How do water companies fund investment?
Water companies are required to maintain, improve and build new infrastructure like pipes and treatment plants. This investment is needed to ensure that customers, now and in the future, receive resilient water supply and sewerage services and to deliver improvements for the environment.
Customers pay for the reasonable costs of these investments through their water bills but over a long period of time, not as the costs arise. If customers were required to cover investment costs as they are incurred, bills would need to be significantly higher, and amounts would also fluctuate – harming customers’ ability to budget for their water.
As the money to meet these costs is collected over time, water companies need to raise the finance to pay for the investment upfront. This finance comes from investors in the form of debt and equity.
Debt and equity therefore have a critical role in funding the investment that is needed to provide customers with resilient water supply and sewage services and environmental improvements.
Over the coming years the water sector must deliver significant investment to protect our rivers and seas, build new reservoirs, reduce leaks and raise the bar on performance, and companies will need to raise debt and equity to help fund that.
See also:
Investment in the water industry – Ofwat
Water companies must deliver a step change in performance and investment – Ofwat
What is debt and equity financing?
Debt financing is the process of borrowing money, for example from a bank as a lender.
Equity financing is the process of raising money through the sale of shares. In acquiring shares, equity investors take a stake in the ownership of the company and the risks associated with ownership.
What is a return?
In providing debt or equity finance, investors expect to earn a reasonable return that reflects the risk they are taking in providing that finance.
This investor return is a cost to the company i.e. the cost to attract and raise the capital needed.
Typically, debt investors will receive a return in the form of agreed interest payments, alongside a repayment of the amount lent at a future date. The return required will vary depending on factors like the investor’s assessment of a company’s credit risk e.g. the cost of debt will be higher if the risk is considered greater.
Equity investors seek a return by way of a cash dividend and/or through growth in the value of their investment. The return to equity investors depends on the profits generated by a company after meeting all if its other costs including interest. As this depends on a range of factors (like company performance and management) the equity return is not guaranteed and therefore the cost of equity is typically higher than the cost of debt.
What is a dividend?
A dividend is essentially a cash distribution to the shareholders from the company’s profits. It is one way that equity shareholders can realise some of the return on their investment.
Why and how do investors in a water company earn a return and who pays for it?
Investors have a choice of where to invest their money and ultimately are looking for a return on the money (the capital) they invest. If they considered that they could not earn a reasonable return that reflects their investment risk, they would not invest and would seek other opportunities.
As the economic regulator of the water and sewerage sectors in England and Wales we have a statutory duty, under the Water Industry Act 1991, to make sure that companies are able (in particular by securing a reasonable return on their capital) to finance the proper carrying out of their functions.
The revenue (the money) that water companies can collect from customers includes an allowance to cover the cost of raising debt and equity. This is to ensure that water companies can attract and raise the finance they need to operate their business and deliver their investment programmes.
In setting price controls our aim is to allow for a return on capital that is no more than necessary for an efficiently run company to get the funding they need, and that ensures customers only pay for a reasonable level of financing costs.
A company’s actual cost of capital (investor return) depends on its own financing choices and performance, but customers only pay for reasonable financing costs as determined by Ofwat.
We carry out a detailed evaluation of our approach to ensuring companies can finance their functions at each price review. This allows us to modify aspects and react to changing financial market conditions.
See also:
PR24-draft-determinations-Aligning-Risk-and-Return.pdf (ofwat.gov.uk)
Does Ofwat set water company dividends?
No, Ofwat sets the cost of capital that companies can recover from their customers through water bills. This is the reasonable cost to the company of raising the debt and equity finance it needs to fund investment.
It is for each company and its Board to decide whether to pay a cash dividend to its shareholders, taking account of its actual performance and returns, or for example to retain and reinvest the profits generated by the company to increase the future equity value of the company.
Typically, equity investors seek to realise at least part of their return through dividends. If a company were to never pay a dividend, shareholders would only receive a cash return when their shares were sold.
Therefore, if a water company decided never to pay a dividend, they could find it difficult to raise the equity finance needed to fund investment, and this would greatly impact on customers now and in the future in terms of both service and bills.
What are Ofwat’s expectations on dividends?
As monopoly providers of essential public services, it is crucial that each company is transparent to customers and other stakeholders about their dividend policy and the dividend decisions they make.
When paying a dividend, each company and its Board must comply with all relevant legislation, standards, and duties. They must also meet the conditions of their licence, including taking account of company performance for customers and the environment in their decision to pay a dividend.
