Water under the bridge or poisoning the well? A regulator’s history of UK privatisations

Written by Max Wilkinson on 19 November 2019 in Feature
Feature

The principles of privatisation are faltering, and – as a book by an ex-regulator makes clear – the right balance between intrusive control and free market initiative remains elusive

Untapped potential Chris Patten and Lord Crickhowell launch the water privatisation in 1989. Photo: PA

Renationalisation is not the only threat to the private utility industry. The Conservative government has continued to take back control and subvert the independence of regulators. The alarm is sounded, loud and clear, in a new book by Sir Ian Byatt, the economist who led the Treasury’s battles against nationalised industries and went on to regulate the water industry in England and Wales, and later in Scotland.

He said at the launch of A Regulator’s Sign Off: Changing the Taps in Britain, a book of his essays and speeches: “Independent regulation has been downgraded by ministerial repossession of ‘policy’, by the ministerial appointment of boards and by reducing the influence of customer representatives.”

With the exception of telecoms, he thinks the principles of privatisation are either faltering or, as in the railways, almost completely reversed. In rail “the tentacles of the Department for Transport are tightening over the train operating companies. And pipe dreams, such as HS2, attract ministerial support.” In energy, he says, “competition has largely been overtaken by climate change policy and investment in generation capacity is now decided by government, not the market.”


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Byatt’s book is based on wide experience. After rising to become deputy economic adviser at the Treasury, he moved to be the first director of Ofwat, the regulatory body for water, after privatisation in 1989. He later became regulator for Scotland’s state-owned water company.

In the final chapter, he argues that south of the border water customers have been overcharged, dividends have been excessive and the companies have been spending too much on capital projects on which they make a guaranteed profit.

He is not alone. In a paper for the Regulatory Policy Institute, Regina Finn, former chief executive of Ofwat and Simon Less, Ofwat’s former director of market reform, said that in the electricity industry “governments have increasingly taken into their own hands the detailed specification of contracts and market outcomes, increasingly limiting the role of the market and economic regulator”.

In another paper for the institute, Prof George Yarrow describes how ministers’ oversimplified views and “managerial metaphors” have contributed to the electricity industry’s move “back towards central planning”.

Even where competition has been established, as in energy supply, ministers have intervened. After companies were accused of discriminating against loyal customers with complex tariffs and ephemeral introductory offers, Theresa May announced from Downing Street that there would be a cap on energy prices – a nostrum that she stole from the former Labour leader, Ed Miliband.

All critics agree that governments must set general policy objectives. The question is how these can best be achieved. Labour’s post-war nationalisation programme under Herbert Morrisson proved a failure, not least because of government interference. Byatt starts his book with a vivid account of the Treasury’s doomed campaign to force nationalised industries to be more efficient, more responsive to their customers and to adopt economic pricing and rational investment strategies. This account of the losing battles of the 1970s and early 1980s has become topical again, and not only because of the Labour Party’s renationalisation plans.

Big numbers The London Stock Exchange marks the privatisation of British Telecom

The privatised industries have been losing support as popular newspapers fulminate against “fat cat salaries” and rising dividends. The Financial Times judges that water privatisation is a “failure”, and with some reason. Byatt notes that water company dividends have far exceeded the price paid by the first shareholders and that the companies have tended not to retain profits for investment. Indeed, in a recent FT article, Jonathan Ford estimated that between privatisation in 1989 and last year, the water companies generated operating cash flows totalling £159bn (in 2017-18 money). This was £33bn more than their spending on fixed assets, but they still built up £51bn in debt, not far short of the total paid out in dividends and interest.

In other words, utilities have outwitted the regulator. Debt, raised ostensibly to finance investments, lowered their average cost of capital, but a fair share of the benefit was not passed to customers via lower regulated prices. Instead, as Byatt says, shareholders received “high-risk rewards for low-risk investments”.

After a soft price settlement in 1984, private equity and sovereign wealth funds, many of them foreign, fell over each other to get a piece of the action. A frenzy of takeover activity left a convoluted ownership pattern, opaque lines of responsibility and subsidiaries in tax havens. Of the nine English water companies, only three are now listed on the London Stock Exchange.

Byatt says the private equity funds that now own most of the water industry “seem exclusively concerned with quick profits in a long-term monopoly serving a wide public”. Foreign takeovers meant the companies had “limited independence and limited ability to commit to actions vis a vis the regulator”. There is also growing anxiety about failings that Byatt’s book describes as the “poisonous effects of monopoly”. Thames Water has been fined nearly £30m for polluting waterways and missing leakage targets. Recently three employees at Southern Water were convicted for obstructing the collection of pollution data.

