mining town of Featherstone in west Yorkshire in the early 1950s, one collier seemed to sum up the consensus feeling when he said: “Anything the management wants the men to do is bound to be to our detriment. That’s what I’ve always been taught.”

Fast forward 30 years, and nationalisation’s shortcomings meant privatisation was all the rage. With the benefit of hindsight, the process of selling off state-owned assets into private ownership propelled the notion of ‘neoliberalism’ into all walks of life. It was one thing for the state to sell profitable companies it happened to own (British Aerospace or Rolls-Royce). But if natural monopolies could be made to look as if they belonged in the marketplace – rather than being a ‘societal’ good – what could not be shoved into the market? In the UK, which was the leader of this trend, first it was water, then the electricity industry and – in its most contrived form – the railways (what a great success that has been).

Polls show big percentages in favour of re-nationalising

Sure, it might be caricatured as quaint to dispute that some parts of life belong in the market and some don’t, but privatisation has never been popular, except with the people who stood to make a fast buck from it. Therefore, it should be no surprise that consumer polls consistently show big percentages in favour of re-nationalising the water companies. Granted, the question mostly gets asked when the standpipes come out, sewage washes up on the beach or when bosses’ pay hits the headlines, but even so.

Ostensibly, pay will be much on Ofwat’s mind during the pricing review; or, at least, Ofwat warns that “we are consulting on a licence change to strengthen company accountability on dividends and taking action on executive pay”. The ‘single-figure’ pay, which includes long-term bonus payouts, for the chief executives of the three water companies still owned by public companies shows that the boss of Pennon (PNN), which operates South West Water, gets by far the least; predictable since Pennon is the smallest operator of the three. The other two – Steve Mogford at United Utilities, who left earlier this year, and Liv Garfield at Severn Trent (SVT) – have between them averaged £3.2mn a year for the past three years.

That’s about the same as the average for a FTSE 100 boss. But one question is whether the boss of a water company is worth the Footsie average? The harsh view is that, for someone who just runs a utility company, £3.2mn is an entrepreneurial-style reward without the risk. True, but a similar comment could be made about many of the guys and gals who run well-established listed companies.

Investors will be more concerned that Ofwat’s tough talk will trim their returns. Lower dividends would mean not just less future income but lower share prices today as values are trimmed to reflect less future income to be capitalised in the present. And it’s not as though investors have been that well rewarded in the past.

The original investment selling point for water utilities was that they would generate dividends that gently rose in real terms. The chart shows that the dividend performance of their listed parent companies, which are dominated by their water subsidiaries, have had mixed success, to put it kindly. It tracks the dividend payments of the listed three in relation to consumer price inflation. To restrain the spread of the ‘y’ axis, the data has been rebased to 100 in 2009 when United Utilities halved its dividend. Despite slashing its payout in 2020-21, Pennon’s is the only dividend that has outpaced inflation over the 20 years, with annual compound growth of 3.5 per cent compared with 2.5 per cent for inflation. Severn Trent’s dividend growth is the smoothest, despite a few blips (it has been cut three times).

UK water companies outperform

Yet, of course, total return is what really counts and the average share price of the listed three, unweighted by their respective equity market value, has comfortably beaten the FTSE All-Share index over the past 20 years. True, on a global view, that may be nothing to get excited about, but can much more be asked of shares in wholly UK-orientated companies?

Paradoxically, that outperformance might be because – despite the occasional failing in dividend growth – investors consistently expected the pattern of future dividend growth to be better than the past. If so, that also implies that, on average, investors assumed that companies would outsmart the regulator; that whatever demands Ofwat made on financial performance, or whatever the constraints on price increases, the bosses of water companies could always find ways around them.

However, even if that were the case, the table indicates that this has come at a price. For various measures, the table contrasts the latest full year with the 10-year average and, generally, the 10-year average is better, and very much so in the case of profit margins and return on assets. Similarly, in 2022-23, the companies struggled to pay dividends and Pennon’s net profit was so tiny as to make cover on its much-reduced dividend meaningless.

Ofwat versus water – the rematch

So now the stage is set for the re-match between the water companies and Ofwat. At first glance, the regulator doesn’t even seem to be acting that tough. Sure, it will no longer index permitted changes in the value of the companies’ capital base using retail price inflation and is substituting the stingier CPIH measure (consumer prices with housing costs included). Yet it inclines to allow water companies a real return on equity of 4.1 per cent, which seems generous for a utility supplier, even one operating in a sector as politically sensitive as water.

We all know that, if the clock were wound back, there is almost zero chance that water would be privatised all over again. Yet there is about the same chance that it will be re-nationalised. Hate them or not, we are stuck with privatised water operators and for income-seeking investors that's not such a bad prospect. 

bearbull@ft.com