Water Industry Risks Briefing 2017

(Full Report)

A Review of the Environmental, Regulatory and Financial Risks of the Water Industry of England

Including the Conviction of Thames Water Utilities Limited at Aylesbury Crown Court as a Case Study

“Flow Clipping” of Sewage at Aylesbury and Little Marlow Sewage Treatment Works

Environmental, Regulatory and Financial Risk Ratings

Dr Matt Prescott June 2017

Disclaimer

'This report represents the opinion of The Environmental Rating Agency Limited (ERA) and is for information purposes only. It is not intended to be investment advice. This report reflects our best understanding of the evidence heard in court and available in the public domain. The ERA will correct any factual errors brought to our attention by the water industry or other parties.’

Table of Contents

Executive Summary 8 The Prosecution of Thames Water at Aylesbury Crown Court 8 “Flow Clipping” 8 Desk Research 8 The Failure of Self-Regulation 8 Privatisation and Nationalisation 8 Independent Environmental Monitoring Data 8

Introduction 9

Aylesbury Crown Court 9 Self-Regulation and Conflicts of Interest 9 “Flow Clipping” 9 Self-Regulation 9 Sentencing Judgement 10 Fines for Environmental Offences that are Proportionate to Turnover and Ability to Pay 10 Analysis for Shareholders and Regulators 10

Water Industry : Environmental, Regulatory and Financial Desk Research 11 Thames Water 11 Water Industry Trends 11 Environmental Rating Agency : Water Industry Risk Ratings by Company 12 Environmental Risks : Environmental Performance Assessments 12 Regulatory Risks : Prosecutions, Cautions and Fines 12 Financial Risks : Annual Accounts and Statements 12 Conclusions and Recommendations 12

Key Findings 13 The Attraction of Privatised Water Companies to Investors 14 The Regulation of Privatised Water Companies by the State 14 Sustainable Business Models 15 Gaps in Regulation 15 Too Big To Fail 15

Thames Water Case Study 16 Background 16 Environmental Offences : list of charges 16 Aylesbury 16 Little Marlow 16 Henley 16 Didcot 16 Littlemore 16 Arborfield 17 Figure 1. A map showing the locations of all the pollution incidents 17 Figure 2. Photographs illustrating the pollution incidents 18

Flow Clipping 20 “… a false impression of the sewage treatment works’ performance” 20 The permitted use of storm tanks 20 “Flow Clipping” Explained 21 Figure 3. “Flow Clipping” : A Simplified Schematic of How Effluent Flows Can Be Clipped 21 Figure 4. Aylesbury Sewage Treatment Works site plan and schematic 22 Figure 5. Little Marlow Sewage Treatment Works site plan 23 1

Official Statistics : 95% - 99% Environmental Permit Compliance 24 Figure 6. Percentage of environmental permit conditions met (%) by water company 24 Failures to Self-Report 25 Operator Self-Monitoring 25 Sewage Works Operated at 50% Capacity 25 Basic Maintenance and Removal of Rag Debris 26 Blocked Pumps 26 Storm Tanks 27 Illegal Discharges 27 Table 1. Illegal discharges at Aylesbury and Little Marlow 28

The New Sentencing Guidelines 29 Table 2. “Determining the offence category” in relation to culpability and harm 29 Table 3. The bands of harm and range of fines taken from the sentencing guidelines 30

Proportionality: Using a Proportionate Multiplier to Calculate Fines 31 Applying a Proportionate Multiplier to Calculate Fines 31 Thames Water Turnover (2015) 31 Figure 7. Thames Water “Our Finances Explained” 31 A Mechanistic Multiplier Based on Turnover Alone (40x – 50x) 31 Theoretical Calculation for the Most Serious Offences (£120 - £150 million) 32 Court of Appeal : Statement on Deliberate, Category 1 Offences 32 Calculating a Proportionate Fine Multiplier for Thames Water 32 Prevention Better Than Cure 32 Sending a Signal to Shareholders 32

Aylesbury Crown Court : Sentencing Judgement 33 Calculating Fines using a Proportionate Multiplier (incl. culpability, harm and turnover) 33 Corporate Responsibility 33 Sustainability 33 Shareholders 33 Regulators 34 Environmental Risks 34 Financial Risks 34

Corporate Responsibility 35 Defining Reckless 35 Junior staff 35 Logbook entries 35 Senior staff : “Hang or shoot the soldiers, and spare the generals” 36 Green Shoots 36

Sustainability 37 Protect and Preserve 37 The Future 37

Summary of Penalties 38 Amounts Awarded Against Thames Water Utilities Limited, Aylesbury Crown Court (22 March 2017) 38 Table 4. Penalties imposed on Thames Water Utilities Limited 38 Fines per Sewage Works / Pumping Station 38 Costs for Investigation / Prosecution 38 Compensation / Community Fund 38 Total (penalties) 38 “Should not be cheaper to offend, than take appropriate action” 38 Green Shoots of Recovery 39 2

Analysis of Aylesbury Conviction for Shareholders 40 “Totally foreseeable, totally predictable, totally preventable” 40 “Proactive not Reactive” 40 Corporate Responsibility 40 Reduce Complexity 40 Passive Investors 40 Due Diligence and Fiduciary Duties 41 New Metrics 41 A New Business Model 41

Analysis of Aylesbury Conviction for Regulators 42 Operator Self-Monitoring 42 Sewage Treatment Works Procedures 42 Self-reporting of Licence Breaches 43 Permits 43 Environmental Enforcement 43 Environmental Restoration 43 Stress Testing Regulation 44 Real-World Metrics 44

Water Industry : Environmental, Regulatory and Financial Desk Research

Thames Water 45 Thames Water Financial History 45 Thames Water Corporate Structure 45 Figure 8. A simplified illustration of Thames Water’s corporate layers 45 Thames Water Utilities Limited (TWUL) Net Debt 46 Table 5. A summary of Thames Water Utilities Limited’s Net Debt and Gearing 46 Kemble Water Finance Limited (KWF) Net Debt 47 Table 6. Kemble Water Finance Limited’s Consolidated Net Debt (31 March 2015) 47 High Annual Borrowing 48 Interest Rate and Inflation Rate Risks 48 Inter-Company Loans and Dividends 48 Figure 9. Where do Thames Water’s dividends go 48

Water Industry Trends 49

ERA Risk Ratings 50 Environmental Rating Agency : Water Industry Risk Ratings by Company 50 Environmental Risks : Environmental Performance Assessments 50 Regulatory Risks : Prosecutions, Cautions and Fines 50 Financial Risks : Annual Accounts and Statements 50

Environmental Indicators : Environmental Performance Assessments by Company (2013 – 2015) 51 Table 7. Water and sewerage companies’ Environmental Performance Assessments (2013) 51 Table 8. Water and sewerage companies’ Environmental Performance Assessments (2014) 52 Table 9. Water and sewerage companies’ Environmental Performance Assessments (2015) 53

Environmental Indicators by Company 54 South West Water 54 Southern Water 54 Northumbrian Water 54 Anglian Water 54 Thames Water 55 Yorkshire Water 55 Wessex Water 55 United Utilities 55 Severn Trent 56

Regulatory Indicators : Prosecutions, Fines and Cautions (2014 – 2015) 56 Table 10. Prosecutions, Fines and Cautions per Water and Sewerage Company (2014 – 2015) 56

Financial Indicators : Summary of Water Industry Finances 57 Water Industry Net Debt (Post-Privatisation) 57 Figure 10. Debt and equity in the water industry, 1990-01 to 2014-15 57 Net Debt by Water Company 58 Table 11. Net Debt (2015) and Gearing (%) by Water Company 58 Gearing by Water Company 58

Financial Issues 59 Financial Engineering 59 Asset Stripping 59 Tax Havens 59 Thames Tideway Tunnel : Super Sewer 60 Reducing Systemic Risks 60 4

ERA Methodology for Ranking and Rating Water Companies 61 Ranking 61 Rating 61 Risk Profile Groups 62

ERA : Charting Environmental, Regulatory and Financial Risk Ratings 63 Figure 11. Water Company Environmental Risk Rankings (2013 – 15) 63 Figure 12. Water Company Environmental Risk Ratings (2013 – 15) 63 Figure 13. Water Company Regulatory Risk Rankings (2014 – 15) 64 Figure 14. Water Company Regulatory Risk Ratings (2014 – 15) 64 Figure 15. Water Company Financial Risk Rankings (2015) 65 Figure 16. Water Company Financial Risk Ratings (2015) 65 Figure 17. Water Company Mean Environmental, Regulatory & Financial Risk Rankings (2013–15) 66 Figure 18. Water Company Mean Environmental, Regulatory & Financial Risk Ratings (2013-15) 66 Figure 19. Water Company Mean & Individual Environmental, Regulatory & Financial Risk Rankings (2013–15) 67 Figure 20. Water Company Mean & Individual Environmental, Regulatory & Financial Risk Ratings (2013–15) 67

ERA : Water Industry Grouped Risk Ratings by Company 68 Figure 21. Water Companies Grouped by Environmental, Regulatory & Financial Risk Ratings (2013-15) 68

5 Conclusions

Overview 69

Environmental Risks 69 Poisoning and Polluting Rivers 70 Basic Failures in Maintenance and Operations 70 “Flow Clipping” 70 To Self-Report, or Not To Self-Report 71 Use of Storm Tanks 71 Permit Conditions 71 Alarming Alarms 72 Environmental Monitoring Data 72 Enhanced Use of Technology and Transparency 72

Regulatory Risks 72 “Flow Clipping” 72 Economic Regulation versus Environmental Regulation 73 Using Available Treatment Capacity 73 Polluter Pays 73 An End to Wishful Thinking 73 Essential Public Services, Multiple Complex Risks 73 Market Failures 73 Self-Reporting versus Independent Reporting 74 The Hidden Costs of Self-Regulation 74 More Effective State Regulation 74 The Environment Agency 74 Ofwat 74 Independent Environmental Data 75 Pricing Imperatives Over-Ruling Responsible Regulation 75 Undisclosed Risks 75 Corporate Responsibility 75

Financial Risks 76 Excessive Debt 76 Highly Leveraged and Complex Finances 76 Thames Tideway Tunnel 76 Profits and Value for Money 77 Protecting Essential Services from Financial Insolvency 77 Reducing Corporate and Financial Complexity 77 Ownership Transfers: Nationalised Industries, Listed Companies, Private Equity 77 Regulations that Protect Investors and the Public 77 Simplification of Corporate Structures and Finances Required 77 Stress Testing the Securitisation Ring-Fence 78 Direct and Indirect Costs of Fines 78 Moral Hazards 79

