Rivers of Sewage: Britain’s Failing Experiment
The UK is one of the only countries in the world to have privatised water. Now the system is collapsing, with investors writing off billions and wondering if it was all worth it.
If you go for a swim in an English river this summer, your chances of coming face-to-face with a floating lump of human excrement are – according to official figures – uncomfortably high.
Last year, sewage was dumped into England’s rivers for a total of 3.6 million hours, up 54% on the year before, according to the UK Environment Agency. Back in 2016, the figure was only around 3% of that.
Pick up a newspaper on any given day, and you are likely to read about a private water company (probably owned by a big pension fund) pumping effluent into a beloved natural waterway.
Earlier this month, United Utilities was found to have been pouring untreated sewage straight into Lake Windermere – a top tourist destination in the Lake District. A few weeks earlier, rowers at the iconic Oxford-Cambridge boat race were warned not to enter the River Thames because high levels of E-coli had been detected as a result of the river’s sewage content.
These stories have become run-of-the-mill. It’s an astonishing state of affairs for a country generally regarded as one of the world’s most developed – and has led a disgusted public to blame the UK government’s decision, 35 years ago, to privatise its water companies.
“The way privatisation was handled in the UK water industry was an absolute, total and unmitigated disaster,” says Charles Watson, Chair and Founder of activist group River Action UK – reflecting a broadly-held view. “There are models of privatisation that work well. The privatisation of British Telecom and British Airways, for example, was brilliant for consumers because it brought in competition. But not water.”
Thatcher’s great experiment
The story of how England’s rivers came to be swimming with effluent begins in the 1980s. It was the era of privatisation, and investment bankers were getting their heads around a lucrative new asset class: big state-owned infrastructure.
Ports, roads, power grids, airports, railways and telecom networks, traditionally publicly owned, were coming onto the market with increasing regularity. Water, however, remained largely off-limits. Governments considered it too essential a resource, and too ill-suited to competition, to entrust to the profit motive.
But Britain under prime minister Margaret Thatcher was an exception. In 1989, her Conservative government floated England’s public water utilities on the stock exchange in what was – and has remained – one of the few examples globally of total privatisation of the water sector.
Private equity groups soon bought up many of these companies and took them private, and today some of England’s largest water utilities are privately owned by global pension and sovereign wealth funds.
But today, underinvestment has led to creaking infrastructure that struggles to handle the needs of an ever-growing population, while a climate change-linked increase in heavy rainfall is testing stormwater storage capacity.
As a result, many now argue that privatisation was a catastrophic mistake.
Financial engineering
Experts point the finger at two parties for this failure: the regulator, Ofwat, which they say has focused too much on price and too little on investment; and private equity. Among the latter, Australian financial services giant Macquarie Group looms largest.
Macquarie bought Thames Water back in 2006. It held the company for a decade, borrowing heavily, and eventually sold it to a consortium of pension and sovereign wealth funds.
It was Macquarie’s use of debt – which went in part towards paying dividends to shareholders – that many say was the beginning of Thames Water’s current troubles. River Action’s Watson, who worked in finance at the time, is scathing of Macquarie’s behaviour.
“Macquarie came in, put in huge levels of debt, took out huge special dividends, then sold its stake off and was gone by the time the consequences of that had come home to roost,” he tells ESG Investor.
Those consequences were triggered by a change in the interest rate environment, Watson says. “They geared the thing up to the absolute limit to financially engineer it to make high returns, and in doing so, completely destroyed [the company’s] balance sheet. So now, it’s looking at insolvency.”
Macquarie, however, rejects such claims, saying it invested £11 billion in the company over the 11 years it owned it – during which time it also paid shareholders £1.1 billion in dividends. The group also defends its “whole-of-business securitisation” strategy as being standard practice and lowering the cost of borrowing.
Although Macquarie acknowledges that Thames Water’s debt over its ownership period nearly doubled from £6 billion to £11 billion, it says this growth was in line with the company’s asset base.
A spokesperson for Macquarie tells ESG Investor that its “record investment programme” in Thames Water “achieved significant improvements in key areas including pollutions, leakage, security of supply and drinking water quality”.
Notwithstanding these arguments, many share Watson’s view. Jim Wright, Listed Infrastructure Fund Manager at Premier Miton, accuses private equity groups of “egregious behaviour” – most notably Macquarie.
