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30 years on from privatisation, what's next for the water utilities?

We look at whether talk about extra regulation and renationalisation is a cause for concern for investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Back in 1989 the UK’s water authorities were privatised in a £3.6bn deal. And after 30 mostly benign years that have been characterised by a steady flow of dividends to shareholders, two interesting questions are bubbling up.

Going full circle?

Margaret Thatcher’s argument was that privatising industrial and commercial bodies would improve the UK’s economic performance. That’s a view that’s been generally accepted by a string of leaders on both sides of the House, including the current occupant of Number 10, Boris Johnson.

But the rise of Jeremy Corbyn, the first staunchly left wing political heavyweight in a generation, means there’s no longer a uniform consensus. The Labour Party’s position is to renationalise water and electricity utilities. With an election looming, that means the possibility of a return to public ownership is a very real one.

Of course, we’re not here to evaluate the merits of that policy, or assess whether society would be better or worse for the change. But with over £13bn of shareholders’ money in the listed water groups, it would certainly impact investors.

Takeovers usually go through for at least the market value of the target company, but the Labour leader has said there’s no guarantee shareholders would even get the prevailing market value for their investments.

It’s hard to get a grasp on what the sector is worth, as 12 of the 15 UK water groups are not publicly listed. However, Labour has suggested that the whole sector could be taken for just £14.5bn. That figure equates to the cumulative book value, which is the difference between assets and liabilities. That’s well below the £34bn at which a recent study by the Social Market Foundation valued the equity.

A third option would be to take the assets for their regulatory value. Those figures are still less than their current market capitalisations, so not an ideal scenario for shareholders. But it could limit the downside.

When looking at the table below, it’s worth remembering that around a third of Pennon’s profits come from non-regulated activities at Viridor, the waste management subsidiary. This likely wouldn’t be part of any nationalisation deal. This goes someway to explaining why the difference between Pennon’s market cap and Regulatory Capital Value (RCV) is so high.

Market capitalisation Book value Regulatory Capital Value (RCV) minus net debt
Pennon £3.2bn £1.7bn £1.4bn
Severn Trent £5bn £1.2bn £3.4bn
United Utilities £5.5bn £3.1bn £4.5bn

All book values and RCVs taken from results to 31 March 2019

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Regulation, regulation, regulation

While the risks of nationalisation attract the headlines, there’s another threat looming – regulation.

Most industries don’t have the need for price control. For example, the presence of Tesco limits Sainsbury’s pricing power, because it’ll lose customers if it increases prices. Consumers benefit from the presence of healthy competition.

It’s a different story in the world of utilities. It doesn’t make sense for lots of companies to invest in all the infrastructure needed to run a water company then compete for customers. It’s what an economist would call a natural monopoly. With this in mind, water companies are instead assigned certain territories where they are the only supplier.

Of course, it’s not quite a free rein. To compensate for the lack of competition, which would help keep prices in check in a normal marketplace, business activities are heavily regulated. Pricing reviews take place every five years, and use the size and cost of the asset base (measured by regulatory capital value and the depreciation expense) to come up with an industry estimated weighted average cost of capital (WACC) which ultimately dictates allowed returns.

The regulator, Ofwat, uses WACC in its calculations because it blends the costs of the different methods of financing a business, debt and equity.

Ofwat is proposing to cut inflation adjusted WACC from 3.7% to 2.4%. A lower WACC has the effect of reducing allowed returns, making life tougher for the water groups.

So where does this leave us?

In a nutshell, all the ‘ifs, buts and maybes’ mean the sector carries significantly more risk than it has done previously.

However, investors will be pleased to hear this isn’t all bad news. For example, while the water groups face tougher regulation, they still have the potential to earn extra returns by delivering good performances and all three of the listed groups have seen their plans for the next regulatory period awarded fast track status.

The worries around nationalisation only become relevant if there is a change in government. Of course, that can’t be ruled out, but at the moment, it’s tough to pencil in either.

And while there is plenty of uncertainty, one thing we can say for certain is that the worries around the sector have pushed valuations to more attractive levels. On average, the price-to-earnings ratio of all three companies are significantly lower than their recent averages, and dividend yields are higher however these are not guaranteed or a reliable indicator of future income. Provided there are no changes to dividend policies, investors could well get more bang for their buck.

That means while the everyday businesses remain as boring as ever, the debate over the investment case is far from dull as dishwater.

Remember this is not personal advice and all investments can fall as well as rise in value, so investors could lose money.

More on Pennon

More on Severn Trent

More on United Utilities

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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