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Investing in UK water utilities has hit rough waters in recent years. Historic underinvestment in aging infrastructure and high dividend payouts has led to poor environmental performance and an urgent need for water companies to upgrade their Victorian-era assets.
The required investment into water assets greatly surpasses payouts since privatisation, but a combination of past dividends and pressure from Ofwat, the industry regulator, to keep bills low over the past few decades has meant we are seeing investment and subsequent bill increases landing at a time consumer budgets are challenged. While high expenditure is necessary given the state and age of the infrastructure in the UK, consumers are understandably sceptical about whether increased bills will deliver the promised improvements, especially in the context of the cost of living crisis.
Attracting investment is also becoming difficult. Capital markets are crowded as utility companies look to raise money and boost spending for the sustainable transition. Investors are also looking at water companies elsewhere in Europe and America, where the allowed returns are higher and public perception is better. The table below also shows how trust in water companies is falling among the public.
Trust in water companies’ ability
Figure 1: Source: Ofwat, February 2023
The table above (Figure 1) shows that while most consumers believe there is decent service and water quality, trust has fallen over sewer inflows and insufficient investment in the aging network.
Most negative impact on water quality in rivers
Figure 2: Source: Ofwat, February 2023
Wetter weather and a subsequent higher use of overflows have led to a public perception which is worse than reality. Consumers believe overflows are the worst contributor to the health of rivers according to Figure 2. However, nationally, they account for only around 4% of the reasons rivers fail good ecological status. Agriculture is a larger contributor than overall water company operations, although this does not reduce the sector’s responsibility.
Going forward, the sector must focus on improving its environmental performance before expecting an improvement in public perception. Plans for the next five years must be deliverable, and companies must ensure that supply chains are robust and set up to deal with increased capital expenditure. They must also use this time to shore up financial resilience, with the effects of complex capital structures and increasing leverage coming home to roost. Lastly, improvements must be affordable to the consumer, especially considering the backdrop. Balancing long-term needs with immediate affordability is crucial. The most vulnerable customers need support as well, and we would support a national scheme that standardises measures across different companies and increases accessibility.
Engagement
With this in mind, we met with each of our UK water utility holdings across the Sustainable Future fixed income and managed funds, following our initial engagement exercise with them in 2022. This time around, we focused on assessing their plans for the next regulatory period and further out, and how credible hitting their targets would be. We also questioned them on biodiversity initiatives given the rising focus there (these can improve environmental performance). We continue to challenge them to have better defined and measurable links that more closely align executive pay with environmental performance. In these discussions we learned of many innovations, as companies work to improve environmental performance and restore public perception.
Findings
Severn Trent remains one of the top performers from our perspective. It described to us its work worldwide with both water and non-water companies to determine best practice for its operations, and how it shares this with peers at home. The company has invested a lot into obtaining the correct expertise for each of the issues it faces and has taken the lead with pre-funding its equity raise. The company’s ambitions extend to emissions as well, developing the world’s first carbon neutral wastewater hub which is to be operational this year.
Anglian Water, with middle of the table environmental performance, mentioned it was in the process of revoking overflow permits for allowed combined sewer overflow (CSO) usage, which it will do as it creates additional capacity to render storm overflows permanently inactive. This is to show commitment to its zero spillages target, with the plan prioritising sensitive sites, like a Special Site of Scientific Interest or chalk stream. Efforts such as these, eliminating the legal ability to use overflows altogether, and beyond what the regulators are calling for, can be the first steps to restoring credibility in the sector.
Any operational recovery must be a green recovery, and we were pleased to hear that this is the case with nature-based solutions becoming more prevalent. When we spoke to Yorkshire Water, it informed us of its nature first initiative which means it looks at these solutions first before any other. These can be cheaper and more environmentally friendly, and the company is currently working on building them up to use on a larger scale.