ERA Risk Ratings 79 A Broad Basket of Risk Indicators 79 Avoiding Environmental Disasters, Regulatory Fines or Reputational Harm 79 ERA Risk Rating Groups 79 Additional Groups 80 Future Assessments 80 Gaps in Analysis 80 New Insights 80 6

The Future Ownership of Water Utilities

Essential Public Services… More than Ownership 81 Funding 81 Protecting the Public Interest 81 Problems with Self-Regulation 81 Pros and Cons of Privatisation and Nationalisation 81

Privatised Utilities 82 Diversified Ownership Models 82 Simplified Corporate Structures 82 Reduced Financial Complexity 82 Aligning Risks and Rewards with the Public Interest 83 Proactive Regulation 83 Independent Data 83 Independent Regulation 83

Nationalisation 84 Routes to Nationalisation 84 Financial Insolvency 84 State Nationalisation 85

The Best of Both Worlds 86 World-Class Services, World-Class Prices 86 Increasing Resilience 87 Increasing Competition 87 Hybrid Solutions 87 New Models of Capitalism 87 Responsible Regulation 87 Set for Success 88 Hope for the Best, Prepare for the Worst 88

References 90

Appendix 98 Appendix 1. Volumes of untreated or inadequately treated sewage discharged into the River Thames 98 Appendix 1.1 - Aylesbury STW – Volumes of untreated discharged unlawfully 99 Appendix 1.2 - Little Marlow STW – Volumes of untreated sewage discharged unlawfully 100 Appendix 2. Individual prosecutions, fines and cautions by water company (2014 – 2015) 102

7 Executive Summary

This report investigates the environmental, regulatory and financial risks inside the nine biggest water and sewerage companies in England, and uses the 22 March 2017 conviction of Thames Water Utilities Limited at Aylesbury Crown Court 1, 2 as a case study. This investigation uncovers serious failures in environmental self-regulation and uses desk research to quantify, benchmark, compare and average nine fundamental environmental, regulatory and financial indicators of risk, so that shareholders, regulators and customers can extend their assessment of material risks beyond traditional financial risk metrics. The report ends by discussing how independent regulation and data could help either a privatised or a nationalised water industry to provide better services whilst protecting the public interest, investors and the environment.

The Prosecution of Thames Water at Aylesbury Crown Court

The first half of this report covers the prosecution of Thames Water at Aylesbury Crown Court on 22 March 2017 for the illegal discharge of over 4.2 billion litres of sewage into local rivers 3, 4 and the subsequent handing down of £20 million in fines and costs. 5, 6 The judge used a proportionate multiplier 7 to calculate the fine that Thames Water should pay, which factored in its turnover and ability to pay as well the culpability of the offender and the harm of the environmental offences committed, as was recently permitted by the Sentencing Council 7 and supported by the Court of Appeal.8, 9 The judge’s sentencing judgement 1, 2 could therefore have implications for the regulatory risks of all polluting industries.

“Flow Clipping”

The evidence heard in court also revealed the use of a technique to manipulate sewage effluent flows through the sewage treatment process known as “flow clipping”, 1 and highlighted the difficulties associated with expecting the private companies that operate England’s public water and sewerage utilities to self-regulate their environmental monitoring in the public interest.

Desk Research

The second half of this report uses desk research to identify nine indicators of environmental, regulatory and financial risk for the 9 major water and sewerage companies in England, and rank and rate them in order to identify issues that are not visible when investors rely on financial metrics alone. With these risk ratings it has been possible to group the water companies into three distinct risk profiles that demonstrate (i) high corporate performance across all indicators, including low exposure to financial risks, (ii) high to moderate corporate performance across most indicators, but high financial risks in terms of leverage (gearing) and (iii) poor environmental and regulatory corporate performance, but low financial risks.

The Failure of Self-Regulation

This report ends by making recommendations for reducing the environmental, regulatory and financial risks uncovered by this investigation. Self-regulation has failed in this industry. This report recommends stricter regulation and an honest debate about the funding required to provide essential public services.

Privatisation and Nationalisation

Finally, this report discusses how the (i) privatisation of water companies might be better regulated by the state to protect the public, the environment and investors or (ii) nationalisation following outright state purchases, or insolvencies, might focus on providing value for money and protecting the public interest.

Independent Environmental Monitoring Data

Both private companies and the state face conflicts of interest when they self-regulate their actions, so governments need to be conscious of this and to equip regulators with the independent data and regulation they need to ensure that future profits and/or water bill reductions will not gained by externalising environmental risks, shifting financial risks off-balance sheet or transferring risk to the public. 8

Introduction

Aylesbury Crown Court

The first half of this report covers the evidence heard before His Honour Francis Sheridan at Aylesbury Crown Court during the prosecution of Thames Water Utilities Limited for illegally discharging over 4.2 billion litres of sewage 3, 4 into the River Thames and its tributaries at 6 sites (Aylesbury, Little Marlow, Didcot, Henley, Littlemore, Arborfield) 10, 11, 12 spread across Oxfordshire, Buckinghamshire and Berkshire, and includes the subsequent sentencing judgement which resulted in a record £20 million in fines and costs being imposed on Thames Water.4, 5

Self-Regulation and Conflicts of Interest

The evidence heard in court has highlighted the commercial and regulatory conflicts of interest associated with relying on water companies to self-monitor their pollution levels at sewage works, self-report licence breaches to regulators and self-limit their exposure to financial risks. An unhealthy tension appears to exist between maximising returns for shareholders and companies’ self-reporting of pollution incidents and pollution levels to regulators, which are used to determine their future prices, profits and investments.

“Flow Clipping”

The court heard evidence that the final effluent flows at sewage works, and the associated official environmental self-monitoring data, were being manipulated using a technique that the HH Judge Francis Sheridan referred to as “flow clipping”. 1

“Flow clipping” involves reducing the sewage passed forward to the sewage treatment process by diverting it through storm tanks into the river. One of the consequences of this is that it artificially ensures that the final effluent at a sewage works complies with the environmental permit conditions imposed by regulators, by reducing the load on the treatment process and sending the rest untreated to the river. In court we heard that up to 50% of the sewage that a sewage treatment works was designed to treat was by-passing the treatment process completely.

We heard evidence that untreated sewage was routinely being sent to storm tanks during non-storm conditions before being illegally discharged, and that partially treated sewage was also being diverted to a wildlife lagoon before it reached the official monitoring and discharge points.

The clipping of the final effluent flows in this way meant that it was possible for a sewage works to appear to be complying with its permit conditions whilst simultaneously discharging 100s millions of litres of sewage into rivers illegally; without a pollution incident being reported to the Environment Agency or it being included in the official statistics used by Ofwat to set prices, profits and investment plans.

This “flow clipping” makes a mockery of the present form of self-regulation, as it makes it impossible for the environmental regulator, the Environment Agency, 13 to protect the environment properly and the economic regulator, Ofwat, 14 to ensure that water bills and investments are sufficient to ensure that operations meet safe and legal standards and that companies are not making excessive profits by under- investing in necessary operations or assets.

A detailed explanation of “flow clipping” is included in the section dealing with the evidence heard in court.

Self-Regulation

Although a well-intentioned objective, self-regulation only works when those monitoring themselves can be trusted to report the whole truth. 9

It doesn’t work when companies are able to manipulate the key metrics relied upon by regulators, shareholders and customers to ensure that the environment is being protected as required by law.

This investigation has followed the evidence and uncovered multiple risks that justify concern from investors, regulators and customers.

Water bills may be burdensome on customers and laws expensive for regulators to enforce, but sewage needs to be treated. Someone has to pay for this to happen, and to make sure that it is done to the standard required by law. The reliable supply of clean water and treatment of sewage are clearly in the public interest, but have often proven difficult for both private and state-owned entities to fund and deliver.

Sentencing Judgement

In his sentencing HH Judge Francis Sheridan2 assigned the second most serious levels of culpability (reckless) and harm (category 2) to the two biggest pollution incidents at Aylesbury and Little Marlow.

Importantly, the judge also left room for future environmental offences that are even more serious (deliberate or Category 1), to result in fines in excess of £100 million or up to 100% of pre-tax profits, as allowed by the new sentencing guidance 7 and supported by the Court of Appeal. 8, 9

Following this judgement, the regulatory risk associated with polluting the environment has dramatically increased for all industries, but especially the water industry. Any company that has under-invested in avoiding pollution offences or been willing to pay relatively low fines after polluting on a vast scale could find that they face significant increases in infrastructure maintenance and investment costs as well as the payment of fines.

This legal development will be especially difficult for any company or industry that is already heavily indebted and/or relying on regular borrowing to finance their operations, as is the case with most UK water companies.

Fines for Environmental Offences that are Proportionate to Turnover and Ability to Pay

Historically, the fines imposed for environmental offences following prosecutions by the Environment Agency have remained relatively low and only recently breached the £1 million 15 - £2 million barrier.16

By hearing several cases together, this court was able to identify systemic failures and decided to impose £20 million in penalties for environmental offences 4, 5 that were 10x the previous record for sewage pollution cases 15, 16. Although a record figure, £20 million was still equivalent to less than 2 weeks of Thames Water’s £742.2 million annual operating profit. 17

The court’s use of a proportionate multiplier, which factored in the company’s turnover and ability to pay, 7 when setting fine levels means that any very large company with a turnover in £ billions and operating profits in the £100s of millions that pollutes now has a lot more at stake financially. The higher fines now being imposed by the courts greatly strengthen the rational economic case for companies to maintain and operate their sewage works to the highest modern standards, minimise pollution incidents and avoid the risk of expensive fines. However, these higher fines also challenge the industry’s existing heavily indebted and highly leveraged business models, and significantly increases the regulatory risks for shareholders and lenders that are associated with water companies polluting the environment.

Analysis for Shareholders and Regulators

After summarising the evidence heard in court, and the main elements of the sentencing judgement, an analysis is made of the specific implications for shareholders and regulators of this privatised public utility. 10

Water Industry : Environmental, Regulatory and Financial Desk Research

The second half of this report summarises the information that the Environmental Rating Agency (ERA) has collected and used to develop a unified overview of the (i) environmental, (ii) regulatory and (iii) financial risks found in the English water companies as of 2015, which offers a unique way of understanding the fundamental risks in these companies. The water companies of Scotland, Wales and Northern Ireland are separately regulated and have not been included in this initial assessment for this reason.

Thames Water

After learning in court of the risks that Thames Water was taking with the environment, the ERA has examined whether this company had adopted a similarly risky approach to their finances. What we have found is deeply alarming; especially for anyone that assumes that water companies are “prize assets” 18 suitable for pension funds or other long-term investors.

