Water company governance: what’s it got to do with the regulator? Ideally, nothing at all. But Ofwat chair Jonson Cox believes stronger board leadership is essential for investor-owned public service monopolies. He argues that a test of transparency and legitimacy with customers and stakeholders is relevant and that at present not all companies in the sector pass it.
Cox raised the issue in March in his speech at the Royal Academy of Engineering. A couple of weeks ago, Ofwat followed up with an information note on board leadership in which it told companies to spell out clearly in their upcoming financial reports how they meet the requirements of the UK Corporate Governance Code, which is enshrined in their licences. The regulator demanded “the highest governance standards”, noting: “This applies not only to the regulated company board but also the way in which the holding company operates and interacts with the regulated company.”
Is Cox right to suggest the governance of investor-owned water companies deserves more scrutiny? If he is, what should be the role of the regulator? And finally, how should the companies themselves respond?
Good governance is a slippery concept. An operational view of governance is that it is the way that boards make decisions effectively, including the right trade-offs between competing interests. It entails having well qualified, independent boards with good information available and transparent assurance that they have used this information in their decisions.
It would be undesirable for water undertakings, whatever the reality, to become seen in the same light as Amazon and Starbucks have been recently. Cox’s specific concerns (see box) are about the transparency of governance arrangements, the leadership of water company boards, the unexplained complex ownership structures, and dividend payments that have not been justified in terms of the risks to which the companies are exposed. He feels the last of these is particularly important at a time when water bills (linked to RPI) are rising faster than customers’ incomes.
Cox’s criticisms do not apply to all water companies, and the Ofwat chairman is asking questions rather than reaching conclusions. If complex structures are there for a good reason, this can be explained. If they are not explained, then they should be changed.
One of the objectives of Ofwat’s broader price-setting reforms is to put as much responsibility as possible with companies and offer a less intrusive approach to those that demonstrate they have produced a well-balanced and well-evidenced 2015-20 business plan.
If water companies are to be “fast-tracked” in this way, Ofwat will need to have confidence in the leadership and governance of the companies and their owners; that the companies and their structures are compliant with the spirit as well as the wording of licence conditions; and that business plans have had regard to wider considerations of legitimacy and the interests of customers.
If a company does not meet these criteria, Ofwat will not adopt a lighter touch. In terms of governance, this might mean:
· re-writing licences to reflect up-to-date thinking on governance and leadership;
· setting code compliance as a minimum requirement;
· compliance with requirements for greater transparency about ownership and returns;
· Ofwat playing a more active role in the appointment of non-executive directors.
For many, these steps would be going beyond the appropriate role of the regulator. Some would doubt that Ofwat has the capability to design such changes, in a timely way, to improve the situation without triggering unintended consequences. After all, one could argue that it was Ofwat’s decisions, made for other reasons, that led to some of the governance and transparency weaknesses that have been identified. Cox is inviting chairmen, non-executive directors and investors to propose better arrangements themselves.
This raises the question: what should be the balance of regulator and company action? Good practice, strong non-executive directors and transparency already exist in the sector, and while few companies may be meeting all the criteria, it should not be too hard to make a start on addressing the areas and instances where weaknesses are present.
Ofwat intends to initiate action. For this to result in a good outcome, the companies and their investors will need to review and understand the full implications of the arrangements they have in place. They will also need to develop proposals for improvements that will be acceptable not just to investors but also to others with a valid interest in the board leadership, transparency and legitimacy of this important public service.
Ofwat in turn should offer public validation of effective arrangements, and in particular of proposals that prove effective in initiating change. It has left it open what form such proposals should take and this provides scope for the companies in their individual circumstances to come up with innovative proposals that will work for them.
Ofwat intends to hold meetings (it may have had them already) with those companies facing, in its opinion, the greatest challenges in this area. The intention seems to be to allow companies to make some improvements in this year’s reporting cycle, with full compliance to good standards in time for submissions to the next price review, PR14. Ofwat has invited owners to get involved in this work.
It will require boards to understand and rethink their arrangements. For credibility and new ideas they could consider giving their independent non-executive directors a prominent role in the review process and involving those with experience of strong board leadership in other sectors, including experts in governance working in investing institutions. Far from thinking that change will increase risk, they may conclude that there would be a bigger risk in doing nothing.
Clearly, voluntary action by the companies will be the best way forward, but only if it is purposeful and quick enough for change to be effective for PR14. Cox is understood to be open to constructive approaches and impatient with any who would try to delay. It will be up to the sector and Ofwat to engage openly and constructively to get a good result.
Felicity Furness is a principal consultant at Indepen
High-risk five
Where might firms be non-compliant with the UK Corporate Governance Code?
· the board of the regulated company is seen as “operational”, with strategy and structure reserved for the investor board;
· independent directors are not in a majority;
· chairs are not always independent of management and investors;
· non-executive directors in some highly leveraged companies do not seem to grasp the complexity and risks of their structures;
· there is not always a clear role for independent directors in setting the structure of management rewards.
This article first appeared in Utility Week’s print edition of 3rd May 2013.
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