There was a time when privatised British water companies were as unpopular as they are now. During the hot summer of 1995, the managing director of Yorkshire Water, Trevor Newton, achieved notoriety when he urged customers to use less of his company’s product by issuing a motivational message: “I personally have not had a bath or shower for three months.”

After a round of jokes about “the filthy rich” – because megabucks pay for water company bosses was also in the headlines in those days – Newton invited the press to watch him washing with a flannel and bowl. It later emerged he had been popping out of Yorkshire for a soak at his parents’ and in-laws’ homes.

The serious aspect of the farce was that, just as now, the public was outraged by the mismatch between rewards for investors and the standard of service being provided by a privatised utility. Yorkshire had just paid a £50m dividend to shareholders and yet the city of Bradford was at risk of running dry. A new grid was behind schedule and the company was reduced to transporting water by tanker through the Dales. “Public anger exploded,” recalled Sir Ian Byatt, the first head of the Office of Water Services, or Ofwat, the regulatory body created at privatisation in 1989, in his account of his career.

The saga also underlined the rotten state of the water infrastructure, the reason given for privatisation in the first place. The UK was regarded as the “dirty man of Europe” on account of pollution on beaches and in rivers. Spending by the industry on overhauling its pipes and sewage-treatment works had been falling from the mid-1970s to the mid-1980s and now the UK had to meet new European Community standards on pollution.

Margaret Thatcher’s administration, which had already privatised British Telecom and British Gas, decided only private capital and stock market ownership could deliver improvements. “Much emotive nonsense was talked along the lines of, ‘Look, she’s even privatising the rain that falls from the heavens’,” wrote Thatcher in her memoirs. “I used to retort that the rain may come from the Almighty but he did not send the pipes, plumbing and engineering to go with it.”

More than three decades later, that same infrastructure requires a big upgrade, with bills to soar when Ofwat outlines the regime for the next five years on Thursday. In the meantime, the 10 English and Welsh water and wastewater companies have paid £78bn in dividends since 1989, and accumulated £60bn in debt. Meanwhile, the biggest of the lot, Thames Water, is at risk of temporary renationalisation. Only three of the 10 are still listed on the stock market. Meanwhile, the industry has become synonymous with mismanagement, corporate greed and pollution, as a string of sewage spills, water leaks and hefty fines led to deep public anger. How did we get here?

Sold on the cheap

To make privatisation happen in December 1989 – a month after the fall of the Berlin Wall – the government cancelled all the long-term debt owed by the previous water authorities and injected cash into the new companies as a “green dowry”. Such exercises meant the net proceeds to the Treasury, even after selling the companies for a total of £7.6bn, was roughly zero.

There was, though, the usual quick win for investors in the stock market listings: shares in the 10 companies rose 20% on average within a month. Half the small investors, encouraged to buy with the slogan “You could be an H2Owner”, took their profits and sold their shares within a year. It was a period of corporate exuberance, lampooned by Harry Enfield’s “Loadsamoney” character.

But extra spending did arrive. Investment roughly doubled in the four years after the sellout, from £3bn a year to £6bn. Privatisation fans could also argue that the discipline of a stock market listing, plus a smack from an independent regulator, could force underperformers to improve. After Yorkshire’s shambles in 1995, Ofwat sent in investigators, which led to a management clear-out. By the end of decade, the company was top of the class for performance. Byatt also proposed that Yorkshire should return £40m to customers in the form of price cuts and “after some discussion, it concurred”.

But it was immediately obvious that the companies had been sold far too cheaply. Customers’ bills went up by a third in the first five years on the assumption at sale that the companies would need ready access to cash to fund the step-up in investment. Debt levels, it was thought originally, would comprise a maximum of only 35% of the value of the assets – the leverage, or gearing, ratio. The bond market, however, was willing to lend far greater sums to monopoly businesses with captive customers.

And, strange as it may now sound, the regulator was keen to see financial gearing rise. The rationale was that savings from lower funding costs would be passed to customers in the form of lower bills. Ofwat’s first five-yearly price review in 1994 slowed the bill rises imagined at privatisation; the second, in 1999, cut bills by an average of 12%.

The companies were happy to play the debt game. Some, flush with rising share prices and access to cheap capital, caught the diversification bug in the go-go 1990s. Thames won contracts to run water networks as far away as Indonesia and Chile. Welsh Water lost a packet by buying hotels and country clubs. In 2000, Anglian Water bought a construction company.

Takeover games

Then there were the takeover games, which began when the government cancelled its golden shares in the 10 companies in 1995. Northumbrian Water was bought by Lyonnaise des Eaux of France. Scottish Power bought Southern Water. Enron of the US – before it crashed in scandalous style in 2001 – bought Wessex Water. Water companies were not allowed to buy one another, but some adopted the fashionable notion of “multi utilities” and bought regional electricity suppliers, which were privatised in 1990. North West Water bought its local supplier to become United Utilities and Welsh Water took over South Wales Electricity, restyling itself as Hyder.

None of this activity was slowed by a windfall tax on the privatised utilities, water included, imposed by the incoming Labour government in 1997. Thames, for example, was sold for £922m at privatisation but was valued by the stock market at £2.9bn in July 1997; Severn Trent had risen from £849m to £3bn.

By the end of that first decade, the privatised water sector was changed beyond recognition. This newspaper reflected in 1999 on “the mixed effects of water privatisation”. On one hand, too much of the extra profits had been “dissipated in ill-advised diversifications, excess dividends and unearned mega-increases in boardroom pay”. On the other, “a lot of money was invested in improving the infrastructure, so that we now have much improved drinking water”.