Thames Water is highly leveraged, with 80% of its official regulatory capital value currently accounted for by debt. 19 In fact, the company, and the group it is part of, have managed to accumulate approximately £10 billion 20, 21, 22 of net debt since being bought by a consortium led by Macquarie Bank for £8 billion in 2006. 23, 24 The company has also acquired an extremely complicated corporate structure which is examined in some detail later in this report.

This is despite Thames Water being a regional monopoly with up to 15 million captive domestic customers and Ofwat ensuring a healthy operating profit for the company. Instead of being a rock-solid business, this company has added almost £1 billion a year in debt, paid out £1.16 billion 24 in dividends between 2006 and 2015 and had a pension fund deficit of £260 million in 2015. 24 Even though Thames Water paid in £45.5 million into their pension fund during 2015-16, 25 the company’s finances remain tightly stretched and the company is vulnerable to insolvency if interest rates or inflation increase unexpectedly or the new Thames Tideway Tunnel super sewer experiences any major cost overruns.

In fact, the National Audit Office has already raised questions about the value for money of this super sewer project and the potential for a transfer of risk away from Thames Water towards taxpayers, which could potentially cost taxpayers up to £6.6 billion under reasonable worst-case scenarios. 26

Water Industry Trends

When the water companies of England and Wales were privatised in 1989 27, 28, they were listed on the stock exchange 28 and almost debt free. 27 As regional monopolies these companies still have to agree prices, profits and investment plans with their economic regulator, Ofwat, every 5 years. Ofwat makes sure that they can fund all basic maintenance, investment in new infrastructure and make a healthy profit. 29

The rationale behind the privatisation of the water industry was that profit-seeking investors would help to drive innovation and find efficiencies that the under-funded and risk-averse public sector was unwilling to fund via public debt or taxation. Over time, several of these water companies have been taken off the stock exchange and taken over by private equity firms that have piled on debt, extracted generous dividends and leveraged the value and cash flow of the underlying water assets to finance debt using sophisticated financial engineering. 24, 30

Instead of remaining relatively simple and locally-focused businesses, distributing clean water and treating sewage, these companies have morphed into water service companies embedded within complicated international holding companies that have multiple subsidiaries and high levels of complex debt spread around the world. It is not unusual for 10 or more different companies to separate the licenced water company from its ultimate shareholders 23, 24, 30, 31, 32, 33 and for companies within each group to lend each other money, defer tax payments and hold additional debts offshore. 34, 35 Little of this corporate complexity or financial engineering were envisaged when the industry was privatised, and the cracks can be evidenced in the tangible form of substantial amounts of untreated sewage in our rivers. 11

Environmental Rating Agency : Water Industry Risk Ratings by Company

In order to aid interpretation and comparison of the different risks found in the water industry, the ERA selected a basket of the financial and non-financial risk indicators that were consistent and informative enough to be combined to generate a fair assessment of the core risks inside the water industry and to help identify informative patterns.

By combining environmental, 36, 37, 38 regulatory 39 and financial risks 20, 21, 40, 41, 42, 43, 44, 45, 46, 47, 48, 49, 50 in a new way, we have been able to identify three distinct approaches to handling fundamental risk within the England’s nine largest water companies.

Environmental Risks : Environmental Performance Assessments

The environmental risks included as indicators were taken from the Environment Agency’s Environmental Performance Assessments for 2013 – 2015, 36, 37, 38 which include metrics for the number of category 1 – 3 pollution incidents per 10,000km of pipeline (including less serious category 3 incidents), the number of serious category 1 – 2 pollution incidents per 10,000km of pipeline, % of pollution events that were self- reported and % of permit conditions met. Metrics that quantified minimal variation between years and companies or repeatedly scored between 99% and 100% were excluded.

Regulatory Risks : Prosecutions, Cautions and Fines

In order to assess regulatory risks, Freedom of Information requests were made to the Environment Agency 39, which made it possible to quantify the number of (i) court cases and (ii) cautions as well as the (iii) fines imposed on each of the main water companies during 2014 - 2015.

Financial Risks : Annual Accounts and Statements

The Environmental Rating Agency compiled net debt financial information from the annual accounts of the company being investigated, 20, 21, 40, 41, 42, 43, 44, 45, 46, 47, 48, 49, 50 as well as their parent companies and key subsidiaries, and gathered official statistics on levels of leverage (gearing) published by the regulators. 19

Conclusions and Recommendations

Having uncovered basic problems with the meaningfulness and completeness of the environmental data from sewage works that is being generated by operator self-monitoring and self-reporting this investigation concludes by looking at the insights can be gained by looking at several different types of risk indicator in order to better understand the quality of each water companies environmental, regulatory and financial risk management. The ranking and rating of the risks inside individual water companies has made it possible to identify three different risk profiles and a new, more holistic way for shareholders, regulators and the customers to understand companies.

The analysis raises concerns about gaps in regulation of the heavily indebted and leveraged private water companies that are relied upon to operate essential public utilities and the extent to which environmental risks persisted over time and financial risks have expanded and diversified over the course of decades.

The analysis provided by this report should be particularly relevant now that the regulation of the private companies running essential public utilities is being discussed for the first time in many years and the possibility of the water industry being renationalised has even been proposed. It is clear that both the public and private sectors have found it difficult to fund the water industry to the extent that is required to keep up with increased demand and aging infrastructure, so this report ends by recommending how both privatised and nationalised water companies could benefit from independent regulation and independent environmental data.

Key Findings

As the Volkswagen Dieselgate / “cheat-device” scandal 51, 52 has recently shown, regulators need to be proactive when it comes to enforcing regulation and to maintain a constant vigilance for attempts to exploit regulatory loopholes or manipulate key metrics.

The Environment Agency and Ofwat need access to robust and fully independent monitoring inside and outside sewage works, backed up by randomised spot checks, so that greater confidence can be placed on key metrics, without an optimistic reliance on operator self-monitoring.

The present reliance on operators to self-report licence breaches also needs to be earned as a privilege following an extended period of reliable reporting, rather than something that all operators can expect as a right, irrespective of performance or convictions.

Ofwat might like to consider shifting the industry towards simplified corporate structures that produce simpler and more transparent accounts. The present dicing and slicing of debt around the world, 23, 34, 35 including tax havens, opens up investors and wider society to a variety of financial and regulatory risks, 45 which it would be wise for any essential public service to avoid, including insolvency.

Although the level of debt inside the water industry has crept up slowly over almost 30 years, it now stands at a very high level which merits renewed attention by regulators and the public at large. 53, 54, 55 A certain level of debt may be sustainable and efficient, but serious questions deserve to be asked regarding the level of debt that is it wise to allow any essential public service to carry.

Regulators and shareholders need to ensure that they understand all of the potential implications of essential water services carrying so much complex debt and how even minor changes in interest rates, inflation, exchange rates or credit risk rating could increase financing costs. Questions also deserve to be asked whether sophisticated financial engineering, including inter-company loans, derivatives and currency hedges, provide the best long-term value for money for customers and whether basic public services should run the risks that can be associated with these complex financial products.

The Great Financial Crisis of 2008 was partially triggered by heavily indebted banks relying on constant access to liquid, wholesale money markets. 56, 57, 58 Based on this recent bitter experience, it could reasonably be asked whether any lessons have been learned when regulators allow heavily indebted water companies to rely on heavy debt, annual borrowing and financial engineering to finance their operations and debt.

If any major water company was suddenly pushed into insolvency by events outside of its control, it is possible that the entire industry could be forced into public ownership as a result of the ensuing loss of confidence, and the taxpayer be forced to take onboard £40 billion - £50 billion of industry-wide debts 53, 54, 55 almost overnight. Given this possibility, it would appear wise for regulators and shareholders to take immediate action to assess and reduce such systemic risks and to reduce the levels of debt, gearing and financial complexity across the industry to more sustainable and resilient levels.

In the opinion of the ERA the sewage illegally discharged into local rivers by Thames Water is indicative of the financial risks that have crept into the water industry – and potentially other privatised utilities - over decades, which have now reached levels that leave water investors, regulators and users vulnerable to unexpected changes in market and/or regulatory conditions.

If the industry is ever nationalised, deliberately or in a crisis, it would be important for the government consider all of the environmental, regulatory and financial risks inside the industry. Whoever owns the water utilities, the public deserve a robust form of regulation that has access to independently sourced environmental metrics and avoids obvious conflicts of interest when deciding how to allocate resources to assets and operations, whilst also protecting the environment and public health. 13

The Attraction of Privatised Water Companies to Investors

Shareholders such as private equity firms and pension funds consider water companies to be prize assets with highly predictable cash flows and profits. British water companies are particularly highly prized because the country is wealthy enough to fund and regulate essential water services to a high standard. However, the vast scale of offending that Thames Water has been found guilty of indicates that all is not well.

Existing board members have a fiduciary duty to shareholders to understand all of the material risks associated with their investment, whilst new or prospective shareholders would be well advised to conduct rigorous due diligence in any company that is offending to such a level whilst also being well funded and regulated on a predictable basis.

It is worth highlighting at an early stage that water companies in England and Wales are regional monopolies with relatively captive customers and little competition. In agreement with Ofwat, 14 these companies are wholly funded by bill payers to protect the environment 59 and expected to maintain their assets, fund investments and make a profit. These water companies are also paid to treat effluent to a secondary standard, which involves settling out solids, maintaining levels of dissolved oxygen and limiting levels of ammonia. This basic protection of the environment is not discretionary, but mandatory under all but extreme weather conditions, when limited discharges are permitted under licenced conditions.

The question therefore arises whether the serious and sustained pollution events prosecuted at Aylesbury Crown Court 1, 2, and elsewhere, 8, 15, 16, 60 are the result of too much money being taken out of these “too big to fail” water companies by shareholders or because senior managers have become distracted by the complex company structures, heavy debt and sophisticated financing arrangements that have crept into their businesses since privatisation, and simply lost focus on their basic water-based activities. In either case, shareholders would be wise to look at the conditions that allowed sewage to pollute rivers.

The Regulation of Privatised Water Companies by the State

The regulation of the water industry has not dramatically changed for many years. However, today’s water industry is very different from the relatively simple and focused, if under-funded, nationalised industry that was originally privatised. Over decades, international financiers have turned publicly traded water utilities into private companies, with multiple international subsidiaries and owners. They have then added a great deal of debt 19, 53 and complexity, 23, 30 and gradually changed and complicated the issues and risks that need to be monitored and addressed by regulators.

