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I’m not the first to highlight deficiencies with the United Kingdom’s water and waste sector. If you haven’t seen comedian Joe Lycett’s attention-grabbing stunts you are likely to have received news about pollution spilling into our rivers and seas. Or be aware of Thames Water’s well-publicised financial difficulties, with the company perilously close to running out of money.
You may think we’d be mad to invest our clients’ capital in any of the private companies which manage this infrastructure. However, there are 17 companies in the UK we can choose from in this sector and they do not all share the issues of Thames Water.
Investors risk throwing the baby out with the bathwater – a judicious and in-depth analysis has led us to a more optimistic view when considering investments for our Sustainable Income strategy.
Companies in this sector fit a category we call ‘regulated infrastructure’. In the UK, Ofwat is the water regulator which monitors the standards companies are expected to meet and sets the level of financial return they can generate. It needs to strike a balance between ensuring good value to customers and ensuring financial stability in the sector by attracting flows of capital.
When we invest in regulated infrastructure, we look for a combination of a supportive regulator that rewards long-term investment in critical services and well-managed companies that can deliver sustainable operations while effectively managing costs.
When this formula works well, customers benefit from good service levels at reasonable prices and investors receive attractive returns in the form of resilient dividends that can grow with inflation.
Essential infrastructure hits the headlines when this equation breaks down. After a decade of under-investment, and with financial investors seeking to maximise shrinking profits by loading balance sheets with debt, UK water companies are creaking at the seams. There are many parties to blame and numerous problems to face: pollution, drought and financial stability, to name but a few.
We believe the tide is turning. The UK water industry needs to revolutionise, it needs to invest in ageing infrastructure, and it needs to adapt the system to a new environment.
The public knows this, the water companies know this, and finally the government and regulator are waking up to this reality. We are finally seeing all stakeholders aligned.
This year will mark a watershed for the regulatory environment. Ofwat will approve a new five-year Asset Management Plan. The plan details the investment and incentives to meet the Environmental Agency’s stringent 2050 targets that have zero tolerance for pollution incidents.
We invest globally for the Sustainable Income Strategy and this helps provide context, opportunities, and sometimes a blueprint for success. The United Kingdom is not the only country to experience problems in its private water industry.
For example, Chile privatised its water industry at a similar time to the UK. A few years’ ago it also experienced public backlash and protests over its management of the country’s water services.
Aguas Andinas, a holding in the Sustainable Income portfolio since April 2023, presents a model of how to overcome antagonistic relationships and shows how working together can improve the situation for consumers and the industry. It also demonstrates that, as the dust settles, the fundamentals and strong income generation of well-managed companies will come through.
Fiery political rhetoric previously weighed on the shares of Aguas Andinas. However, the risk premium attached to the company has faded during the past 18 months. This, combined with the company’s investments in key infrastructure, means the outlook for sustainable dividend growth is strong.
The key phrase in this example is ‘well-managed’. While a supportive regulatory backdrop is essential, we need to look for companies that are placed to perform well. We have recently invested in two companies in the UK that we believe are set up to navigate the currents of change and emerge as winners: Severn Trent and United Utilities.
The revenue for regulated utilities is explicitly linked to pre-determined operational metrics such as amounts of leakage, customer satisfaction surveys, asset health and supply interruptions. These two companies share excellent operational track records, both achieving top environmental scores and the highest performance-based bonuses in the sector.
Severn Trent and United Utilities have each proactively engaged with their customers, suppliers, and local and national governments to ensure they can meet and outperform the future service requirements of their networks.
On the cost side, they each have strong balance sheets which allow them to fund investments into the network at a lower cost, and well-managed networks.
These two sides of the equation underpin robust dividends that typically increase with UK inflation.
We believe these two companies have been unfairly lumped in with the rest of the sector, providing a great opportunity to invest in premium infrastructure assets within a long-standing regulatory regime and strong common law legal framework.
It will take time for the UK water industry to repair its reputation with consumers and investors. However, we believe that this will be achieved over time as Severn Trent and United Utilities deliver on their promises, to the benefit of their customers and our clients, as income and dividends grow over time.
Actual Investors
look to the future.
Not the past.
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