We expect investors of well performing companies to be able to generate a reasonable return on their investment and to be able to pay dividends. We have set out guidance, that a dividend yield of up to 4% (in nominal terms) may be reasonable for an efficient, well performing, company with little real growth to fund.
Resilient and efficient companies, that outperform our determinations (cost and service benchmarks) can generate a higher equity return and may have capacity to pay cash dividends above our guidance levels. By delivering outperformance, customers and the environment also benefit from better or more efficient levels of service. Companies that underperform, that have significant investment programmes to fund or are challenged by their levels of financial resilience will need to restrict their dividend payments, even to zero if this is necessary.
What are Ofwat’s powers on dividends?
Ofwat issues licences to operate to all water and wastewater companies.
The licence puts conditions on what each water company can and cannot do, offering protections for customers, the environment, and the water company. This includes a set of conditions called the regulatory ring-fence. In March 2023 we implemented a range of modifications to these licence conditions to strengthen protections for customers, including around dividends.
All companies must now maintain at all times, two Issuer Credit Ratings which are Investment Grade Ratings from two different Credit Rating Agencies, unless otherwise agreed with Ofwat.
Should a company’s credit rating fall to a certain level, they will trigger the cash lock-up condition in their licence. While in cash lock-up, the water company is unable to make certain payments, including dividends, without Ofwat’s approval. From 1 April 2025, the trigger for cash lock-up increases, strengthening the regulatory protections where financial resilience may be at risk.
In addition, when deciding to pay a dividend a company’s Board is required under its licence to take account of the service it has delivered for customers and the environment, alongside the investment needs and financial resilience of the regulated water company (the Appointee, the company that has the licence to operate and provide water and wastewater services).
Each company must demonstrate how it is has taken account of performance in the round in reaching a decision to pay and declare a dividend. Companies may face enforcement action if they fail to do this.
Whilst we regulate the Appointee, each company under its licence must also procure legally enforceable undertakings from its Ultimate Controller(s) (owners), which protect the regulated company from the influence that the owners could exert.
See also:
Decision_document_financial_resilience_proposals.pdf (ofwat.gov.uk)
How does Ofwat assess dividends?
Under their licences, all regulated water companies are required to take account of service delivery for customers and the environment, as well as their current and future investment needs and financial resilience over the longer term, in their dividend policies and decisions. They are also required to transparently explain to their stakeholders the basis for their dividend decisions.
We review the dividend information reported by companies, including in their annual regulatory submissions and published accounts, and assess compliance with the licence condition.
We have provided guidance to companies on the factors we consider in our assessment of dividends.
Alongside licence compliance, dividends are a factor considered in our wider assessment of company financial resilience. We report on company dividends in our annual Monitoring Financial Resilience Report.
See also:
Monitoring financial resilience – Ofwat
IN 23/04 Guidance on factors Ofwat considers in assessing dividends declared or paid – Ofwat
What action can Ofwat take on dividends?
If through our assessment of dividend information, we are unable to conclude that a company has clearly taken account of the principles set out in its dividend policy licence condition in its decision to declare or pay a dividend, we will use our powers to investigate.
If through our investigation work, we determine that the company has not met its licence requirements, we will take appropriate action.
There are several possible outcomes, for example action might include imposing a financial penalty on the company or agreeing enforceable undertakings with the company (where they commit to take forward particular actions).
2023-24 is the first Annual Performance Review submission by companies following licence modifications to update the dividend policy condition. We will be assessing APRs and dividends against the relevant licence condition.
See also:
Our approach to enforcement – Ofwat
What is the dividend policy licence condition?
The dividend policy licence condition is in the licence of all water companies.
In March 2023 we published our decision to implement a range of modifications to companies’ licences. This included the dividend policy licence condition.
The latest condition, which has been effective since 17 May 2023, is as follows,
The Appointee shall declare or pay dividends only in accordance with a dividend policy which has been approved by the Board of the Appointee and which complies with the following principles:
- That dividends declared or paid will not impair the ability of the Appointee to finance the Appointed Business, taking account of current and future investment needs and financial resilience over the longer term;
- That dividends declared or paid take account of service delivery for customers and the environment over time, including performance levels, and other obligations;
- That dividends declared or paid reward efficiency and the management of risks to the Appointed Business.
For the purpose of this licence condition, dividend refers to any distribution declared or paid in respect of any ordinary shares or preference shares.
In June 2023 to help companies understand our expectations we also finalised our guidance on factors we consider in assessing dividends declared or paid
IN 23/04 Guidance on factors Ofwat considers in assessing dividends declared or paid – Ofwat