Ofwat 14 is the economic regulator responsible for setting the prices and profits that water companies can achieve. The views and priorities of Ofwat are therefore of primary concern to all water companies. 14, 59 Traditionally, Ofwat has focused on agreeing the investments in assets that will be made by water companies every 5 years and encouraged the reduction of water bills. As they are not responsible for environmental protection, they inevitably have to read a lot into a limited number of environmental performance indicators and seem to not be overly concerned with how financing is raised,59 so long as companies manage to keep down the annual cost of water bills. 61, 62

The Environment Agency 13 is responsible for environmental protection associated with the water industry, as well as every other industry. It therefore has a limited capacity to investigate problems and understandably has to prioritise effort on the most egregious offences in each sector. Their investigations of environmental offences tend to be rigorous, but inevitably have to place a great deal of emphasis on acute offending rather than chronic or systemic problems, as their responsibilities cover all industries. In an atmosphere where there have been large public sector job cuts, including at DEFRA and the Environment Agency, it is possible that the capacity of regulators and their independence from political pressure will be eroded by cuts and increased centralisation. 63, 64, 65

Sustainable Business Models

By using Thames Water’s prosecution and conviction at Aylesbury Crown Court 1, 2 as a case study this report attempts to explore and summarise the environmental, financial and regulatory risks currently found inside the UK’s water industry. We then discuss some of the priority areas for consideration by shareholders and regulators, so that this essential public service can be made more resilient to unexpected changes in economic conditions or regulation.

After covering the implications of the judge’s sentencing judgement 1, 2 based on the evidence put before the court this report attempts to put these in context with regard to the finances of Thames Water, 20, 21, 45, 46 and the water industry as a whole.

We then attempt to demonstrate how the environmental problems documented in this report are the result of regulatory and financial problems that have mounted up over decades. 53, 54, 55 Today, the business models of most UK water companies are now based on a reliance of high net debt and low bills, 19, 61 that have to be supplemented by constant borrowing (approximately 20% - 30% of turnover 41) in order to function as required.

If water companies are to provide high quality water services over the long term then they need more sustainable business models – less dependence on long-term debt, annual borrowing and sophisticated financial engineering – so that these essential public services become sufficiently resilient to absorb unexpected changes to interest rates, inflation or credit risk ratings. Excessive risk taking and an over- reliance on economic conditions remaining benign has recently bankrupted the banking sector 56, 57, 58 and could do the same to public utilities if shareholders, regulators and the public do not heed the warnings showing up in polluted rivers and outlined in this report.

Gaps in Regulation

Although the Environment Agency and Ofwat are both diligent at fulfilling their original roles, no regulator has so far seen it as their job to ask too many probing questions about how and where water companies are financing their investments or assessing the systemic risks and costs associated with allowing essential water services to be owned by companies that have increasingly acquired complicated corporate structures and large amounts of complex debt over the course of decades. 23

Too Big To Fail

If any of the most heavily indebted water companies are pushed to insolvency by unexpected changes in market conditions or stricter regulation, it is possible that these “too big to fail” public services 66 will lose their investment grade status have to be nationalised at short notice and great expense – just as happened to the banking sector in 2008.

With approximately £40 billion - £50 billion of debt inside these companies, 53, 54, 55 the sudden socialising of these private debts could prove extremely controversial and destabilising. They might also cause further knock-on problems in all of the other public utilities privatised during the same era, which have been regulated using similar forms of conflicted self-regulation.

Thames Water Case Study

Background

Prior to the environmental offences prosecuted at Aylesbury Crown Court in early 2017, Thames Water Utilities Limited (TWUL) had already been fined £1 million and £380,000 in 2016 for similar problems in 2013 at two of their other sewage treatment works at Tring 15 in Hertfordshire and Princes Risborough 67 in Buckinghamshire in earlier cases brought by the Environment Agency.

The court was informed that TWUL had already been convicted, in individual prosecutions, of pollution offences at six other sites in the same period of time as the six cases before the court – mid 2012 to early 2014 (see Figure 1 and 2). Thames Water attempted to maintain that these offences were the result of unprecedented wet weather and also the result of the public putting products such as wipes and condoms down the toilet. However, the Environment Agency were careful to exclude the periods of wet weather as a cause of the offences charged and, pointed out that modern sewage equipment, properly maintained, can and does cope with the contents of foul sewers – as the operation of the same works with properly operating equipment is now demonstrating. 10

Environmental Offences : list of charges 10:

Aylesbury Sewage Treatment Works polluted the River Thame, a tributary of the River Thames in Buckinghamshire, between January 2013 and November 2013. TWUL had previously been prosecuted in 2004 for offences at this Sewage Treatment Works in 2002. There were two distinct and repeated illegal actions at Aylesbury STW which resulted in pollution of the River Thame. One was the by-passing of the treatment process by up to half of the incoming flow of untreated effluent and its discharge, untreated, into the river. The other was the diversion, at the end of the treatment of process, of poorly treated effluent away from the only permitted outfall and sampling point into the river, through a disused and unauthorised land treatment area and thence to the river. Amongst the persons affected were a cattle farmer who lost the value of a prime beef cow due to a human tape worm and a professional crayfish fisherman who suffered losses of £25,000 in 2013 and further losses in the next 3 years.

Little Marlow Sewage Treatment Works, polluted the River Thames, Thames Path and farmland both directly and via the Spade Oak Brook in Buckinghamshire between November 2012 and December 2013. The most serious pollution incident ever recorded in the River Thames from Little Marlow Sewage Treatment Works (STW) resulted in over 100 complaints from the public about sewage in the water. The water company’s inadequate investment, maintenance and poor management caused months of misery for local communities and visitors and affected the River Thames for over 1km.

Henley Sewage Treatment Works (STW), polluted the River Thames via the Fawley Court Stream in Oxfordshire between May 2013 and June 2014. Pollution from Henley STW caused the death of fish and had a detrimental and long term impact on Temple Island Meadows a Site of Special Scientific Interest (SSSI), in particular aquatic invertebrates.

Didcot Sewage Treatment Works, polluted the Moor Ditch, a River Thames tributary in Oxfordshire, in April 2013. Pollution from Didcot STW was spotted by a cyclist who saw a black cloud of polluted water containing toilet roll, sanitary towels and other solids. Environment Agency officers spotted extensive sewage fungus in the watercourse. TWUL managers were regularly made aware of issues by their own staff including that the storm tanks were ‘black and septic’ and that ‘if storm tanks discharge to stream fish kill imminent’.

Littlemore Sewage Pumping Station, polluted the River Thames in Oxfordshire between February 2013 and April 2013. Pollution from Littlemore Sewage Pumping Station (SPS) created a visible plume of brown raw sewage. The TWUL ‘clean-up’ was not adequate, leaving sewage debris and black colouration to the channel and causing months of misery for local communities. 16

Arborfield Sewage Treatment Works, pollution of Barkham Brook, tributary of the River Loddon in Arborfield Berkshire on 29 September 2013 untreated sewage discharged from the storm tanks due to faults with the inlet pump systems and failure to heed alarm and telemetry systems, causing a significant water pollution incident, resulting in the deaths of a significant number of fish in the river, as well as other flora and fauna.

Figure 1. A map showing the locations of all the pollution incidents that Thames Water Utilities Limited has now been prosecuted and convicted for committing between 1 July 2012 and December 2013. Orange labels used for the sites sentenced on 23 March 2017. Purple labels used for previous incidents prosecuted separately. Note the location of towns, drinking water abstractions and watercourses downstream of pollution incidents marked on map. 68

Figure 2. Photographs illustrating the pollution incidents prosecuted at Aylesbury Crown Court 69

(i) Full storm tank

(ii) Didcot Storm Tank (full and septic)

(iii) Didcot Storm Outfall (18 April 2013)

(iv) Sewage foam collects around boats at Bourne End Marina on the Thames Path

(v) Scum in a ditch downstream of Henley STW

Flow Clipping

“… a false impression of the sewage treatment works’ performance”

One of the most surprising aspects of the evidence heard in court involved a technique referred to by the Judge as flow clipping. This technique involves limiting the quantity of sewage admitted into the sewage works for full treatment, and sending untreated sewage to storm tanks before illegally discharging it into the river during non-storm conditions. By reducing the quantities of sewage sent through the treatment process it was possible to manipulate (clip) the final effluent, so that the fully treated effluent officially discharged and monitored, complied with the site’s discharge permit.

Judge Sheridan said that he felt the final effluent was managed to ensure compliance with regulatory requirements, and provide a “false impression of performance” and a totally distorted picture in favour of Thames Water, quite falsely, on top of their repeated failures to report incidents; despite managers being fully aware.

The following quote has been taken directly from a transcript of Judge Sheridan’s remarks prior to sentencing 1:

“… the constant use of flow clipping to protect the treatment process, so that, despite the regular and prolonged discharge of untreated sewage to the River Thames via the storm outfalls, all samples taken at the final effluent outfall complied with the permit. This was deliberately done and gave a false impression of the sewage treatment works’ performance and undermined the operator’s self- monitoring process.” 1 His Honour Judge Francis Sheridan

The permitted use of storm tanks

During a typical day flows arriving at any sewage works will vary due to the habits of the local population, which means a range of flow rates are recorded.

Some sewer systems collect rainfall runoff as well as foul sewage so the amount of flow arriving at a Sewage Treatment Works (STW) may vary enormously from dry to very wet conditions.

Sewage Treatment Works are not generally designed to cope with the maximum flow entering them during heavy rain. Instead they will normally have an overflow weir to storm tanks to avoid flooding, this is usually set at less than 3 times the flow in dry weather to match the capacity of the sewage works.

The storm tanks provide storage to intercept some of the sewage so it can be treated after the storm subsides when there is some treatment capacity available.

Capturing the initial volume also delays the discharge, which will give the receiving water time to rise and provide greater dilution for the storm discharge once it does commence. 3

“Flow Clipping” Explained

“Flow clipping” involves the manipulative management of effluent flows in and around sewage works, so that the fully treated effluents score well against environmental permit conditions where this is officially monitored (monitor) and legally discharged (discharge) (see Figure 3).

In court, it emerged that up to half of the incoming untreated sewage at Aylesbury sewage works was by- passing the treatment process (1) before being illegally discharged (2) from unlicenced and unmonitored outfalls 1, 2, 10. This meant that only 50% of the capacity for sewage treatment that the works was designed to provide was even being used (see Figure 4).