“There is little doubt they over-leveraged the business and took excessive dividends for their fundholders,” he says.
Meanwhile, KBI Global Investors Senior Portfolio Manager Matt Sheldon argues that private equity firms were “very good at financial engineering, and ignored water engineering”. He is less critical of the investors who came after – including Canadian pension fund OMERS, the UK’s Universities Superannuation Scheme, and the Abu Dhabi Investment Authority.
“It’s very hard to get your feet underneath you after such a degradation of service,” he says. “And the consequence of that is that it makes it hard for incremental capital to come in.”
ESG Investor asked each of Thames Water’s nine shareholders to comment on the company’s problems, and whether they thought had failed in their stewardship responsibilities. All of them either declined or failed to respond.
Insolvency
Thames Water is now facing a crisis that many expect will lead to its re-nationalisation. In April, holding company Kimble defaulted on a debt after its owners declined to inject £500 million. Since then, OMERS – the biggest shareholder with a 31% stake – has written off its investment.
Thames Water is currently awaiting a response for its next five-year business plan from Ofwat, due in July, after which it will seek to raise the required capital. If that fails, Wright expects the company to fall into the hands of creditors.
“Then the question is whether they [the creditors] are prepared to make equity investments,” he says. “My sense is that’s unlikely and that ultimately, Thames Water will end up in special administration – which is basically nationalisation.”
If that happens, Thatcher’s experiment with privatising London’s water and sewage infrastructure will have ended in failure – leaving taxpayers with a hefty investment bill, and institutional shareholders with a multibillion-pound write-off.
Shifting regulatory priorities
Ironically, one of the key problems with privatisation of England and Wales’ water has not been that prices are too high – but that they are too low.
From the beginning, the main concern was that giving profit-hungry investors control of a monopoly over the sector would allow them to charge their customers whatever they wanted.
Protecting consumers therefore became a top priority for Ofwat. Every five years, water companies submit their planned investments to the regulator for the coming five years and request permission to charge customers a certain amount. In the trade-off between low prices and investment, critics say Ofwat has leaned too heavily towards low prices.
“There’s always a trade-off with a utility between affordability and investment, and a lot of the efforts have focused on affordability,” says Sheldon. “The consequence of that is the environment never had a proper seat at the table, and that’s a problem.”
Political pressure has further compounded this problem, Watson says.
“Ofwat has got the government breathing down its neck, saying, ‘We’ve got an election this year, and we don’t want water bills going up’,” he says. “It’s a terrible situation. Everyone is in gridlock. Politicians don’t want bills going up, water companies are desperately trying to put bills up, and investors don’t want to put any more money in.”
Ofwat rejects the claim it puts bills above investment. “Historically, we have not blocked justified investment and at the last spending review we backed all companies’ environmental projects,” a spokesperson for Ofwat said in a written response to questions.
A reason to be hopeful is that there are signs this may slowly be changing. In its latest business plan, Thames Water proposed to invest £18.7 billion over the next five-year period – more than double the current amount. But to do this, it says it must hike prices to an average of £608 per year by 2030 – a sharp increase from the £423 per year that an average household paid in 2023.
Other water utilities have made similar proposals. The question is now whether Ofwat will allow these price increases. Investors will be waiting for the regulator’s provisional ruling on business plans on 11 July.
The case for investment
Such is the controversy around England’s sewage crisis that investors contacted by ESG Investor were reluctant to comment on the record.
Speaking on the condition of anonymity, one executive at a major institutional investor that owns a privately-held water company argues that while the group is committed to the sector, a new “social contract” is needed to recognise the “true cost” of water.
“Right now it feels like crunch time,” the person says. “We need to decide what we are going to do next. We need to reset, get together, and decide what the future of water looks like. We also need to think about the implications – if consumers want water to drink and cleaner rivers, they most likely need to pay for it.”
This is particularly urgent as climate change gathers pace, bringing with it both longer periods of drought and much heavier downpours – both of which will put strain on ageing infrastructure.
All this means more money urgently needs to be spent. And while this does not make the UK’s water utilities an attractive investment proposition today, patience could pay off, Wright argues.
“If investors can see through the next five years to a situation where the equity can grow significantly, then maybe they’ll think it’s worth holding for the long term,” he says.
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