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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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What’s Really Wrong with Thames Water?

UK houses

Thames Water again? We’re not in the water business. But this story has a moral, so read on. There are many reasons for the current predicament in the UK’s water utility business. This situation resembles one of those detective stories where almost everyone is a suspect. The victim, of course, is the British public suffering under boil water alerts and facing increasingly polluted beaches, lakes, and rivers. But who is to blame? The question itself is complex and difficult to answer. Each day another news article appears expressing outrage about excessive management compensation, capital misallocation, or regulatory malfeasance while concluding with a somber note about worsening pollution in some local lake or stream. Making these problems seem overly complex and difficult to resolve has a numbing effect on the public and encourages a kind of learned helplessness. This also permits politicians to avoid accountability for the mess that they or their predecessors created.

But let’s get back to Thames Water. Their obvious problem is water pollution. The equally obvious solution is a much higher level of capital spending on sewage treatment and related facilities. And that’s where the easy answers end. Why? First, because no one trusts the existing management and board, who are ultimately responsible for the dire state of corporate affairs, to properly supervise the billions in needed remedial capital expenditures. Second, no one trusts the regulator either. Ofwat has shown a profound indifference to its public responsibilities while permitting a grotesque overleveraging of its utilities. This excessive debt has financially crippled these once solidly investment grade companies. Dealing with this excessive debt is a big part of what has to be resolved. Bankrupting the holding company, Kemble, and all related non operating entities, would be simplest. But there's another problem. Lastly, the public seems to have lost faith in the private sector’s ability to handle this but it’s even less clear how a re-nationalization of this industry would occur. That’s why these water utility issues are difficult. We have simultaneous problems with misguided management still focused on capital extraction, wildly incompetent regulators, and a public increasingly convinced that privatization was a big mistake and that renationalizing these industries is the best outcome. And all of these issues are linked.

Of all the institutional failures here, the apparent abdication of Ofwat from even rudimentary capital structure regulation is to us the most baffling. As we’ve written before, the water industry is one of the safest and least risky types of utility. Everyone needs their product and demand is predictable. But from an analytical perspective, low business risk implies the ability to take on more financial leverage and vice versa. High-risk businesses should have very little leverage, if any. Said differently, business risk and financial risk are inverse correlates. The Thames Water management seems to have taken this idea of a low-risk water utility business and pushed it to its logical, leverage-able limit. And now they, and the British public, are stuck.

Lastly, the problem regulators have is one of public trust, or the lack of it. Why should people in the UK trust them to properly supervise a large remedial capital program for improved water quality when they have basically ignored all semblance of regulatory propriety in the past? To us that’s the true appeal of renationalization. It gets around a dysfunctional British regulatory body.

Here’s the lesson for us. Years of disregard for the public service function, allowed by a permissive regulator, finally reached the point where even politicians took notice and denounced the market-embracing setup they had previously championed. Who loses? Probably the utility’s owners. Now imagine, across the pond, American electricity customers without service for days in sweltering heat, or in severe cold, and it keeps happening, while regulators sit by helplessly. Can the public trust the regulators or the management to correct the situation? Maybe the key lesson from the Thatcher era of utility privatization is simply that private enterprises can’t provide public services. Or at least not without vigilant regulators. These deregulated utilities keep malfunctioning and it keeps happening. When does an enterprising politician turn this into an election issue?  So far not yet.  But the summer has not yet begun.  Maybe Thames Water should be a case study at some Edison Electric Institute management retreat. Learn what not to do.

By Leonard Hyman and William Tilles for Oilprice.com

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