Storm tanks are supposed to provide extra capacity during storm conditions and to store elevated storm flows so that sewage can be treated once storm conditions have ended (3). If storm flows are prolonged or severe, then discharges of diluted effluent are permitted under separate licence conditions (4), but they are not permitted to discharge sewage during non-storm conditions. 1

We also discovered in court that effluent that had entered the sewage works, and was partially treated, was also being diverted into a wildlife area (5) 1 before it reached the official monitoring point (monitor) and permitted discharge point (discharge) and was being released into local rivers via unmonitored outfalls (6). All whilst the company was officially meeting 95% - 99% of its environmental permit conditions. 70

The routine diversion of non-storm flows to storm tanks 1 (1), in order to aid compliance with environmental permit conditions (discharge), or “flow clipping”, matters because it reduces the storage capacity available to cope with storm flows, and means that storm tanks become a potential source of illegal discharges under non-storm conditions (2). As far as the regulators were concerned nothing had been reported and these sewage works were performing well, whilst in reality they were being operated in a way that illegally allowed hundreds of millions of litres of untreated sewage into local rivers.

Figure 3. “Flow Clipping” : A Simplified Schematic of How Effluent Flows Can Be Clipped

21 Figure 4. Aylesbury Sewage Treatment Works site plan and schematic 3

22 Figure 5. Little Marlow Sewage Treatment Works site plan 3

Official Statistics : 95% - 99% Environmental Permit Compliance

The false impression created by flow clipping matters because Thames Water’s regulators, shareholders and lenders all use these official permit compliance figures when setting prices and profits, and determining the required levels of investment.

Officially, all of the water companies meet their environmental permit conditions 95% - 99% of the time (see Figure 6).

Figure 6. Percentage of environmental permit conditions met (%) by water company (2013 – 2015) www.discoverwater.co.uk 70

Failures to Self-Report

Meanwhile, in reality, large quantities of illegal sewage discharge are going unreported, such as the following for Little Marlow sewage works 1:

“Between November 2012 and the end of 2013 Thames Water did not self-report any breaches of permits (at Little Marlow) despite the widespread sewage pollution (approx 1.4 billion litres).

The detailed opening sets out the numerous incidents, including over-flowing manhole covers, fish kills, sewage leaking from pipes entering the sewage treatment works, (as well as an outfall spraying sewage ten feet into the air) and of course the awful stench which accompanied all of this. There is evidence of the grey plume in the River Thames and the thick sewage fungus downstream of the works.

When the Environment Agency attended to look at the split pipes and to see how the problem was being dealt with, there were no managers on site and no one at the site appeared to know anything other than the fact that the split had been there for several months. It was a shocking and disgraceful state of affairs.” 1

The fact that such a distorted picture of compliance is possible means that regulators and shareholders cannot simply trust what they are being told by operators and that an independent method for monitoring environmental performance and reporting licence breaches is required.

Operator Self-Monitoring

By diverting over 4,200,000,000 litres (see Appendix 1, 1.1 and 1.2) of untreated or partially treated sewage to storm tanks and unlicenced discharge points Thames Water has undermined the completeness and reliability of the operator self-monitoring data that Ofwat and the Environment Agency use to monitor water company performance and regulate the industry.

The precise reasons for Thames Water’s use of flow clipping are known only to them, but it could be significant that their price setting-regulator, Ofwat, considers their official environmental permit compliance statistics when determining the prices that customers can be charged, the levels of investment that Thames Water must make every 5 years and the profit that they can make as a regulated regional monopoly. 14, 61, 62

Based on the importance of the environmental performance data submitted to regulators by Thames Water and other water companies, 36, 37, 38 it would surely be wise for all relevant regulators to pay serious attention to this portion of the evidence and sentencing judgement, so as to ensure that any future manipulation of official statistics by any water company can be eliminated.

The evidence revealed in open court 1, 2 demonstrated that large and unmeasured quantities of sewage were being released via unlicenced outfalls pipes, without being officially monitored or reported, and this evidence alone seriously undermines the reliability and credibility of operator self-monitoring.

Sewage Works Operated at 50% Capacity

In addition to diverting sewage effluent once it had entered the sewage treatment works, it came as a total surprise to many in the court that Thames Water had operated sewage works at less than half their designed capacity 1, 10, whilst simultaneously diverting 100s of millions of litres of sewage into wildlife areas 1, 10 and discharging billions of litres of sewage into rivers via unlicenced discharge pipes (See Appendix 1) at the same time.

Judge Sheridan utterly rejected the defence’s contention that multiple site managers could have decided to operate their sewage works at less than half their capacity. He also said the following 1:

“The flow records show the pumps to full treatment were routinely set to pass forward approximately half the intended and required flow for treatment and the flow above that level was then diverted to the storm tanks almost daily.

The specified flow to treatment was 680 litres per second when, in reality, the average level of operation was half that or just under, 300 litres per second. For reasons I have explained, that impacts by giving the false impression that Thames Water were meeting their obligations.” 1

So while national permit compliance data was reporting compliance 95% and 99% of the time, 10 up to 50% 1, 10 of the sewage at this sewage works was not even being treated as the regulators and public would rightly expect. This discrepancy makes a mockery of operator self-monitoring, especially when there are also problems with pollution incidents not being self-reported, as they should have been, sometimes for months at a time.

Basic Maintenance and Removal of Rag Debris

The reason for only admitting half the sewage that a sewage treatment works was designed to treat was unclear during the prosecution and defence submissions, but the court heard evidence that poor maintenance was leading to frequent problems, with inlet pumps and screens being blocked by debris such as tampons, nappies and condoms, commonly known a “rag”, which could imperil compliance.

According to the judge these problems should not even exist because:

“Rag” is an industrial recognised problem, and the prices set for water by OFWAT and approved by OFWAT make allowance for the cost of dealing with it because it is a recognised industrial problem and needs to be removed. 1

At the relatively small Didcot sewage treatment works, two skips of “rag” were recovered each week after the installation of new wash water meters and new screens, which, prior to the installation of that new equipment, was simply being pumped straight into the river.

At Little Marlow the company “failed to remove large amounts of “rag” and, in consequence, there were major equipment failures and untreated effluent spilled into the Spade Oak brook in addition to the storm discharges and sludge blanket losses. All of these problems were foreseeable, all of these problems were avoidable by any competent operator. 1

The fact that rag can be removed to a very high standard when competent operators make use of modern equipment and undertake basic maintenance means that there are limited excuses for allowing such serious pollution events to occur over such an extended period of time, especially when you consider that this basic function is being paid for by customers via their bills.

Blocked Pumps

When basic equipment is not properly maintained or rag is not removed on a regular basis then debris can clog up and eventually block inlet or back-up pumps, so that effluent flows can start to run out of control and be compounded by any further operational deficiencies.

“A Thames Water Utilities official informed the Environmental Agency that the sewage treatment works was unable to treat all the incoming sewage and about 200 litres per second was being discharged without full treatment via the tanks, due to the problems with the pumps which were blocked with “rag”. 1

This equates to 4 million litres of untreated sewage every day, say the prosecution. The pumps could not be fixed as Thames Water chains could not be used to lift them out of the water as the safety certificates for the use of the chains had expired.” 1

Storm Tanks

Another issue mentioned in the sentencing judgement was the routine, even daily use of storm tanks that are designed to provide extra storage capacity for sewage in the event of heavy rain. This additional capacity is designed to keep peak storm flows of sewage contained, and to allow this stored sewage to be treated once off-peak conditions return.

However, if this extra capacity is used to ease the day-to-day running of the sewage works, or clip the pollution levels of final effluent flows, then less storage capacity is available when a storm actually occurs and it becomes more likely that sewage will be discharged into the river. Discharges from the storm tanks are permitted following storms on the basis that this effluent will be diluted during storm flows but not at any other time. The danger to the environment therefore increases if the capacity of the storm tanks is reduced on a routine basis and the storm tank capacity is not available to buffer storm flows, whenever these might occur.

Once pumps and inlet screens have become blocked with rag debris it becomes harder for a sewage works to operate correctly, and comply with permit conditions, without inappropriately relying on storm tanks, which may eventually overflow in non-storm conditions (and remove the capacity to cope with storm flows).

“There were failures in the equipment, pumps breaking down, delays in replacement, repeated and deliberate diversion of untreated sewage over a six-month period.

On many occasions the diverted flow itself overflowed through the storm tanks in non-storm conditions, so it was a complete misuse of the storm tanks.

Had Thames Water complied with their obligations, the treated effluent should have had no detrimental effect.” 1

Illegal Discharges

Because treatment data was not retained by Thames Water it was difficult for the Environment Agency to calculate exactly how much effluent was illegally discharged.

The figures that the Environment Agency have put before the Court rate the figures as “high level of confidence” and then they grade it from there down. These figures do not include further volumes which certain evidence indicates were likely to have been discharged into the River Thame.

The figures below relate to the treatment works at Aylesbury and I shall now go through them: 2.8 billion litres of which 500 million litres was untreated sewage. Five hundred million litres. (In total) That is equivalent to 1,146 Olympic swimming pools or 14 supertankers. 1 (see Table 1, Appendix 1, 1.1 and 1.2)

Table 1. Illegal discharges at Aylesbury and Little Marlow (Environment Agency, Freedom of Information request. See Appendix 1) 3

Aylesbury Little Marlow Total quantity of untreated or (See Appendix 1, 1.1) (See Appendix 1, 1.2) inadequately treated sewage discharged from Aylesbury and Little Marlow STWs only

2.8 billion litres 1.4 billion litres 4.2 billion litres [of which 0.5 billion litres was [All untreated sewage] [of which 1.9 billion litres was untreated sewage] untreated sewage]

Equivalent to: Equivalent to: Equivalent to:

1146 Olympic pools 562 Olympic pools 1708 Olympic pools 14 supertankers 7 supertankers 21 supertankers

The New Sentencing Guidelines

The Sentencing Council’s new sentencing guidelines for environmental offences 7 provide a formula for calculating the fine that should be levied for environmental offences.

This formula takes into account the culpability of the offender (from negligent through reckless to deliberate), the category of harm that they cause to the environment (Category 4 for more minor harm through to Category 1 for the most major harm), as well as their annual turnover and ability to pay (see Table 1).

These guidelines use the example of a large company with a turnover of £50 million or over to set out the range of fines that can be set for different levels of culpability and harm (see Table 2 and 3).

