"Aggressive dividends are at the heart of the public distrust"

He’s done it again. Every couple of years, since assuming the chairmanship of Ofwat in 2012, Jonson Cox takes to the stage and makes a speech that sends shivers down water company bosses’ spines. The first time, in the shadow of the Section 13 debacle just months after his appointment, he set out a six-point plan for water company reform. In 2015, he set his view of a more fragmented, diverse and differentiated water sector, insisting “the logic of vertical integration no longer works”.

But this time was different. When Cox addressed the Water UK City Conference this week (Thursday 1 March) he was speaking not only of his own and Ofwat’s concerns about corporate behaviour in the sector, but also those of secretary of state for the environment, Michael Gove. Gove hit the headlines earlier this year when he wrote to Cox decrying the use of opaque financial structures and excessive executive pay in the sector, promising to give Ofwat any new powers it deemed necessary to crack down on the behaviour. Cox, in turn, promised to respond to Gove by early April this year with a progress report and next steps – and this speech set out his thinking ahead of that deadline.

Cox has long been critical of the practices of certain water companies – indeed, he took to the pages of Utility Week last year with an unprecedented public call for Thames Water to reform its corporate governance. This week, he repeated those criticisms, insisting that the current “crisis of confidence”, as he called it, was “about corporate behaviour and aggressive financial structures.”

Cox reiterated the steps Ofwat is already taking to work with those companies that are highly leveraged – by which he means, leveraged above 70 per cent: “We have said consistently that some companies must take action now to address apparently weak capital structures to maintain resilience into the long-term and an acceptable investment-grade rating. We continue to engage with these companies.”

Notably, he added that unless companies can meet financial stress tests, they may need to replace some of the equity that has been taken out of the business, asking: “Shouldn’t that equity be unencumbered (i.e. it cannot be debt at a higher part of the same corporate structure where the interest burden passes to the regulated company)?”

In another challenge for highly leveraged companies, Cox plans to deploy one of his favoured tools – transparency. From the 2017-18 financial year onwards, all water companies will need to publish a comparison of their actual returns on regulated equity versus what those returns would have been if they operated Ofwat’s notional structure of 60 per cent gearing. Using the examples of Southern Water and Anglian Water, Cox demonstrated how higher gearing can increase investor returns.

Graph: gearing of nine largest water companies (Wascs) in 2017

Red line illustrates notional gearing set out by OfwatSource: Ofwat

He said: “A customer might well understandably say that by having about a half of the equity that their customers pay for, both have flattered their equity returns and dividend yields by up to two times. There may be an element of outperformance on totex and performance incentives, but it appears that a significant part derives from a thin equity structure. Companies will have to explain this to their customers, who paid for the cost of a notionally-financed prudent structure.”

Cox reiterated the importance of financial resilience in business plans for the price review, PR19. He warned that companies whose financial structure differs significantly from Ofwat’s notional structure will have to work hard to convince the regulator of their resilience, and held out the threat of the ‘significant scrutiny’ business plan classification, with all the tough financial consequences that entails.

One of the most controversial financial issues water companies face is the level of dividends they pay out to their shareholders. Cox insisted that “aggressive dividends are at the heart of the public distrust,” and said he had been talking with a number of “progressive” water companies about what an appropriate dividend policy might look like:

  • A ‘gateway’ to any dividend pay-out, that the company must be delivering what it promised its customers
  • A base dividend set at about the level in Ofwat’s notional structure – currently around four per cent – adjusted downward pro-rata if the company has higher gearing
  • An additional outperformance dividend, set to ensure cash to investors was matched first by cash to customers in the form of bill reductions
  • Strong regard to employee interests ensuring that fair and appropriate payments were made before the dividend to pension deficits, for example

The headlines didn’t stop there. Cox turned to another of his recurrent themes – board leadership and corporate governance. Acknowledging the progress that has already been made on this issue, he raised a new suggestion – that independent executives should form the majority on the board.

Summarising all of this action, planned and underway, on corporate behaviour as ‘Tier One’ activity, Cox went on to detail Tier 2 – more fundamental reform that will require changes to water company licenses. These would be threefold – first, a new licence requirement on companies to put customers’ and society’s interest at the heart of their business. Second, a new requirement around resilience – financial as well as operational – which would oblige companies to maintain a standard investment grade credit rating.

Last, but by no means least, Cox raised the prospect of changing the way in which Ofwat makes licence changes – the proposal that caused so much controversy five years ago, just before his term as chairman began: “We all know that the process for licence changes is clunky, and our board is considering asking the Secretary of State for support – which a number of companies indicated they could support five years ago – to rationalise and make simpler the process for bringing about licence changes.”

In this multi-faceted programme of reform, there are many issues that at least some water companies will have difficulties with. But Cox was clear that, if they don’t fall into line, stronger action could follow. He hinted that, long-term, questions might be asked about whether companies should be allowed to set their own capital structures if they vary widely from Ofwat’s notional structure, and whether companies with higher gearing should receive a different cost of capital. He also held out the prospect that the current 25-year notice period on a company for revocation of its licence might be too long.

In a clear warning to companies, Cox said: “We’re not proposing to go there, but unless the industry moves forward on the steps I have indicated above, and achieve a ‘re-set’, these existential questions may be pressed on us.”

In case the chief executives and water company executives present at the conference were left in any doubt as to the pressure under which they find themselves, Cox’s speech was followed by the secretary of state himself, Michael Gove. Gove repeated his excoriating criticism of companies for their corporate behaviour, executive pay and – as he has it – lack of investment in long-term infrastructure. He praised Cox and the Ofwat team and promised to give them any powers necessary to fulfil their agenda.

As the speeches came to an end, the chief executives and investors were largely silent – reflecting, perhaps, that it would be a brave water company that takes on Cox and Gove together.