Fixing the water sector: is regulation enough?

Good morning from New Economy Brief.

Bills are rising; rivers, seas and lakes are full of sewage, and water company bosses and shareholders have drained billions from the UK’s water industry since privatisation in 1989, leaving it heavily indebted and starved of investment. 

How do we get out of the quagmire? This week's New Economy Brief looks at whether the government’s proposals for stronger regulation will fix the water sector, and explains the economic and political arguments being put forward for public ownership. 

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Fixing the water industry

The Independent Water Commission, chaired by former Bank of England deputy governor Sir Jon Cunliffe, published its final recommendations to fix the English and Welsh water sectors last week. Environment Secretary Steve Reed responded by announcing plans to abolish Ofwat, saying the regulator had “failed to protect customers from water companies’ mismanagement of their hard-earned money and failed to protect our waterways from record levels of pollution”. 

Instead, the government will combine four regulators’ water functions into “a single powerful super-regulator”. The Cunliffe Review recommended a “fundamental reset of economic regulation” and changing how the price of water is controlled “to ensure companies are investing in and maintaining assets” and “attract long-term, low-risk investment”. The government will publish a White Paper in the Autumn explaining which recommendations from the Review it will adopt, followed by a consultation and a water reform bill. 

Public ownership wasn’t an option. Steve Reed banned the Cunliffe review from looking at nationalisation, arguing that regulation and companies’ management were bigger factors in their performance than their ownership structure. 24 campaign groups, trade unions and community organisations responded with a statement of no confidence in the recommendations. They say these won’t deliver the systemic change needed to fix our broken water system, because they ignore the fundamental problem: private ownership. 

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Is stronger regulation enough?

A 2023 Unison report on the water industry demonstrated how Ofwat senior staff move freely between the regulator and lucrative jobs at the water companies. For example, Ofwat’s previous CEO is now a director at struggling Thames Water. This revolving door is argued by Unison to have helped the water industry “capture” the regulator.    

Profiteering. An important part of this is the five-yearly ‘Price Review’ process, in which Ofwat permits companies to let them raise prices based on their investment plans. It has also been argued by academics at Greenwich University that water companies have been gaming the Price Review process by overpromising and underdelivering on investment, claiming they made ‘capital efficiency’ savings and using this to justify paying extra dividends. In over three decades since privatisation, “shareholders have literally invested less than nothing” and consumers have paid for what little investment there has been. Water companies are now well over £65bn in debt, while shareholders have taken dividends worth more than £85.2bn in real terms. 

Regulatory capture. Laurie MacFarlane, an economist who used to work at Ofwat, thinks the sector is now “an engine of wealth extraction”. He doubts any new regulator can compete with the resources of 16 water companies with combined revenues of £12bn (Ofwat’s annual budget is around £30m), who can hire the best experts to “game the system”. Regulators already have powers to fine, prosecute or revoke licenses for poor performance, but haven’t used them effectively. Campaigners like Compass warn that the Cunliffe Review offers no plan to avoid regulatory capture, and worryingly also recommends that regulators waive fines if companies claim paying them would hinder investment…

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Why was public ownership off the table?

So why not remove the incentive to maximise profit extraction by bringing the water sector back into a form of public ownership, like in the majority of European countries? Nationalising water companies would require compensating shareholders. The government estimates this would cost taxpayers around £100bn, which they argue would be better spent on other public services. But Ewan McGaughey’s briefing for Common Wealth explains that this figure “is not based in law” and comes from a report funded by water companies, “cynically calculated to scare gullible governments off public ownership”.

What would it cost? According to McGaughey, the government does not even have to pay market value (itself far lower than the ‘regulatory capital value’ behind the £100bn figure) because of the extent of water companies  breaching their statutory duty for poor performance – particularly for regularly dumping untreated sewage into rivers. The government can remove licences or put the companies into special administration, where only secured creditors would be paid ‘appropriate value’ while shareholders would receive nothing. It would be up to a court to decide what ‘appropriate’ compensation is, and the government could argue that damage from pollution or monopoly profits taken by shareholders should be subtracted from market values. 

UK precedents for nationalisation without compensation. There are several precedents of governments taking private companies back into public ownership with little or no compensation to shareholders when this is considered strongly in the public interest. Northern Rock was nationalised in 2008 without any compensation, and Railtrack was put into special administration, giving shareholders just £500m for the entire UK rail network in 2001/2. McGaughey concludes: “If a future government makes proper use of this evidence… compensation could well end up close to zero”.

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The case for public ownership.  

The water sector desperately needs investment to ensure a functioning and safe water supply and the protection of fragile ecosystems and communities at risk of flooding, especially as climate change, population growth and economic development drive demand higher. But under private ownership, this can only be funded through higher bills for consumers. Ofwat increased bills by 36% by 2030 in the latest Price Review to allow the companies enough profits to fund the necessary investments (and receive £22bn for their return on capital). The government hopes this will halve water pollution and win votes. 

Private ownership costs the public more than nationalisation. Publicly owned water is cheaper for two reasons. Firstly, the public sector can borrow far more cheaply than the private sector (e.g. Thames Water’s latest £3bn loan pays 9.75% interest, whereas public sector bodies can borrow at close to the bank rate – currently less than half that). Secondly, profit that would previously have gone to shareholders can be used for reinvestment in critical water infrastructure and services instead (over a third of water bills currently pay for dividends and interest payments). We Own It calculates that public ownership would cut households’ annual bills by £100–160 or allow £3-5bn more investment per year.

‍The government needs to reduce the cost of living. Lingering in the background of this debate is Nigel Farage’s pledge to nationalise half of all utilities, including half of the water industry. The state of England’s water is a radicalising issue for many voters because it is such a strong symbol of an economy that is rigged against ordinary people, and Reform UK are telling voters that neither Labour nor the Conservatives will stand up for them. 82% of the public support nationalisation of water, and groups within the Parliamentary Labour Party like the Living Standards Group are already warning that the government will lose the 2029 election unless it adopts more radical ideas to address the cost of living.