Table 2. “Determining the offence category” in relation to culpability and harm. Taken from the Environmental Offences Definitive Guide published by the Sentencing Council in 2014, effective from 1 July 2014. 7

Table 3. The bands of harm and range of fines taken from the sentencing guidelines for environmental offences, which specify the fines that should be applied to large companies with turnovers of £50 million and over per annum. These guidelines allow judges to move outside the suggested range to provide a proportionate sentence (see multiplier discussion below) for very large organisations. Taken from the Environmental Offences Definitive Guide published by the Sentencing Council in 2014, effective from 1 July 2014. 7

Proportionality: Using a Proportionate Multiplier to Calculate Fines

A critical part of the sentencing judgement was how the judge should determine the fines for a company of Thames Water’s size. According to the new sentencing guidelines, individuals can be fined up to 600x their weekly income and smaller, but still large companies with a turnover closer to £50 million can be fined up to £3 million. 7 The key challenge was therefore how to determine a proportionate fine that would send a message to shareholders when the company with a turnover in the £ billions commits serious offences.

Applying a Proportionate Multiplier to Calculate Fines

Judge Francis Sheridan was clear that the sentencing guidelines 7 must not be applied mechanistically to very large organisations, such as Thames Water, but instead applied proportionately; 1, 2 in order to factor in their turnover as well as the severity of their offences.

Thames Water Turnover (2015)

Thames Water has an annual turnover of over £2 billion [£2.027 billion from water bills + £612 million from borrowing = £2.639 billion],46 and made an operating profit of £742.2 million 17, 45, 46, according to its latest financial results for the full year ended 31 March 2016 (see Figure 7).

Figure 7. Thames Water “Our Finances Explained” an Illustration from “Bridging the Gap in 2014/15” (October 2015). 46

A Mechanistic Multiplier Based on Turnover Alone (40x – 50x)

Applying a purely mechanistic or mathematically multiplier to the fines listed for a large company with a turnover of £50 million and over, could therefore result in fines that 40x – 50x greater for a very large company with a turnover of £2 billion - £2.6 billion. 46 31

Theoretical Calculation for the Most Serious Offences (£120 - £150 million)

Given that a large company, with a turnover of around £50 million, which can attract a fine of up to £3 million 7 for the most serious levels of harm (Category 1) and culpability (deliberate), taking a purely mathematical approach could thus theoretically result in fines in the region of £120 - £150 million for very large organisations, with Thames Water’s (£2 billion – £2.6 billion) turnover 46 for the very most serious environmental offences.

Court of Appeal : Statement on Deliberate, Category 1 Offences

Importantly, The Court of Appeal has also stated that for very large organisations deliberate Category 1 offences (the worst types of environmental offence) can attract a fine up to 100% of pre-tax profits, in the year in question, even if this results in fines in excess of £100 million, and need "to bring the message home to the directors and shareholders of organisations... sufficient to have a material impact on the finances of the company as a whole." 8, 9

Calculating a Proportionate Fine Multiplier for Thames Water

In this case, by sentencing Thames Water of causing Category 2 harm (the second most serious) and being at the high-end of recklessness for culpability (the second worst class), and applying a proportionate multiplier of 20x to the range of fines mentioned in the new sentencing guidelines, the judge seems to have left room for future, more serious offenders with the same turnover to be fined at even higher multiples (e.g. closer to the 40x – 50x levels for this company) if future offences ever justify this. 2

By basing this record £20 million fine, 2 including compensation, (see Table 3 below) on a new application of the proportionate criteria set out in the sentencing guidelines, 7 this judgement means that any very large organisation that commits environmental offences can have their turnover, and ability to pay (i.e. pre-tax profits) fully taken into account when being fined. As a result, this judgement makes it possible for very large companies to be given much higher fines for the most serious environmental offences.

Prevention Better Than Cure

The previous record fines levied on Thames Water for polluting the Grand Union Canal from Tring Sewage Treatment Works (£1 million) 15 and Southern Water for polluting the Margate beach with untreated sewage (£2 million), 16 for environmental offences do not appear to have deterred serious pollution events from occurring.

By making the hard-nosed business case for appropriate upfront investment much more financially compelling, it is more likely that firms will choose to make the upfront investments and to take the preventative steps that regulators and the rest of society already expect of them anyway. The “very dark period” 1 during which Thames Water accepted repeated failures to clear rag (debris) from essential equipment, took 19 years to replace inlet screens, allowed E. coli levels to be 72x – 315x higher downstream of their sewage works, ignored permit conditions and alarms for days on end or allowed foreseeable problems to spiral “out of control” 1, 71 is hopefully at an end. Now that the courts have imposed environmental fines in the £10s of millions, it is more likely to be economically rational to address pollution problems at sewage treatment works before they arise or escalate.

Sending a Signal to Shareholders

By raising the level of fine that a water company has received for previous environmental fines by 5x - 10x 15, 16 this judgement has sent a clear signal to shareholders that the totality of their offending could start to have a material impact on their profits, dividends, credit risk rating and financing costs, from this moment on. As a result senior managers are also more likely to start finding that their bonuses and careers start to get directly linked to their company’s environmental performance. 32

Aylesbury Crown Court : Sentencing Judgement

On Wednesday 22 March 2017, Judge Francis Sheridan delivered one of the most important sentencing judgements 1, 2 ever made in relation to environmental offences in England or Wales. The judge did more than hand down a record penalty of over £20 million 4, 5 to Thames Water Utilities Limited, for their discharge of over 4.2 billion litres of untreated and partially treated sewage into local rivers at 6 sites spread across 3 English counties – enough effluent to fill more than 1700 Olympic swimming pools or 21 supertankers (See Appendix 1). 3

He also (i) applied the new sentencing guidelines using a proportionate multiplier to calculate the fine that Thames Water should pay, (ii) said senior managers had a corporate responsibility to avoid systemic failures and (iii) invoked a duty to protect and preserve the environment.

Calculating Fines using a Proportionate Multiplier (incl. culpability, harm and turnover)

By applying a proportionate multiplier (20x) to the bands of harm and ranges of fines listed in the new sentencing guidelines for environmental offences 7 for large companies with a turnover of £50 million and over, Judge Sheridan used the court’s power to calculate a proportionate fine based on not just culpability and harm, but also on the offender’s turnover and ability to pay.

Individuals can be fined up to 600x their weekly incomes, 7 but very large organisations have typically faced relatively small fines, nearer to 1x their weekly operating profit.

By considered Thames Water’s turnover and ability to pay, on top of the culpability and harm of their offences, this judgement has helped to define how future proportionate fines will be calculated and to “send a signal to shareholders”.

The two biggest offences, at Aylesbury and Little Marlow sewage works were judged to be reckless (with deliberate actions) and Category 2 levels of harm. This judgement has thus left room for future more serious environmental offences by very large organisations that are either deliberate or cause greater (Category 1) harm to result in fines closer to the £100 million level that the Court of Appeal 18, 19 has already stated that it would support.

Corporate Responsibility

This sentencing judgement has also effectively redefined corporate responsibility for all very large organisations / companies, by assigning a level of responsibility to senior managers for systemic failures. The judge explained the grounds on which he was justified in assigning corporate responsibility to senior managers; including the logbook entries made by site workers at different sewage works and the vast scale of environmental offending.

Sustainability

The judge also said that we all have a duty to “protect and preserve environment in at least the condition they found it in”. This judgement could provide grounds for future environmental offences to be penalised much more severely, especially when they severely degrade or deplete the environment. 1

Shareholders

Shareholders must focus on their core mission of providing reliable and high-quality water services to millions of people on a daily basis, whilst also making a healthy profit, and may need to discuss less risky ways of operating and financing their businesses in consultation with regulators. It is technically possible to operate sewage works to very high standards, which contain and treat almost all sewage pollution and make only limited use of permitted discharges following storms. Shareholders need to look at the

operational, managerial and financial priorities that have allowed serious illegal discharges of sewage into rivers, and rationalised or normalised such offending.

If shareholders do not demand better operator self-monitoring or self-reporting of licence conditions they will be the ones made into environmental criminals and forced to pay ever-bigger punitive fines.

Regulators

Thames Water has several different regulators, including the Environmental Agency, Ofwat and the Drinking Water Inspectorate. Each regulator has specific roles and limited budgets, so allows Thames Water to self-regulate to a considerable degree. As industry norms have shifted over the years, regulation does not appear to have kept pace. The scale of illegal sewage discharges that Thames Water has been convicted of causing at Aylesbury Crown Court indicate that regulation needs to be updated to reflect the environmental laws and standards of today, and to protect public health and bill payers in a more robust and less trusting fashion.

Regulators may want to pay more attention to how sewage works and pumping stations are operated up to the point of discharge and to put stricter licence conditions in place. They may also need to develop an inspection regime using fully independent, randomised testing of sewage treatment works so that there is a better chance of preventing serious and sustained pollution of the environment. Action is necessary because operator self-monitoring and self-reporting have not proven 100% reliable 36, 37, 38 at alerting regulators to serious licence breaches in a timely fashion, with members of the public needing to bring pollution to the attention of the Environment Agency and Ofwat instead.

Environmental Risks

By the time billions of litres of sewage has been discharged into rivers, a lot has gone wrong. This prosecution has revealed serious deficiencies in Thames Water’s daily operations, long-term strategic management, operator self-monitoring, self-reporting of licence breaches, and investment in essential equipment, such as pumps and inlet screens.

The evidence put before the court and highlighted in the judgement has revealed startling weaknesses in the operator self-monitoring data that regulators rely upon to judge the performance of water companies, and raised the possibility that regulatory data is being manipulated by techniques such as “flow clipping” which the judge said gave a “false impression of performance” and a totally distorted picture in favour of Thames Water, quite falsely, on top of their repeated failures to report incidents; despite managers being fully aware. 1

Financial Risks

After hearing the evidence put before the court the Environmental Rating Agency has investigated the finances of Thames Water and the water industry. We have found very high levels of debt and borrowing, extremely complex company structures and finances as well as business models that are at risk of insolvency in the event of unexpected changes in interest rates or inflation. Most of these risks have built up gradually over the decades since privatisation, but have now reached levels that should be of concern to everyone.

In the opinion of the Environmental Rating Agency, the scale and spread of illegal sewage discharges into local rivers by Thames Water is a symptom of deeper problems in the finances, business model and priorities within this company, and industry as a whole, which shareholders, regulators and customers would be wise to address sooner rather than later.

A full summary of our financial investigation can be found later in this report.

Corporate Responsibility

Another important issue that the judge addressed directly was corporate responsibility.

More specifically, he made it clear that very large organisations, and senior managers, could not expect to shed their corporate responsibility by blaming junior staff (with limited authority), site managers (with limited decision-making powers or budgets) or regional managers (expected to oversee up to 240 sites) 1 for systemic problems or offending at a vast scale that could have been foreseen.