Executive pay has been at the forefront of media attention. We continue to challenge businesses we are invested in to make stronger links between environmental performance and pay throughout the organisation, as we believe this creates the right incentives for better operational performance. However, it is still difficult to justify bonus payments when sewer overflow use is so high. Incentives for executives need to be aligned with consumer needs, especially around an essential right like access to water, and we will continue to encourage and monitor this.
The main objective of this engagement exercise was to critique the business plans submitted to Ofwat late last year. There was a wide range in the responses, and we have used the results of our engagement to inform our fund position sizes of these businesses and to ensure we are best positioned for upcoming catalysts in the space such as Ofwat’s draft determination and the Environment Agency investigation.
Sustainable Future ratings system
Inside the Sustainable Future team’s long standing sustainability process, we have made the decision to downgrade all UK water utilities from an A to a B on their product score. While water is a human right, and essential for life and many facets of modern economies, the provision of it in the UK is held back by systemic underinvestment since inception, both under national and privatised regimes. In rating the management of UK water companies, we will apply greater stringency using longer-term performance, including scores received by Ofwat and the Environment Agency, but we will retain a flex factor so the analyst can integrate additional positive or negative factors into the score.
Are things getting better?
Figure 3: Source: Ofwat, Company Business Plans, October 2023
A combination of rising bills, more debt issuance and equity support will mean capital expenditure will increase markedly from past levels to upgrade water infrastructure and improve environmental performance and customer satisfaction. The difficulty with our single-circuit system that captures both waste and surface water is that it is very costly to increase capacity, and they have been underinvested in since inception. The sector will invest a record £96 billion in the next regulatory period, with goals on improving both pollution incidents and increasing water resilience. Improvements have already started, with monitoring of overflows in England and Wales now at a level that will capture nearly every discharge. Companies can now leverage big data to better target the worst Combined Sewage Overflows (CSOs) first. While we are encouraged by the step change in the plans to address these issues, there are still a huge amount of investment and operational improvements to be implemented before we see meaningful change.
Conclusion
Private, public and nationally-owned[1] water companies in the UK, who are facing increases in spills with the wetter weather, must adapt to climate change with an increase in investor capital and support. The last new reservoir in the UK was built in 1991, and the history of economic regulation in the UK does not inspire confidence. While the next government will want to reverse this, a cash-strapped treasury limits options. It will take time to fix underinvestment and regulatory scrutiny is important.
There is a danger of the focus on the next regulatory period and bill increases within it. Now, more than ever, as the twelve months to February were the wettest on record in England, there is a need for long-term climate-resilient planning that accounts for growing populations. Uncertainty created from the multiple different regulators has also not helped the situation. Ofwat has received stronger powers, but more responsibility for enforcement should also now fall to the regulatory body. However, while it should and does possess the ability to curtail shareholder payments, that does not mean the return framework cannot be stable or clear. Every amount of additional equity reduces the pressures on consumers, which is encouraged by a strong regulatory framework.
These assets have existed for 125 years and there has been chronic underinvestment during this time. While there have been failures in every stage of the ownership cycle, the responsibility lies with current owners and the regulators to define and action a clear pathway to improvements. As debt investors to these companies, we believe there is a route to better outcomes. We believe in the benefits the sector can provide as a job creator and driver of economic growth, alongside facilitating the sustainable transition while upgrading our water infrastructure for the benefit of all stakeholders.
Deepesh Marwaha, Investment Analyst, Sustainable Investment Fixed Income team
[1] Scottish Water and Northern Ireland Water are both nationally owned and face a similar set of challenges in terms of needs for investment to improve the water network and assets and operational performance
Figures and sources
Figure 1 and 2 – slides 6 and 26 respectively from Trust and perceptions: People’s views on the water sector - full report - Ofwat.
Figure 3 – made using data from Key facts and data from water company plans - Ofwat Detailed data also available here: Expenditure allowances submitted by water companies in their PR24 business plans - Ofwat
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Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.
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