Thames Water fiasco: lessons to be learned

Gordon Gekko, the central character in the 1987 film, Wall Street, and played by Michael Douglas with just the right measure of nastiness, is the one who gave us the now iconic phrase “Greed is good!” I was there. Or nearly. I did not make my first trip to One Wall Street, the headquarters of my then employer Irving Trust, later to be acquired by Bank of New York, until 1988 but I did get pretty close to kissing the stone. I was, however, there in time to buy Connie Bruck’s book on the phenomenal rise and fall of Michael Milken, The Predators’ Ball. Whether or not Milken’s misdemeanours should have been pursued with the vehemence with which they were is moot and whether the destruction of Drexel Burnham as a firm was justified is equally contentious. Whether both were sacrificed on the altar of District Attorney Rudi Giuliani’s ruthless political ambitions will no doubt be discussed as long as people who were there at the time live on.

What is sure is that, without the extraordinarily innovative thinking of Mike Milken, we would not have the private equity business we have today. And those who know me will not be surprised to hear me suggest that we might be better off without it. Or at least some aspects of it. The late 1980s had an air of “can do” about them. Sure, many of the routes down which we travelled eventually proved to be dead ends, but what did stick was the markets’ ability to raise astronomical amounts of money in order to execute trades that might previously have been unthinkable. The “Greed is good” affected not only Wall Street but brought with it a culture of corporate kleptocracy which is sadly with us to this day, the high point of which was surely the leveraged buyout of RJR Nabisco in 1989 for US$ 24 billion – equivalent to US$ 75 billion in 2024 dollars. The hated corporate raiders morphed into activist investors, the dodgy buyout boutiques became private equity giants and the lowly junk bonds they used to finance their business became the base of the now entirely legitimate high-yield debt market.

Concurrently with the rise of the mad money, we in Britain had Margaret Thatcher and her economic guru Alan Walters. Thatcher believed that markets were significantly more efficient in allocating capital than the state was and that therefore any enterprise that was state-owned and state-run should be denationalised and given over to the private sector. Beginning with the behemoth British Gas – then followed by the electricity and water infrastructure – huge privatisation sales took place, in the process of which the dream of wider household share ownership was pursued. During the privatisation share sales, private citizens’ applications were given priority status even though, when all was said and done, in most cases the few hundred shares people did get were rapidly sold for a quick profit which was then spent down at the pub.

Expecting a more efficient employment of capital in a privatised utility business on paper looked right, especially if overseen by an independent authority tasked with representing the public’s interests and assuring that they remain paramount and above those of shareholders. Thus were created Ofgem, the Office of Gas and Electricity Markets and Ofwat, the Water Services Regulation Authority. Yes, I’m on my way to the Thames Water fiasco but I’m not quite there yet.

One of the key Thatcherite mistakes was to break the national monopolies into too many smaller groups, ostensibly in order to create competition between the businesses which was in turn supposed to generate the best supply prices to end users at both corporate and household levels. Competition would drive them down while the regulators, Ofwat and Ofgem, would cap them to the upside when adjusted for necessary as well as desirable infrastructure investment. What could go wrong?

The myriad of bite-sized utility companies with steady cashflows was irresistible and more or less as quickly as the companies were being denationalised, foreign nationalised utilities pitched up and began buying them. Not only the utilities but privatised public transport units were being snapped up. Thus the London bus network now bears the logo of RATP, the state-owned French transport group serving Paris. One need not go far to find EDF, the state-owned Electricité de France, on one’s electricity bill as they own and operate London Electricity, SWEB, Seeboard and British Energy. E.ON is a German-owned group that was formed from the merger of German companies VEBA and VIAG. The group bought UK energy company Powergen back in 2002 but it wasn’t until 2007 that its UK energy operations were renamed E.ON. Npower is a subsidiary of German energy company RWE Group. It was bought in 2002, having evolved out of National Power, later renamed npower, which had bought the likes of Calortex, Independent Energy and Midlands Electricity following privatisation. ScottishPower was formed in 1990 from the South of Scotland Electricity Board which went on to buy Manweb, the energy company supplying Merseyside and North Wales. In 2006, the company was acquired by Spain’s Iberdrola. I’m sure none of them are in there for the love of Britain.