When convicting Thames Water on the basis of reckless culpability, Judge Sheridan mentioned the following section from the sentencing guidelines:

Defining Reckless

Actual foresight of, or wilful blindness to, risk of offending but risk nevertheless taken by person(s) whose position of responsibility in the organisation is such that their acts/omissions can properly be attributed to the organisation;

OR reckless failure by organisation to put in place and to enforce such systems as could reasonably be expected in all the circumstances to avoid commission of the offence. 7

The judge especially emphasised the importance of this second clause, on his thinking, covering the reckless failure by organisation.

Junior staff

Although the site managers and their regional manager (who was personally responsible for overseeing 240 sites at the time) were well placed to identify environmental protection problems and agree remedies, in consultation with the Environment Agency, the judge referenced a notice to employees that was found by an investigator in the following manner:

“The thoroughly objectionable and aggressive instructions to employees is evidenced by what was found on the 2nd of July 2013. The notice of “dos and don’ts” found on site — and I quote — “Don’t discuss your views as the cause of the problems with the Environmental Agency.” 1

Self-regulation relies on co-operation and openness with regulators, so the judge took a very dim view of this notice. Thames Water claimed this notice had been issued by the company’s previous owners (approximately 10 years ago), but the judge did not accept this excuse.

Logbook entries

Judge Sheridan then gave numerous examples of where junior staff had tried to warn their managers via logbook entries as a way of voicing their frustration with line managers about the systems they were expected to operate under, with “pathetic state of affairs”, “illegal discharges known to manager”, “failure waiting to happen” and even “I resign today!” being amongst the comments entered into logbooks by site workers.

These logbook entries do not reflect well on Thames Water’s approach to corporate responsibility at the time that these offences were taking place and help to explain why the offences were considered to reflect reckless culpability rather than negligence.

Senior staff : “Hang or shoot the soldiers, and spare the generals”

On several occasions Thames Water Utilities managers led the Environmental Agency to believe that all was well at the site when it clearly was not. In relation to the managers at Thames Water the judge said the following: 1

“… it is inconceivable in my view that the knowledge of what was going on stopped at a level far down from the Board. The evidence indicates that knowledge of what was going on went very high indeed. It must have done.

All the managers at different sites would not individually decide to run the equipment at less than full capacity without that either being an instruction or being known to the higher command, as it should have been.

Thames Water presented, by operating that system at all these different sites, a better view of their compliance with their permits than in truth was ever the case.

I find it inconceivable that all of these separate managers on day and night shifts, those in the Control Command Centre, again on day and night shifts, all individually made the decision to run the pumps at less than capacity.

I am afraid I do not accept that argument; I reject it utterly. And when I am told that there are sackings, I am afraid it rather sounds like the defeated army saying, “Hang or shoot the soldiers on the ground, but save the generals.” That is an unappealing submission. It had no force whatsoever in my assessment and I am not prepared to proceed on the basis that it was merely the lower echelons of management that take responsibility here. The decision to run the equipment at less than full capacity had advantages to Thames Water, as I have already indicated.” 1

By these statements, the judge appeared to attribute corporate responsibility to the senior managers, and shareholders, for their role in setting the strategic direction of the company, and not to accept that the individual site workers or regional managers bore sole responsibility for the “dilapidated and parlous state of sewage works” when stating that “no lessons [had been] learnt from previous incidents”. 1

Green Shoots

In mitigation, the judge acknowledged that the CEO had listened to a “catalogue of disgrace” and “breaches of the law to flagrant degree” 1, which took place under the watch of his predecessor, and taken this on the chin.

He also took into account as mitigation that the CEO had looked after the “little people” 1 affected by his big company, by shaking hands quickly with regard to offering proper compensation, and was responsible for the “first green shoots of progress” 1 at Thames Water.

Sustainability

When a water company illegally discharges billions of litres of untreated and partially treated sewage into rivers the environment pays a price. In this case, we heard that fish, ducks and swans were killed, cattle were infected with human tapeworms and miscarried, a crayfisherman had not been able to catch crayfish along a 3km stretch of affected river for the past 4 years, 1, 5 and some species of fish will not reach their full size and reproductive output again for another 9 years.

Protect and Preserve

The duty expressed in the judgement to “protect and preserve environment in at least the condition they found it in”, could therefore have further very major implications for any business that has environmental impacts in England and Wales, by imposing duties on companies to limit harm and restore environmental conditions that have been depleted of species or degraded in quality.

Deliberately setting inlet pumps so that sewage works were run at less than half their designed capacity, allowing 3500 alarms to go off (Aylesbury in 2013), 1 using storms tanks on a daily basis along the associated “diabolical management” and “disgraceful conduct” should therefore be operational problems which will not be repeated. 1

This aspect of the judgement could come to be seen as particularly important over time, as although the River Thames is no longer biologically dead,72 as it was 60 years ago, and Thames Water has even won an international award 73 for transforming the overall ecological health of the Thames, this judgement makes clear that it is unacceptable to repeatedly polluted rivers with illegal sewage discharges in ways that poison wildlife or harm the environment. This principle of doing no harm or leaving the environment as you found it could have major implications for any water company or other business which impacts the environment in future.

The Future

After hearing the prosecution case put forward by the Environment Agency and the mitigation put forward by the defence on behalf of Thames Water it is clear that wholly unacceptable levels of sewage pollution were illegally discharged into the rivers of Oxfordshire, Berkshire and Buckinghamshire during 2012 and 2013, and into 2014.

Although it is to Thames Water’s credit that they pleaded guilty to all of these charges, the evidence put before the court made it clear that the problems inside Thames Water were “out of control”, 71 as the judge put it. The rag (debris) that appeared to clog inlets and pumps between 2012 – 2013 is an industry-wide issue for which allowances are made by the price-setting regulator, Ofwat, in order to allow for investment in appropriate solutions, which are extremely effective when properly applied. 1

As the judge pointed out, the public have a responsibility to put only human waste and paper down the toilet, 1, 69 but the fact that rag and other material needs to be screened out and removed is not new, and should be done on a more reliable and robust basis than has been demonstrated in this case.

Perhaps of greater long-term concern to investors and regulators is the evidence that serious pollution events were never, or belatedly, self-reported by Thames Water to the Environment Agency and that the quality, resolution and reliability of self-monitoring data means that it is difficult for managers, regulators and investors to know exactly what is going on inside all sewage works. 1

In several cases, the regulator has been lucky that members of the public took it upon themselves to report pollution in their local rivers, given the failures by Thames Water to self-report pollution incidents that were serious, sustained and systemic. 1 How many other offences have never been reported by anyone? Should essential public services be operated and regulated in a way that allows such serious pollution incidents to ever occur? What improvements could be made? 37

Summary of Penalties

Amounts Awarded Against Thames Water Utilities Limited, Aylesbury Crown Court (22 March 2017)

Below is a summary of the penalties that were handed down at Aylesbury Crown court for the illegal discharges of sewage at six sites by Thames Water Utilities Limited (see Table 4). The most serious offences at Aylesbury and Little Marlow were considered to be reckless, with deliberate acts, which caused Category 2 harm. The remaining sites involved smaller discharges that were judged to be negligent and to have caused Category 2 harm. 2

Table 4. Penalties imposed on Thames Water Utilities Limited at Aylesbury Crown Court (22 March 2017). 2

Fines per Sewage Works / Pumping Station Penalty (£) Aylesbury £9 million (25% discount) Little Marlow £8 million (25% discount) Henley £1 million (25% discount) Didcot £800k (25% discount) Littlemore (near Oxford) £800k (25% discount) Arborfield £150k (33% discount)* Sub-total (fines) £19.75 million (estimate) **

Investigation / Prosecution Penalty (£) Costs (Environment Agency) £611k

Compensation / Community Fund Penalty (£) Compensation (victims) £257k Community Fund (ex gratia) £1.5 million ** Sub-total (victims + environment) £1.938 million

Total (penalties) £20,361,140.06p

Prior to these convictions, the fines for Aylesbury (£9 million) and Little Marlow (£8 million) would each have set new records for sewage pollution fines. A full discount of 33% * was applied to the fine for the offences committed at Arborfield in recognition of Thames Water pleading guilty at the earliest opportunity. A lower discount of 25% was applied to the fines for the offences committed at the other 5 sites, because Thames Water did not plead guilty at the earliest opportunity. 2

The sums marked ** were not read out in court. Further explanations will need to await the publication of the judgement’s text, which was not made publicly available immediately.

Thames Water were initially given 21 days to pay, but asked for this to be extended to 56 days, having previously said that paying a fine would be no problem. 2

“Should not be cheaper to offend, than take appropriate action”

By stating that it “should not be cheaper to offend, than take appropriate action” this judge has also established a pragmatic and proportionate framework for deciding future penalties that are more likely to have a deterrent effect.

Even though high by historic standards, the judge emphasised that even a £20 million fine was less that 2 weeks of Thames Water’s recent operating profits (£742.2 million) which are around £2 million per day. 2, 46 He added that he wanted Thames to learn the lessons from previous incidents, to avoid adding to its 167 previous convictions 2 and to agree with Ofwat a way of not passing on the costs of this penalty to innocent customers.2 After hearing the evidence put before the court, the judge had voiced concerns about 38

Thames Water’s attitude to risk, which had demonstrably allowed the serious and sustained pollution events to occur, and the historic inability of the company to create systems that quickly and reliably escalate problems from sites up the chain of command to the appropriate senior managers.

Green Shoots of Recovery

However, during sentencing, the judge was very positive about green shoots of recovery under the new CEO, Steve Robertson whom he described as a successful industrialist and considered to have exhibited leadership in court by shaking hands on compensating the “little people” affected by his big company by shaking hands on over £257,000 of compensation over the course of a short break in court proceedings. 2

Analysis of Aylesbury Conviction for Shareholders

Responsible investors might like to ask whether a water utility capable of polluting the environment on such a scale is the prize asset that they have assumed, even if the company has a predictable income from bill payers and owns water assets of vital national importance. What, if any, financial, operational or attitudinal issues could these environmental convictions indicate?

“Totally foreseeable, totally predictable, totally preventable”

The judge said that “Aylesbury [sewage works was] dilapidated and appallingly run” and that the environmental offences he had heard about were “totally foreseeable, totally predictable, totally preventable”, a sign of “systemic failure” and that there was a “need to send a message that what [has been] done in terms of pollution and poisoning fish and loss of amenity [was] not acceptable”. 1

“Proactive not Reactive”

Do investors consider it acceptable for managers to wait for rivers to be polluted with human excrement before they act or do they need to change the way they operate in order to avoid future pollution events from happening, by being “proactive not reactive”, as the judge suggested, when it comes to dealing with managing their sites and their pollution risks?

Corporate Responsibility

If the company needs to become more proactive, how does it need to change its attitudes to risk and corporate responsibility, in order to ensure that senior managers become fully engaged in serious problems at the earliest opportunity and prevent them arising?

