Divining the profits

Consumers have been paying over the top since privatisation, argues <strong>Anna Bradley, </strong>d

Consumers have been paying over the top since privatisation, argues Anna Bradley, director of the National Consumer Council

Among the four-fifths of households in England and Wales whose water is not metered, the average bill is £255 - compared with £118 in 1989-90, when the water and sewerage industry was privatised. Bills have doubled over the period, increasing three times faster than general inflation.

Not surprisingly water customers, local campaign groups and consumer bodies are dismayed at this price hike on an essential public service. Are they justified? Ofwat, the water industry regulator, thinks so. This month it is likely to propose one-off cuts in domestic charges from next April.

Ten years ago consumers were warned to expect price rises after privatisation. As the new water regulator succinctly put it: "The time of cheap water is over." The increases were meant to do two things: meet a shortfall in the capital spent on repairing and upgrading our old sewers and mains system, and improve the infrastructure to meet coming demands for such things as higher water quality and cleaner beaches and rivers.

Many people agreed that improvements were necessary. But since the water industry was supposedly being privatised in order to gain easier access to funds, through equity and borrowings, steep hikes in water charges were not inevitable. So from the start, the National Consumer Council decided to track the financial behaviour of the new water companies, to monitor how consumers' money was used and whether the companies were trying hard enough to secure alternative funding.

Unfortunately, as a result of several low-rainfall years and new European environmental regulations, some environmental groups pressed the regulator to increase consumer prices further. This was necessary, they argued, because the industry needed more funds to invest in environmental improvements.

But there doesn't have to be a trade-off between price cuts and environmental improvements, because, in reality, the companies' corporate decision-making and financial behaviour are major factors determining how much they invest and in which capital programmes. Dialogue has developed between some environmental and consumer groups, and as a result there is now more common ground between us on this issue.

At privatisation the new companies received more than £6 billion from the public purse, mainly to write off nominal debt and launch them into the private sector with better balance sheets. Since then every domestic consumer has funded the water and sewerage companies, to help ensure they cannot go bust. (Ensuring their solvency is one of Ofwat's main tasks.)

In the first year of privatisation, domestic consumers contributed, we estimate, £1.98 billion to the ten new companies in England and Wales that provide all sewerage services for consumers and 75 per cent of the water. By 1998 that figure had increased to £4.06 billion, with more than 95 per cent of the rise coming from price hikes. So during this time, residential consumers have contributed £28 billion to the ten businesses, of which more than £10 billion came from higher charges. Capital investment over the same period has risen from £1.6 billion to more than £3 billion. We pay more so the businesses can invest more. But have we paid too much?

Ofwat, which sets the price limits, operates a partially closed regulatory system. Many of the regulator's detailed deliberations are fenced off from public scrutiny, partly because of so-called commercial confidentiality - though this seems hard to justify with monopoly businesses - and partly because it uses a financial regulatory model peculiar to itself. Ofwat's financial figures are not presented in the same way that the regulated core water and sewerage businesses present their annual regulatory accounts. Nor are these accounts directly or easily comparable to the normal annual financial accounts of the parent companies that own the regulated businesses.

So the system is far from transparent and means that few outside the water industry actually know whether the businesses have met their required increases in capital investment.

What is clear is that domestic consumers' contribution to the businesses' total income has stayed at about 70 per cent, which has directly helped to boost their aggregate turnover from £3.3 billion in 1989-90 to £5.8 billion in 1997-98. This contribution by consumers has also enabled the companies to increase their operating profits from £993 million to £2.6 billion over the past eight years, with profit margins increasing from 28 per cent to 45 per cent.

It is clear, too, that most of the profits increase has come from higher prices, rather than increased efficiency. The businesses argue that this increase is justified because a substantial amount of capital investment is funded from profits. But of the businesses' £16 billion profits over this period, £9.5 billion have been transferred out of these core businesses through "dividends" paid to the parent companies.

Some, but not all of these "dividends" eventually show up in the parent companies' dividends to shareholders. For example, last year about 40 per cent of "dividends" paid by the ten regulated water and sewerage businesses were returned, indirectly, to shareholders of the parent groups. What happened to the other 60 per cent? We have to assume it was absorbed back into the operations of the parent companies. After several years of urging by the NCC, Ofwat is now scrutinising the dividends issue, and our hope is that the next price cap will be tougher and result in the companies relying much less on income from consumers and more on alternative sources of finance.

Has this level of profit and dividend growth led the parent companies to raise money on equity markets to help fund capital expenditure in their core water and sewerage businesses? The short answer is no. Has it allowed them to borrow funds for investment more cheaply? Here the answer is probably yes. Yet although interest charges on borrowings declined to 6 per cent in 1997-98, borrowings still accounted for only a third of the businesses' capital employed. Ofwat's view was that loans could nearly double without presenting significant problems.

The businesses could have increased their borrowings by £6 billion or more without adverse affect on either the cost of loans or shareholder confidence in the parent companies. Such high profits growth and generous payments to shareholders could also have allowed them to raise serious extra money on the equity markets. Instead they have relied much more on the rapidly rising flow of money from captive consumers.

Consumers have therefore contributed much more than their fair share since 1989-90. The exact amount probably starts at £6 billion and could well be a lot higher: an estimated total overpayment of £300 a household over the decade of privatisation. That is why the NCC will be supporting Ofwat if, on 27 July, it proposes a one-off price cut. In any event, we will oppose any proposals for higher prices after next April.

We are also repeating our call for a change in the way the regulatory process works. It has to become more transparent, fair and accountable. This is an urgent priority because five of the ten big businesses are part of multi-utility groups or have otherwise been taken over. Southern Water, for instance, is part of a group owned by Scottish Power, which also owns the regional public electricity supply company Manweb and has other businesses within the corporation.

It is already difficult to track how the consumer contribution to the regulated businesses is used; it is doubly difficult to discern how the income from water and sewerage customers is treated in groups that run other utility and non-utility businesses. There has to be a serious chance that the large corporations, including US- and French-based conglomerates that now own some of these major water utilities, could outmanoeuvre both Ofwat and consumers and keep prices higher than necessary.

Affordable and efficient water and sewerage services should be a basic human right. They are also crucial for public health. So when those who provide this essential service are in effect monopolies, their actions should be subject to public scrutiny, with effective redress and representation mechanisms for those who pay for and use the service.

Consumers are, in our view, getting a bad deal while shareholders are receiving excessive returns. Companies clearly prefer to use secure and rising revenues from consumers, rather than working harder to secure low-cost funding from elsewhere. The consequent increases in water bills have undoubtedly created problems for millions of low-income households. High utility prices can only make the problems worse for those who are already suffering economic hardship.