Water (Special Measures) Bill [HL]

Committee (1st Day) (Continued)

Amendment 10

10: Clause 1, page 2, line 3, at end insert— “(d) requiring a relevant undertaker to assess and report regularly to the Authority on actual or planned financial structuring of the undertaker, including debt levels, coverage of the associated commercial strategy and any associated risks.” Member’s explanatory statement The amendment requires that financial engineering becomes a regular focus area for timely reporting in order to assist in regulators’ understanding and alert them in good time to risks or distortions.

Amendment 10 in my name and Amendment 13, which we discussed earlier, seek to address the problem that lies at the heart of what went wrong with our water industry; the regulators were simply outsmarted by PE financial engineering, either because they were not paying sufficient attention to what was going on or because they just did not understand it. Regulators have either lacked or failed to deploy the skills needed to assess the impact and purposes of financial engineering introduced by corporate investors.

Amendment 10 addresses that shortcoming directly by requiring water companies to report regularly, not only on any financial restructuring or structuring but on the strategy lying behind it and any associated risks. This will ensure that such activities have to be made overt rather than, as hitherto, taking place under the regulators’ noses but apparently below their radar. I beg to move.

My Lords, I am delighted that Clause 10 does not appear to envisage a role for Ofwat. The amendments in this group are not really related to each other. As such, I shall confine my remarks to Amendment 86 in my name and I shall be brief.

Under the “Special administration orders” section of the Bill relating to the insolvency of water companies, Clause 10 gives the Secretary of State the power to modify a water company licence in order to recover any shortfall in costs for the Government from its consumers. New subsection (4) extends this recourse to all other companies in the sector.

I hope the Minister will tell me that I am mistaken in my interpretation of what this new subsection is designed to achieve. Does it not force good companies and their blameless customers to bail out failed companies? Can this possibly be justified? It has been a recurring theme of this debate, supported by the comments of many noble Lords, that the sector is in critical need of substantial investment to raise standards across the board and deliver the service that consumers and the general public so rightly expect. Any suggestion of collective punishment for the financial woes of others is to be resisted.

The consequence of imposing an unquantified and unquantifiable potential liability on the sector will at best push up the returns required by investors to inject capital into the water companies, inevitably increasing costs to consumers. At worst, it risks making the sector uninvestable. That is surely not the intention of new subsection (4), but it may be the consequence. My amendment would remove that risk, and I hope the Minister will support it.

My Lords, I will address my comments to the amendment in the name of the noble Lord, Lord Cromwell. I agree with him that financial restructuring of companies has led us to where we are now, with Thames Water potentially on the brink of collapse—who knows who is going to have to fund the huge injection of capital that has apparently now been agreed. Other water companies are heavily indebted. Ofwat, which is after all the economic regulator, did not query, question or challenge those decisions made in the early years of water company privatisation.

The consequence is that anything the Government now attempt to do is basically closing the stable door after the horse has bolted—and raced to the other side of the world—because the companies are where they are. Although I agree with the noble Lord, Lord Cromwell, that any future restructuring ought to be put under the microscope of the economic regulator, the current situation is leading us to a potentially very grave position, which the Government are trying to address with the other financial clauses in the Bill. I read the clause referenced by the noble Lord, Lord Remnant, as being directed pointedly at a particular water company.

I support the amendment moved by the noble Lord, Lord Cromwell. I suppose it is better to change the situation now than leave it as it is, but what has happened already is unfortunate.

My Lords, Amendment 92 is very simple. Had it been in place when the water companies were privatised, it would have prevented the aggressive financial engineering that has led to the financial distress we see regularly reported in the press, which has provoked much anger in this House and elsewhere over the years.

Before I address Amendment 92, I will briefly comment on Amendment 10 moved by the noble Lord, Lord Cromwell. It coexists neatly with my amendment, allowing regulators to be better informed on issues with the financial structures of the companies they regulate, and to be aware of future problems. I am pleased that the noble Lord has moved this amendment, and I broadly agree that the regulator should have better information about the financial structuring of water companies in the interests of protecting their viability and preventing circumstances in which they become overleveraged.