More generally, popular perceptions that utilities are controlled by greedy foreign owners adds gall to reports of late trains, bad customer relations and poor service. A prolonged power cut this summer immediately prompted questions over whether the privately owned National Grid had been cutting corners to maintain its 12% annual dividend.

The privatised industry could hardly be more different now from the Thatcher government’s vision of popular capitalism. If consumers and voters had held onto the shares they bought at privatisation, high dividends might now be popular. It is very different when monopoly profits are seen to be shipped off to China, Abu Dhabi and Australia.

“The privatised industry could hardly be more different now from the Thatcher government’s vision of popular capitalism”

These discontents have encouraged politicians to offer quick fixes and to bypass the regulators. Political intervention has another cause, however: the enormous scale of some of the utilities’ projects, such as the Hinkley Point C nuclear power station, the HS2 rail link, the Thames Tideway sewage project, airport expansion and of course the switch to “greener” electricity generation. Such projects clearly raise political issues, but the government’s record in delivering them has been abysmal. Many studies have shown that when governments try to pick winners, losers become expert at picking governments.

What is to be done? Those seeking reform must answer four questions: First, are governments trying to do too much? Second, is more competition possible? Third, how can regulation be made more effective? Fourth, who should own private monopolies?

Byatt’s answer to the first two questions is widely shared. Governments should confine themselves to policies and general rules. Private companies should fulfil these objectives as best they can, under the restraint of increased competition, even in water. Strong and independent regulators should supervise the remaining monopoly activities.

Prof Dieter Helm put forward parallel arguments in his electricity market review two years ago. He said that after the electricity market reform in 2013, the government’s detailed interventions in investments and tariffs increased costs much more than was needed to achieve its climate change objectives. He proposed that the industry should operate with less interference, under a general tax and tariff framework, with more use of auctions and competitive tenders.

But competition must be matched by more effective regulation. This raises an old dilemma: should private monopolies be controlled by the prices they charge or by their return on capital? In the US, state commissions set prices to give utilities a “fair” rate of return. But this resulted in highly intrusive supervision. There was also endless litigation about whether the utilities’ investments were reasonable and what costs could “fairly” be passed to customers.

The Thatcher government hoped to avoid these perils with a system of simple price controls (RPI minus X). Utilities would be given an incentive to be more efficient, without detailed interference. In the early years this succeeded better than expected. But simple price controls do not work well when utilities need to make large investments. The regulator must then decide whether the proposed spending is excessive and what would be a fair return on the company’s approved assets (Regulatory Asset Base).

Byatt faced this problem from the start. The water tariffs he set included a cut to reflect lower operating costs, but also a much larger offsetting rise to pay for the government’s tougher water and sewage standards. As companies were guaranteed a return on these projects, there was obviously an incentive to over-invest. Byatt tried to curb this tendency by comparing data from different utilities. This had some success at first, but it has not worked well in the last two decades. A balance between intrusive control and the benefits of private initiative remains elusive.

“The dominance of financial funds clearly needs to be discouraged by tougher regulation”

The government’s response has been to take charge of big projects. But politicians are notoriously bad at running industries. Byatt’s judgement is confirmed by William Megginson and Jeffry Netter’s unpublished international study From State to Market, which shows that “privately owned firms are more efficient and more profitable than otherwise-comparable state-owned firms”.

That leads to the last question: If utilities are not owned by the state, should there be limits on private shareholding? In the early years, Byatt and others argued that, with some exceptions, the companies should be fully open to the capital markets. It is now clear, by his own admission, that this has gone too far. Profit making monopolies should at least be listed on the stock market and the dominance of financial funds clearly needs to be discouraged by tougher regulation. Another possibility might be to move towards mutual ownership such as at Glas Cymru, the Welsh water company.

Such reforms may be difficult, but the alternative is state control by the front or the back door. Although Byatt’s book is mainly historical, and some of it a bit dated, it is well worth reading for his short but trenchant account of the failures of nationalisation and the clear, well-argued economic principles that emerge from his experience as a regulator.

A Regulator’s Sign Off: Changing the Taps in Britain by Ian Byatt is privately printed in a limited edition, but free digital copies are available by e-mailing: ianbyatt@blueyonder.co.uk

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Max Wilkinson
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Max Wilkinson is a journalist and former chief leader writer at the Financial Times

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