The deal-making kept coming. Thames was bought in 2000 by the German utility RWE, which paid £4.3bn in cash and assumed £2.5bn of debt. The takeover price of £12.15 a share represented a fivefold increase from the 240p at which all 10 water companies were sold in 1989. Foreign capital continued to chase UK utilities and, in the spirit of times, that was seen as an excellent thing. New Labour was not going to mess with the model.

Panic stations

What followed was a critical turning point. In the early 2000s, Railtrack, after a series of horrendous fatal accidents on the railways, was forced into receivership and turned into Network Rail. Then British Energy, owner of the bulk of the country’s nuclear plants, had to be bailed out.

Both events caused political panic, with the City doing its best to stoke fears that foreign capital would evaporate if owners were seen to be short-changed by government action (the unmerited allegation at Railtrack). In the wings, the water sector was still complaining bitterly that the supposed toughness of Ofwat’s 1999 price review left it with insufficient incentives to invest.

The result was two actions that, with hindsight, accelerated financial risk-taking. First, in 2002, Ofwat extended the water companies’ operating licences, which were due to expire in 2014. In their place, 25-year rolling licences were granted. “The longer notice period will enable companies and their investors to plan ahead more securely,” said Philip Fletcher, the late head of Ofwat. That was the hope, but the reform also insulated underperformers from any medium-term threat of being replaced.

Then, in 2004, the next five-yearly price review was widely seen as a giveaway to the companies: bills were increased by 20%. Water was seen as even more attractive for investors.

At that point, takeover action went into overdrive. New buyers were not other utilities, but financial buyers – investment banks, infrastructure funds, pension funds. Macquarie’s fateful £8bn acquisition of Thames from RWE happened in 2006. So did the takeover of the parent of Anglian by a group of Canadian and Australian pension funds. In 2007, Southern Water fell to a consortium including JP Morgan Asset Management after a tussle with US investment bank Goldman Sachs. Kelda Group, the owner of Yorkshire Water, was bought by a consortium including Citigroup and HSBC.

Former regulators have pinpointed this period as one in which the game changed. Byatt wrote in his book A Regulator’s Sign Off: Changing the Taps in Britain: “Private equity infrastructure capital showed the hard face of capitalism, involving leveraged buyouts and short-term policies, namely high borrowing and high dividends, meriting widespread criticism for its lack of transparency and for its financial engineering.”

Jonson Cox, who had spells running Yorkshire and Anglian before he was chair of Ofwat from 2012 until 2022, told a House of Lords committee soon after leaving the regulator: “In the 2000s, investment banks began to realise that there was an opportunity to acquire the water company assets and to put significantly more leverage on to those capital structures. I was not at Ofwat at that time. I have disagreed with that approach and I think it is very unfortunate that it happened.”

Investment banks created skewed incentives, he argued, and created “the predisposition of thinking of water companies as financial assets”.

Financial engineering on steroids

Shortly after Macquarie bought it, Thames embarked on a “whole business securitisation” in 2007 – a fundraising whose banal name belied its aggressive approach. A previously staid business of pipes and sewage treatment works was packaged into a complex corporate structure, with eight layers of ownership – including a subsidiary in the Cayman Islands, which allowed debt to be layered on debt, like the tiers in a wedding cake.

Suddenly, leverage ratios of 50% or 60% went higher than 80% at some companies taken off the stock market. As Thames explained in 2018, this byzantine corporate structure let it borrow more, with the approval of the ratings agencies: “A higher level of leverage is possible at an investment grade credit rating.”

Macquarie has defended its use of a whole business securitisation at Thames, saying it was “very common” at the time. “It was a UK water utility product that was invented, advised and constructed by UK banks,” Martin Bradley, the company’s head of infrastructure, told Infrastructure Investor magazine last year.

For investors in Macquarie funds that cashed in via a staggered sale of Thames in 2017, he pointed to annual gross returns of 12%-13%, which he argued were in line with regulatory guidance in the 2005-09 period. “There’s nothing in our returns that I’m embarrassed about,” Bradley argued.

The Australian bank has also defended its broader stewardship of Thames, saying the company “undertook a record level of investment despite the returns allowed by Ofwat being reduced”.

The legacy of the sector’s debt binge in the mid-2000s era lives on, however. Southern Water, which adopted a whole business securitisation in 2003, had to be rescued in 2021 in what now looks like a miniature version of the financial crisis now engulfing Thames. Controversially, the buyer at Southern was Macquarie, which injected £1bn in new equity to recapitalise the business.

It was only belatedly that Ofwat woke up to the dangers of overborrowing. Powers to stop the payment of dividends if they would risk the company’s financial resilience were introduced only last year.

One core question about the post-privatisation era is whether the gravitational shift from sensibly capitalised public companies on the stock market to heavily leveraged private entities contributed to the sector’s woeful environmental record.

Is it, for example, a coincidence that the two most heavily fined companies over the years – Thames and Southern – were also the two with the most aggressive financing structures?

Debt, it should be said, has also been used for its original purpose of accelerating investment, complementing the portion funded from bills. Overall, post-privatisation investment has totalled £190bn. But the overuse of financial leverage, with the aim of maximising returns for shareholders, is undeniable.

Current Ofwat chief executive, David Black, addressed the point last year when Thames’ financial crisis became acute: “For most companies, debt has been a prudent low-cost source of finance with low interest rates fixed for the long-term,” he said. “However, some companies borrowed too much, most obviously Thames Water. The risk for this – and for correcting this – belongs to the company and its shareholders.”

Therein lies one huge tension at the heart of the recent ruling from Ofwat on the companies’ business plans for the next five years. Investment is needed on a massive scale and customers’ bills are going up substantially, whatever happens. But will the regulator really make the worst debt addicts pay for their borrowing binges?