From the TUC

Can water investors really ‘require’ a 5% return?

03 Jun 2013, by Guest in Pensions & Investment

Everybody needs water; there are no substitutes; there is no competition. The financial risks are minimal. So should consumers simply accept the industry’s belief that a 5% rate of return is justified?

With average water bills rising by 50% (in real terms) since 1989, as our recent report on the water industry found, is it right that 30% of annual turnover is regularly siphoned off to profits?

The report in question and, in particular, the attention it paid to the 30% share of turnover accounted for by operating profits, has not gone down well with the companies’ voice, Water UK, who contest that:

“What the report has not taken full account of is the £108 billion that water companies in England and Wales have invested to improve water and sewerage services over the nearly 25 years since privatisation – that’s over £10 million per day, every day. This investment has been made possible by private investors, who require a reasonable return on their money, currently about 5% – that’s £5 a year for every £100 they put in, very different from the figures quoted by the New Policy Institute”.

Although our report paid plenty of attention to investment, it did not express profit as a rate of return on investment. So where does Water UK’s 5% leave our 30%? Does one number knock out the other? If Water UK is right – as surely it must be – then must we be wrong?

The answer to these questions is ‘no’, for the simple reason that we and Water UK are measuring different things. The main difference lies in what the profit is being divided by to reach the percentage quoted. In our case, we are dividing annual profit by annual turnover. In their case, they are dividing annual profit by the money investors have put in over a period of years.

Since privatisation, water has been marked by the very high levels of investment by the industry – between 40% and 50% of turnover every year. Coupled with the negligible level of retained profit, this means that the total amount of money put in by investors is now bound to be several times larger than annual turnover. That is how our 30% and their 5% can both be right. Tellingly, Water UK’s carefully crafted final sentence restricts itself to the observation that the numbers are ‘very different’.

Even so, Water UK’s statement that private investors currently ‘require’ a 5% rate of return is helpful in taking the argument beyond where our report went. For while ‘30% of turnover’ may sound high, whether profit is reasonable can only properly be judged on the Water UK basis, that is, when it is expressed as a rate of return on capital. So what should we think of 5%?

Answering this depends upon an assessment of the financial risk associated with owning a water company in England or Wales. The business itself is very predictable: water is a necessity and there is no competition. The financial risks, such as they are, arise from the regime of regulation which governs these monopolies. As financial risks go, water is at the low end. The best benchmarks for water are therefore long-dated Treasury Bonds.

At the moment, a 10 year Treasury Bond is yielding about 2% while a 30 year bond is yielding 3%. These bonds, though offer no protection against the damage that inflation will do to the real value of the original investment. How far water investments are protected against future inflation is uncertain. But since privatisation, the price of water has gone up roughly threefold while prices in general (‘inflation’) have only doubled. If water returns are proofed against inflation, the better comparison is with Treasury Index-linked Bonds – where the current yield (on 30 year bonds) is actually negative (-0.5%).

Owning a water company is not risk free and there should certainly be a premium over the ‘risk-free’ rate. Nevertheless, there is an enormous gap between -0.5% and 5%. Say the additional risk was estimated at 3%. That would mean that the return on investment in the water industry should be 2.5%. This would put profits at half their current level. In that case, water bills would be 15% lower, a saving of more than pound a week for the average household.

We are not ‘calling’ for such a cut; at the moment, this is just an illustration of the fact that at this time of austerity, there is a lot of scope for lower water prices. Instead of telling us that their investors ‘require’ 5%, the water companies need to explain to the public and the politicians why they should earn this. After all, if you marched into the bank and simply announced the rate of interest you ‘required’, you know what the answer would be.

GUEST POST: Peter Kenway is Director of the New Policy Institute (NPI), an independent progressive think tank which produces evidence-based research on a range of social and economic issues. Prior to founding NPI in 1996, Peter worked as a manager, consultant and planner in public transport, as well as an academic economist at the University of Reading.