Europe

Long-term Forecasts can Brighten Outlook for Water Utilities

Investors encouraged to engage with regulators and firms to increase performance and innovation.

A longer-term approach is needed from the UK water industry and its regulators to improve the environmental and financial sustainability of a sector roasted by drought conditions over recent months, according to investors.

Already under fire for their poor performance on river pollution, directors of water firms have faced fierce criticism as temperatures have risen over the summer for failing to maintain water supplies and prevent leakages as reservoir levels have plummeted.

A burst water main caused major flooding in Liverpool at the end of July, leaving parts of the city without water for two days and water utility firm United Utilities struggling to identify the cause. Earlier this month, a burst pipe in London caused “tsunami”-like flooding and left six postcodes with no or very little water in 30°C temperatures, while “technical issues” at a nearby reservoir left an Oxfordshire village without water, leading Thames Water to distribute bottled water.

CEOs have been called in to explain their plans to safeguard public water supplies by Environment Secretary George Eustice. But some investors have argued that the UK regulatory framework for the water industry needs to be overhauled to provide stronger incentives for utilities to make long-term infrastructure investments.

Neville White, Head of Responsible Investment Policy and Research at EdenTree Investment Management, said the regulatory regime needs to enable greater forward investment and place a greater economic value on water.

“The long-term focus on keeping consumer bills low has been to the detriment of investment elsewhere,” he said.

“Investment in new and replacement infrastructure is essential if environmental and climate goals are to be achieved; the regulatory regime must encourage new and enhanced technologies that over time reduce waste and costs and enhance ‘circular economy’ models,” White added.

Extending investment horizons

The UK water sector is regulated on a fixed time schedule, with the regulator setting prices and service and performance targets every five years. The Water Services Regulation Authority (Ofwat) issued for consultation its draft price review (PR24) for the 2025-2030 period last month. The water industry uses Ofwat’s price reviews as the basis for a five-year asset management plan (AMP), which defines investment priorities.

White believes that the current regime needs to be reformed to enable longer-term incentives and plans to be put in place, adding that regulators need to work with the industry to set “enabling and ambitious” longer-term goals.

“Given water utilities are inherently long-term investments, there would be some virtue in the regulator signalling longer-term ambitions as part of the regulatory settlement. Whilst delivering strategic goals within a five-year AMP may be possible, others such as investment in rivers may take longer and would benefit from a longer time lens,” he said.

There are signs of a shift in this direction in the regulator’s latest announcements. In its draft methodology for PR24, Ofwat called for the water firms’ business plans for the next five years to be set in context of 25-year delivery strategies to achieve a better balance between short- and long-term priorities.

Under the plan for the next five years, companies will have to meet new performance requirements on water quality, biodiversity and GHG emissions. The regulator’s ten proposals also include greater partnership with and scrutiny by local communities, steps to improve innovation and efficiency, and increased transparency on dividends and performance-related pay policies.

“Shocking performance”

Drought conditions have exposed infrastructure weaknesses, but the current glare of scrutiny follows an extended period of dissatisfaction among customers, regulators and investors.

Just 14% of English and Welsh waters meet ‘Good Ecological Status’ under the Water Framework Directive, according to the Environment Agency (EA). There were 7,600 water pollution incidents in 2019, up from 6,500 in 2015. A £126 million fine was handed to Southern Water for “deliberately dumping billions of litres of sewage into the sea”.

Published in July, the EA’s report on water and sewage companies’ 2021 performance in England found that their overall environmental performance was the “worst we have seen for years”, with the majority of the nine utilities firms falling in the EA’s ratings. Four firms are now rated two stars (out of four), with Southern Water and South West Water falling to one, denoting performance “terrible across the board”.

The EA branded pollution performance “shocking”, with the number of serious incidents rising to 62, the highest since 2013. The report accredits a significant proportion of the blame to water utilities’ company directors, describing their performance as “simply unacceptable”. The EA said “the public have seen water company executives and investors rewarded handsomely while the environment pays the price”.

Water utilities firms are estimated to be leaking 2.4 billion litres of water every day, with Thames Water leaking 635 million per day alone. While leaks declined by 36% between 1994 and 2000, leaks have only fallen a further 8% since then, according to Ofwat. In their AMPs, the majority of firms were targeting a 15% cut in leakages between 2020 and 2025, ultimately working towards halving these by 2050. According to an Ofwat report published in July, 13 of 17 firms met their 2020-21 targets.

Edentree’s White said greater investment in technology and innovation can improve utilities’ performance on leakages and other problems arising from the creaking UK water and sewage infrastructure.

“We are already seeing the rewards from increased investment in technology to prevent failure; sensors and microphones can detect blockage build up so that these can be remediated before they lead to catastrophic failure. Technology is playing the same role in terms of infrastructure resilience,” he said.

Constructive criticism

As well as regulatory reform, increased infrastructure investment is seen as requiring a change in the business models and financial management of utilities firms. Only a minority of UK utilities are currently publicly listed, meaning some do not face scrutiny by institutional investors, with several of those which have gone private in recent years carrying significant levels of debt.

Ofwat was last year given new powers to enforce greater financial resilience in the UK water sector, and recently revealed plans to limit dividend pay-outs from firms with low credit ratings. David Black, Ofwat’s Chief Executive, also warned of the impact of higher interest rates on sub-investment grade debt.

According to EdenTree’s White, investor engagement on the scale similiar to that mobilised to address climate risks is required to help water utilities to tackle their environmental challenges, noting research which suggests investors have not held investee firms to account in recent years.

“Water utilities have largely avoided investor scrutiny on environmental issues and this needs to change. We believe investors should engage with their water utility holdings – both their equity and debt investments – to lobby for better performance,” he said.

But White said increased engagement by investors should be accompanied by an appreciation of the “complex” operating conditions faced by utilities, as well as the broader changes needed to address evolving water access and quality challenges.

Investors should pose questions around new infrastructure investment to build resilience, he said, as well as increased use of technology to detect blockages, and use of nature-based solutions with lower environmental impacts. But they should also recognise that water utilities are “only one piece of the puzzle” on environmental issues such as pollution.

“Investor engagement should not be limited to the companies themselves, but also extend to other key contributors like agriculture, and policy work with regulators and government,” he said.

Investor oversight of water usage by large corporates has increased in recent years, supported by the development of tools and frameworks to measure performance around responsible water usage.

Increasingly, firms in a number of sectors are being urged to adopt circular economy principles, partly to limit the impact of their activities on water supply.

“The circular economy is inseparable from the goal of sustainably managing and protecting Earth’s water supplies – without circularity, clean water resources will continue to be reduced and contaminated,” wrote Yohann Terry and Jann Breitenmoser, both portfolio managers at Man GLG, in a recent commentary piece published by ESG Investor.

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