Privatization with competition was the mantra for 1980s neoconservatives. In the US, they wanted to sell the Tennessee Valley Authority (TVA) and municipal water suppliers. In Mexico they sold the telephone company and in Argentina, well, everything. In Spain and Italy they sold off holdings dating back to the fascist regimes. In the UK, though, privatization was an ideological trophy for the Thatcher government. The privatizations and industry reorganizations produced mixed results, good for investors, so-so for consumers and a bonanza for the Treasury. But the privatization of the water industry in England and Wales (the Scots passed on the opportunity) turned into a fiasco. The government sold off water supply companies with inadequate infrastructures that had responsibilities for water pollution, dirty beaches, leaky pipes, not much in the way of competition (try shipping water long distances) and the need to spend huge sums to fix the systems (which could only be paid for by sharply hiking prices). Does that sound, sort of, like the situation of many American utilities that have let their infrastructure run down for so long? You decide that.
But start by looking at the situation at Thames Water, and ask how it might apply to the energy business. The water utility serving the southeast part of the UK including London, Thames Water, appears to be in extreme financial distress. Newspaper headlines in the UK cite “a 10 billion pound black hole”, the CEO’s sudden resignation, excessive debts (some floating rate), and possible government takeover and financial restructuring—which effectively means renationalization. The Thatcher administration privatized the water and (other former government owned) utilities in 1989. Before privatization these entities borrowed money at the government rate, were debt free, paid no dividends to shareholders, and the senior executives were compensated like senior civil servants. After thirty two years of private ownership and (mis)management this company is now laden with debt, paid out billions in dividends to shareholders, may have scrimped on big capital projects, faces major operating problems, and is on the brink of insolvency. Related: Oil Industry Leaders Remain Confident About Long-Term Demand
Let’s pause and ask a simple question: why don’t privately owned utilities typically get into financial distress like this? The answer is that they are regulated by the government. And further the government via its regulators has input into things like levels of capital expense, the cost of capital, and overall service quality to the customer. So we expect Ofwat, the UK water industry regulator, will have some ‘splainin to do.
Amateur analysts have attributed the company's financial woes to excessive debt leverage (or gearing) which totaled 82% last year. Yes this is high by US and UK standards but typical in say Japan whose utilities are rated solidly investment grade by Moody’s and S&P. And debt is almost always cheaper than equity. So a highly indebted capital structure may actually serve the public’s interest if it provides capital funding at lower costs than those demanded by equity investors. (As in a 5-6% difference in cost between equity and debt). In the US for example, municipal utilities, co-ops, and G&Ts (generation and transmission companies) are 100% debt financed and seldom find themselves in financial distress. This level of balance sheet leverage is high but should not in and of itself be seen as inevitably crippling. The problem for Thames Water is that almost half of their debt is, you should pardon the expression, floating rate, that is, the interest rate they pay increases or decreases with the rate of inflation. And lately that rate has been moving steadily upward increasing interest expense for the corporation on an already bloated balance sheet. This combination, too much debt at a rate floating higher, represents a huge financial burden and one not always survivable. But it gets worse.
If Thames Water was functioning as a best in class water utility we would say this degree of financial engineering and apparent mismanagement might be rectified by stern regulatory treatment and a management change, some of which has already occurred. (Both the CEO and the Chairmen of the Board have already been replaced.) But that’s not the case here. The company’s aging water system is notably leaky and its sewage operation has been troubled by frequent unplanned sewage discharges. This implies a significant future capital commitment which the company in its present state of financial disrepair is unable to finance. The bondholders won't lend them more money and potential equity investors are skittish as well due to fears of nationalization and/or potentially punitive regulatory treatment. The bottom line? Any utility that can’t readily access its domestic capital markets on a timely basis and at reasonable rates is, so to speak, a dead man walking. (Alternatively insert dead parrot joke here.) And that’s Thames’s problem. They have been financially mismanaged to the point where no one will loan them money, neither debt or equity investors. And typically (and sadly) for existing investors the result is inevitably financial reorganization or as we say in the US, chapter 11. Under these circumstances equity investors (along with bondholders at the holding company) can face a massive loss of principal. The only good news here is that because Thames serves over 20% of the UK population including London, financial resolution or at least stabilization should come fairly soon.
The last question to address here is why is this financial distress occurring now? In the utility business there are only two “silent” killers—negative customer growth (leading to the so-called death spiral of ever rising rates on a diminishing customer base) and inflation. Inflation adversely affects utilities because the business is so uniquely capital intensive. Utilities are essentially construction and finance entities which operate what they build. In an inflationary environment both sides of those businesses experience rapid cost escalation: financing costs, labor expense, construction materials all moving up sharply. And yes there are regulators like Ofwat that grant rate relief on a formula basis to compensate for inflation, but the numbers have gotten too big, politically speaking, to ignore.
We view excessive corporate debt as not only a form of frailty or vulnerability. It can also constitute a tipping point beyond which no one will provide capital. Thames Water is at that point. But what is key for us is that a highly leveraged corporate capital structure is a choice that management’s make. In that light Thames’s Water should be seen as weak by design, that is, weakened by all the dividends paid out and debt layered on in its place. The only thing from a post mortem perspective that’s interesting here is why the owners got so greedy or lazy as to kill such a reliable cash cow.
But in turn this raises a broader question about utility privatization thirty years after Thatcher. What did her neoliberalism actually mean? The new owners extracted capital from the business via dividends regardless of earnings levels, added massive amounts of debt, and underspent on capital expenditures leaving the business essentially bankrupt. The term “legal looting” comes to mind here. Aficionados of mob movies will know this by its real name, a “bust out”.
By Leonard Hyman and William Tilles for Oilprice.com
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