I will speak to the dangers of overleveraging and the problems we have as a result of the weakness of the regulator, but we on this side of the Committee are interested in the amendment moved by the noble Lord, Lord Cromwell, which takes a fairly moderate step towards having a better-informed regulator. That said, it may be possible to go further, either by reforming the way the regulator works in the water sector or, as I propose in Amendment 92, by implementing statutory rules on borrowing for water companies and taking effective steps to prevent capital being taken out of companies that are overleveraged. We need to make the water sector attractive to investors so that they bring more capital into it to fund investment in cleaner and better water infrastructure.

I add my whole-hearted support to the amendment proposed by my noble friend Lord Remnant. It seems grossly unfair that a company that has behaved responsibly should be penalised by the actions of another in the sector. I am aware of precedent in the financial services sector, but that is to protect the integrity of the financial system, which is in all participants’ interests. In this case, each water company is a unique entity whose actions have little or no impact on others. Without this amendment, one bad actor could contaminate the industry.

I turn to my own amendment in this group: Amendment 92. Its overriding purpose is to protect the Government as a stakeholder in this industry. The special administration order regime should never have to be implemented. As noble Lords are aware, this industry provides one of the necessities of life and has local monopolies. If the survival of that company and service to the consumer is to be guaranteed, as it must, the Government become, in effect, the owner of last resort. Why should the Government accept this obligation?

The amendment is intentionally simple and easy to implement. The financial services industry, where I spent my career before arriving in this House, thrives on complexity and creating ingenious structures based on that complexity. I hope to avoid that with this amendment. In this case, as I hope the Committee will agree, simplicity is best. I have set a ceiling on acceptable borrowing of 60% of the regulated assets in this amendment. I will not argue that 60% is the right figure, nor that the calculation of total borrowings to regulated assets is the right measure of that percentage. Ofwat uses 60% for its notional gearing. However, as a restrictive level, it may be necessary to go higher; that is, less demanding. Ofwat also uses net debt rather than total debt. I prefer to exclude cash balances, given that they may be necessary for working capital needs and not available to service debt, but I am not wedded to my definition.

I am aware that many of the companies in this industry are beyond this level currently and the impact of my amendment would be to force them to reduce their leverage beneath this level. That would be achieved by requiring all profits to be retained in the company, with no returns to shareholders or debt holders outside the operating company, until that leverage ratio is beneath this 60% cap. I am also aware that many of the water companies have holding companies above them that have debt serviced by the water company operating profits via dividends or other means and potentially debt guarantees. This amendment would sever those debt guarantees and significantly reduce the security of holding company debt holders and shareholders over the operating companies. In debt market terms, they would have been primed; other interests have been given priority over the cash flows of the operating companies without their consent. It is an aggressive move, but one with plenty of precedent in debt markets.

This amendment would make it impossible for an operating company to increase borrowing to fund a capital return or special dividend to a parent company or shareholders, if it took borrowing through 60%. It would also make ordinary dividends unpayable if it took borrowing through 60%. This amendment would help to protect our water companies from excessive levels of borrowing. If capital markets have been unable to set rules and standards for these companies to comply with their responsibility towards customers, employees and government, government must step in and do so.

The water companies have an investment plan of £88 billion, and I read that this is intended to be financed by only £10 billion of equity. Using the 60% rule, this is unlikely to be enough to protect the dividend-paying status of those companies through this investment plan. More equity may be required, or substantially more retained earnings. Ofwat already uses a 60% notional gearing ratio when assessing the industry, so there is acceptance that this is a reasonable number. However, the notional gearing ratio has no teeth. In its own words:

“Ofwat’s decision on the notional gearing level acts as an important signalling mechanism to companies considering their own choice of capital structure”.

It does not appear that much attention is paid to this signal. My amendment creates fangs and a barrier rather than a signal.

Other noble Lords have given cumulative numbers for debt, dividends and capital investment since the initial public offer and the flotation of these companies. The noble Lord, Lord Sikka, discussed the normal capitalisation of interest incurred in the case of construction, as well as repairs and maintenance, as if it is some kind of crime. In my mind, these discussions fail to see the wood for the trees. Financial gearing is the key metric of financial health for this industry, and the target that should be aimed at in the Bill.