I followed the privatisation of Thames Water with special interest as my late brother-in-law Mike Hoffman had been hired as CEO in order to carry it out alongside chairman Roy Watts. I recall well the great public debate over the privatisation of the water industry, the most common argument being that water belongs to all of us. It comes down as rain and now we are selling it to ourselves. Water had for a century suffered from chronic underinvestment. It was living with Victorian infrastructure, in dire need of a significant upgrade. With captive client bases, successive governments had used the utilities as cash cows. Ofwat was created to prevent private owners from doing the same. Until privatisation, water bills were not bills based on usage but were defined as water rates, a flat charge per household. Thus, for all intents and purposes, a user could open all the taps around the clock at no extra charge while a single-person household nextdoor would be paying the same. There was much work to be done, many decades of public sector mismanagement to be caught up.  

In those days, before I was married, I spent a lot of time with my sister and brother-in-law and experienced firsthand the post-privatisation Gordian knot he had to deal with. Mike’s greatest achievement and enduring legacy is the London Ring Main, a single 50-mile long concrete tunnel under London which not only enables the transport and distribution of water under the capital but also serves as a huge reservoir free of the effects of evaporation. As Thames Water’s troubles are now headline news, there are repeated references to then Chairman Roy Watts having died in the Thames. I happen to know of the personal issues with which Watts was dealing and find some of the allusions deeply distasteful.

“Greed is good” and utility privatisation come together when leveraged buy-out firms use the steady cashflows generated from captive customer bases to back huge and highly geared acquisitions, the past master of which is the Australian shop Macquarie. Thus, it can come as no surprise that they have had a dog in the Thames fight. Initially, it was RWE, the German power company, that acquired the Thames Water cash flows, but it then let itself be bought out by Macquarie. Macquarie very craftily established a holding company called Kemble Water Holdings that effectively immunised the owner of the business from the regulated entity which RWE had dumped following its own failure to meet leakage targets. Macquarie is effectively an investment bank and not a utility operator so in due time it sold its holdings to the Kuwait Investment Office and OMERS, the Ontario public sector pension fund. Current Shareholdership in Kemble is wider and notably includes the Universities Superannuation Scheme.

The art of leveraging that beautiful and steady stream of cash that utilities generate was not lost on the new shareholders who continued to generously help themselves to income generated by the holding company at the expense of the operating company. I won’t go into the detail – that has been quite comprehensively explained in the mainstream press – but the effect is that infrastructure investment has not met requirements while debt has piled up and generous dividends have been paid. It appeared as though shareholders didn’t really give a toss for the business of Thames Water as provider of both water and sewage services to a quarter of the population of England but saw it merely as a vehicle to generate enough cash to pay the interest on the debt which in turn provided the dividends. Of course, it’s not quite that simple but it comes close. Let’s face it, pension funds have liabilities and, with the likes of the Universities Superannuation Scheme looking to match tens of thousands of final salary pensions in a low-interest environment, who can fault it for going where the income streams look juicy? I can!

Given the expressed wokeness of the higher education environment – it was they who were amongst the first to “defund” oil – it is an embarrassment to see the USS owning 20% of the shares in Kemble, a company clearly established in order to benefit from utility cashflows without risking direct exposure to the regulatory requirements and, in the case of Thames Water, the failure to meet them. In defence of Thames, one must add that UK water bills are amongst the lowest in the industrialised West. The original opposition to supposedly selling to us what was already ours, which goes back to the late 80s, is reflected in the reluctance by water companies to charge for what comes out of the tap – not only what it costs to get it there but what it will cost to keep on getting it there in the future. A ball was dropped a long time ago when part of Ofwat’s remit was not to involve imposing a cap on the leverage ratios on its wards’ balance sheets. But who in 1989, when Ofwat was established, could have envisaged the corporate debt culture that emerged at the beginning of this century under the guise of shareholder value?

I spent nearly four decades in the corporate debt markets, first in loans and then bonds, watching on as great triple-A and double-A companies sacrificed their once highly prized top-end debt ratings on the altar of so-called shareholder value. Thames Water is not the first company to trip over its debt, but it is surely one of the most prominent. I have sympathy for the management which finds Ofwat reluctant to let it bail itself out by charging a more realistic price for water supplies. But I feel little sympathy for the shareholders who have sat there ringing the till at holding company level while the operating company which fed the fatted calf was itself going hungry. Bondholders are equally guilty of missing the joke. 

Let Thames Water and Kemble go to the wall. Let the shareholders pay the price of their own indifference and bondholders the price of their own naivety and evidently slack due diligence. Do not permit taxpayers to be burdened with rescuing a company with a morally corrupt business model. Should water be back in public ownership? I think not for I am old enough to remember what an unholy mess the businesses were in when they were still state-owned and why they were privatised to start with. Doing the right thing the wrong way does not of itself make the right thing wrong. Rant over.

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