Sewage smells sweet in the stock market

It’s a crowded field, against a backdrop of greedflation and sexual-misconduct scandals, but water utilities have a strong claim to be considered public enemy number one in the British corporate world. Spilling sewage into rivers and coastal bathing waters hundreds of thousands of times a year is no way to win friends and influence people, whatever the mitigating factors or arguments over the relative quality of UK beaches. The industry apologised last week and pledged to triple investment in sewer modernisation this decade to £10 billion ($12.4 billion) — only to provoke further outrage when the companies said they will recoup this later through higher customer bills.

Much of the case for the iniquity of water companies’ behavior has focused on their generous dividends and high levels of debt. There’s a questionable logic at the heart of this narrative. Governments put essential public services into private hands, as Margaret Thatcher did with the water companies in 1989, in the hope they will be operated more efficiently, benefiting consumers and saving the state money. In turn, providers of private capital expect a return. Otherwise, why should they take part?

There’s nothing wrong, in principle, with private, profit-driven companies paying dividends if they have the earnings to support them. Likewise, the capital structure of a company should be something for management to decide. A business that takes on too much debt puts itself at risk of failure, so there’s no incentive for owners to be reckless. This can and does happen, of course, but utilities are more suited than most to taking on leverage because of their stable cash flows. Most people have no choice but to buy water, gas and electricity. It’s not like selling Louis Vuitton handbags; the risk of a business slump that renders a company’s debt unserviceable is small.

The subtext of the high-dividend-high-debt argument is that shareholders are unfairly extracting cash from the business rather than investing in the infrastructure that would prevent sewage from gushing into our waterways hundreds of times a day. This is a regulated industry, though. The utilities have to perform to a standard determined by the Water Services Regulation Authority, or Ofwat. The companies regularly exceed Ofwat’s benchmarks (the word “outperformance” appears 44 times each in the most recent annual reports for Severn Trent Plc and United Utilities Group Plc). If the regulator thinks the water companies aren’t investing enough, then it should design a framework that incentivises them to do so.