UK
Who Pays When Utility Managements Screw Up?
- Britain’s light-touch utility regulation enabled companies like Thames Water to load up on debt, extract cash, and fail operationally while regulators failed to intervene effectively.
- Unlike the stricter U.S. utility model, where regulators closely oversee financing and risk, the UK approach allowed excessive leverage and poor governance that ultimately left Thames Water financially crippled.
- Forcing customers to absorb the costs of rescuing the company creates a major moral hazard
Please excuse the infelicitous wording, but that is what this is all about. Not missteps or misjudgments but genuine, massive screw-ups. Policy makers in the United States worked out that problem over time, dealing with nuclear cost overruns and aborted projects. Three utilities went bankrupt (only one being investor-owned) when the financial burdens of nuclear projects far exceeded the resources of the utility. In most cases, regulatory agencies forced utility shareholders to bear some of the losses or imprudently incurred costs, customers paid some of the costs in higher rates, but creditors came out whole.
In the United States, regulatory agencies regulated not only prices, but also watched over utility financial policies, management dealings and quality of service. They did not necessarily tell the utility how to finance, but they often set rates based on how they thought the utility should finance, and heaven help those who ignored that advice. So there was little likelihood that financial misdeeds or self dealing would take place. Furthermore, the companies and the regulators had an implicit deal. The regulator granted the utility a modest profit that did not leave much margin for error or for unanticipated costs. In return, the utility expected the regulator to cover legitimate costs (whether expected or not) through the ratemaking process. The regulator, in effect, told the utility, “We give you a return commensurate with low risk, and we will keep that risk low for your owners and creditors as long as you don’t play any games with us.”
The British, since privatization more than three decades ago, have taken a lighter-handed regulatory approach. They did not like to interfere with ownership questions or how the company financed. That was management’s area of expertise. Companies could make big profits without regulators watching every move. It was like watching those black and white Ealing Studios movies: old Etonian buddies could not possibly be spies for a foreign country, nor do chaps like us not play by the rules.
Now we come to Thames Water, Britain’s largest water utility, whose fate at the time of this writing is in the hands of the courts. It seems that the previous owners, a succession of them, stripped cash from the business, replaced equity with debt, spent huge sums on capital expenditures charged to water consumers, and still failed to meet water and sanitation goals. (Where was the regulator? Presumably letting boys be boys.) Well, the result was that Thames Water ran out of funding. The shareholders would not put in more money, and they were wiped out. Politicians talked about renationalizing the company, but its fate is now in court, where two creditor groups vie to provide the company with billions of pounds of credit at high interest rates (9.75% or 8% depending on which group wins) to keep the company going until its finances are stabilized.
Now, back to the question of who pays? The stockholders, presumably knew what they were doing when they took money out. And the bondholders, should have known that they were buying into a highly leveraged entity (around 90% debt in recent years). One might argue that the business was leveraged to the point that the debt was more like quasi-equity. But, it looks as if the UK will not renationalize the company to assure service, nor accept a previous proposal from a firm that suggested writing off some of the debt and thereby refloating the company with a less burdensome debt level. Instead, it will choose between loan offers from competing creditor groups. Who will pay the costs of this expensive financing? Well, we suspect the same customers who already paid for all the spending that did not clean up the Thames in the first place.
Look, here’s our beef. If you believe in competition and free markets à la Maggie Thatcher (who privatized these utilities), even in the water business, and you let companies make big profits when they excel, then you should let them fail when they go wrong. (The pipes and reservoirs and staff and computing systems will remain, and the water will flow, we imagine, even in bankruptcy.) Otherwise, the government simply encourages excessive risk taking at the public's expense. If the government regulates utilities like the water business to earn a modest profit while providing a public service, and restricts their activities to limit risks they could impose on consumers, then it owes them aid when they have carried out their duties prudently. One way or the other. We don’t pretend to know British bankruptcy law, but we do know what moral hazard looks like, and water equity, too, if you make customers pay for the mess they did not cause.
Now, having finished our thoughts on regulation, let us quaff some pure Catskill Mountain water provided by the New York City Municipal Water System, which started out as a private company run by a pack of scoundrels. It didn’t take the city fathers long to conclude that they needed to throw out the miscreants if they wanted plentiful, clean, reasonably priced water. Sometimes socialism is the appropriate choice.
By Leonard Hyman and William Tilles for Oilprice.com
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