After listening to the defence arguments that senior managers couldn’t be expected to know about problems in their sewage works, Judge Francis Sheridan said: “No-one above Mr Whittington [a regional site manager responsible for 240 sites] being aware, I find startling. How can the senior management not be aware?” 1 Is it acceptable for senior managers to blame site managers or regional managers for the occurrence of serious pollution events? Is it not the corporate responsibility of investors on the board to ensure that junior staff operate within systems that are able to meet their legal requirements and that the senior managers ensure that day-to-day business operations function in ways that enables staff to do their job properly?

Reduce Complexity

Investors need to look at the complex ways in which their water-based assets are being operated and managed. 23, 24 In particular, they ought to check the underlying organisational and financial issues that have allowed these circumstances to occur and whether their due diligence and fiduciary duties are sufficiently robust.

For example, are they fully aware of and comfortable with all of the debts, inter-company loans and financial engineering taking place within the water industry? Since privatisation these trends have resulted in extremely complicated companies’ structures, including group, holding, financing and service companies domiciled and regulated in different countries, and service companies that are financed by high levels of net debt with operations that are not fully funded by bills and dependent on annual borrowing.

Passive Investors

Passive investors such as pension and sovereign funds might like to consider encouraging the companies they own equity in to reduce their levels of net debt and to ask for more direct funding from customers in future negotiations with Ofwat. They might also like to invite boards to shift more of future borrowing toward commercial bank loans that comply with the Equator Principles 74 and require stricter compliance 40

than the UN Principles for Responsible Investment (UNPRI), 75 that many asset and pension fund managers are signatories, but only cover corporate governance issues, with no, or little, impact on environmental and social issues.

Due Diligence and Fiduciary Duties

Investors of all kinds might also consider lobbying for public policies that simplify the company structures of major utilities, and make it simpler for investors to identify and track all of the debts and liabilities associated with utility service companies and their parent holding companies when undertaking their due diligence and fiduciary duties. This more rigorous approach would help to de-risk their investments and accelerate efforts to improve credit risk ratings.

New Metrics

Within the ERA’s area of expertise we are exploring methods for aggregating relevant environmental / scientific data from trusted sources and developing independent scientific audits and metrics, so that we can help investors to identify any gaps in corporate self-reporting, double-check the usefulness of key performance indicators relied upon by regulators and encourage innovative uses for newly available financial and risk data.

A New Business Model

At the company level, does Thames Water need to ask its price-setting regulator Ofwat if it can increase annual bills, rather than cut them, so that it can develop a business model that allows it to fund all of the long-term investments that are needed to prevent similar pollution events? Should Thames Water continue to borrow an additional 30p for every £1.00 raised via bills? 46

Have investors considered all of the risks associated with Thames Water’s having such a high level of net debt (approximately 80% of the company’s regulated capital value is accounted for by its net debt) 19 and exposure to the weakened governance in tax havens? Do they understand the long-term implications of carrying so much debt and the way in which it has been diced and sliced across so many subsidiary companies?

Does Thames Water’s present reliance on debt from the money markets in order to meet its annual and regulated commitments leave the company unacceptably vulnerable to unexpected changes in interest rates, inflation, environmental fines or credit rating over the long term? What would happen if interest rates returned to their long-term average?

This matters to the public and the government because they could find that they have to bail out and nationalise one or more water companies at very short notice in order to maintain essential water services, and would have little alternative. Indeed, water companies are too important to fail and perhaps it is unhealthy for investors to feel that their debt and business model will always been underwritten by the tax payer, regardless of the environmental and financial risks they might decide to take.

Would it not be wise for Thames Water and other water companies to simplify their company structure, reduce their debts and de-risk their finances, so that their bills and business model reflect more of the real- world costs of running their business through thick and thin?

By doing this, any future changes in economic, social or regulatory conditions are less likely to derail their finely balanced business model which is currently heavily leveraged and financially engineered to provide short-term cashflow efficiency, but consequently left vulnerable to unexpected changes and loaded with potentially expensive liabilities over the long term.

Analysis of Aylesbury Conviction for Regulators

Based on the evidence heard in court, 1 serious questions deserved to be asked about the extent to which it is sensible for regulators to rely on any water company to self-monitor (collect data on its own environmental performance), self-report (report licence breaches to authorities) and self-regulate (based on an assumption of total honesty and trust). Since privatisation of the water industry in 1989, the role of regulators has not been seriously reassessed for decades, but these offences indicate the existence of serious gaps in the ability of regulators to protect the public or the environment from harm and prevent problems caused by recklessness before they arise.

As a minimum, regulators need to put in place measures that ensure that they can rely upon accurate, relevant and informative data of sufficient detail, rigour and independence, to enforce discharge permits (Environment Agency) and set prices and profits (Ofwat) on the basis of information that reflects environmental and practical realities.

The fact that billions of litres of untreated and partially treated sewage has been illegally discharged into rivers above drinking water abstraction sites could also mean that there are more public health risks that need to be considered and eliminated than is currently assumed or tested for by the Drinking Water Inspectorate.

Operator Self-Monitoring

According to the evidence heard in court 1 the official statistics produced by sewage works give a totally distorted picture of reality in favour of Thames Water.

This conclusion places a massive question mark over the ability of Thames Water, and other water companies, to self-monitor their own sewage treatment, effluent flows and discharges on behalf of regulators and the public.

Although it may have seemed like a safe assumption that a sewage works should be operated to the capacity it was designed to treat, based on evidence put before the court during this case, the Environment Agency needs to consider specifying precisely how much sewage each sewage works is expected to treat, when effluent can be diverted to storm tanks and what needs to be done to ensure that effluent is only discharged into rivers via legal discharge points.

Sewage Treatment Works Procedures

The present self-monitoring regime appears to rely upon data that is not granular, accurate or reliable enough for site workers, senior managers, shareholders, regulators or the public to know what is really going on in and around each sewage works or pumping station. 1

In court, we heard that less than half the sewage entering a sewage works was never even pumped into the sewage works for full treatment, that some sewage was pumped into wildlife areas before being illegally discharged into a river and that sewage was being diverted into storm tanks, sometimes daily, even in dry conditions with no rainfall.

We also heard that partially treated sewage that was sometimes diverted to illegal discharge points before it could reach the licenced discharge point, seemingly in a bid to boost the official performance of sites.

Clearly, the rules determining how sewage works are operated need to specify more clearly what practices are and are not allowed by operators, and these rules need to be enforced before serious illegal discharges can occur.

The independent verification of self-monitored data might offer one solution, but the establishment of independent and automated systems to measure pollution levels up and downstream of sewage works, and trigger public alerts, should also be considered.

Self-Reporting of Licence Breaches

Thames Water’s failure to self-report breaches of licence conditions to the Environment Agency for months or ever means that a reliance on self-reporting is not a viable approach for environmental protection. 1

This is the polluters’ equivalent of being asked to mark their own homework.

The increased fines may help to incentivise greater honesty and disclosure, but this really depends on the proportion of illegal discharges that are prosecuted and the levels of future fines.

Thames Water’s failure to operate each of the sites so as to ensure basic compliance with the terms of its licence, such as fully treating sewage, clearing rag from inlet screens and pumps, and only making permitted discharges meant that it failed to a disgraceful degree, and needs to win back trust rather than be awarded trust based on warm words.

Permits

From now on, the permits attached to sewage works need to specify the amount of sewage they are expected to treat per second and to be much clearer about when any exceptions are allowed in relation to managing extreme storm flows, using storm tanks and minimising storm discharges.

No unlicenced discharged points should be used or allowed in future.

Environmental Enforcement

It is notable that the investigation by the Environment Agency was their largest ever in the water industry and only exceeded in size by the investigation of the explosion at the oil storage terminal at Buncefield. 76

The Environment Agency’s thorough and detailed investigation was praised by the judge, and Thames Water were order to pay their full costs. This award will make it less risky for the Environment Agency to pursue future investigations of similar cost and complexity and encourage offenders to co-operate at the earliest stage possible, when they know they are likely to plead guilty.

Environmental Restoration

Importantly, it is noticeable that the ecological restoration of the areas affected by Thames Water’s pollution is not as assured as it might be.

Thames Water could not be compelled to restore the environmental harm it had caused and was allowed to promise to make a voluntary ex gratia payment of approx £1.5 million 77, 78 into a community investment fund, ring-fenced for projects to improve the river, its wildlife and surrounding environment at the affected locations.

A more rigorous and independent system for achieving the best environmental restoration outcomes might need to be considered in future, perhaps by ensuring some of the punitive fine can be allocated to a statutory body for this purpose. Ofwat might also like to consider more demanding methods for measuring environmental performance (so that fewer metrics score in the 95% – 99% range), 70 so that it and other agencies can spot problems before they spiral out of control and do more to ensure that sites are investing the sums agreed in order to remove rag and deal with related industry-wide issues. 43

If the environment is to avoid being permanently degraded or depleted by major or repeated pollution incidents then a reliable system for funding the fully restoration of affected habitats needs to be funded and managed over the long term, based on advice from Natural England and equivalent specialist agencies.

Stress Testing Regulation

Regulators need to ensure that they are comfortable with the all of the levels of risk and investment currently found inside the UK’s water industry and may need to stress test some of their long-established assumptions about their roles, responsibilities and resilience.

As a priority, these court cases have made it obvious that regulators need to identify any gaps or weaknesses in the data that they rely upon to make important decisions.

For example, the permit conditions attached to sewage works have not always specified the exact quantities of sewage that a works would be required to treat per second or the extent to which a sewage works could be operated below the level it was designed to treat.

At another level, gaps in the regulatory responsibilities assigned to the different water company regulators may after 30 years have allowed systemic financial and environmental risks to accumulate around our essential public services. Those that exist need to be identified and addressed.

Regulators might like to ask ahead of trouble if it would remain sufficient for them say that it was not their job to deal with plausible or recurring problems. For example, who would be to blame if one of the big water utilities was pushed into insolvency by unexpected changes in market rates or regulatory conditions, and the government was forced to nationalise essential services at considerable cost to the public purse?

By not having automated, independently administered or sufficiently detailed monitoring within sewage works it is currently impossible for regulators to be sure about the precise quantities and grades of treated sewage passing through different sections of sewage works. For cheaper and more effective regulation to become possible the present situation certainly needs to be improved and funded.

Real-World Metrics

When listening to the evidence put before Aylesbury Crown Court one of the most glaring problems for any fair-minded observer was the fact that the regulator responsible for protecting the environment had to use educated estimates to “guess” the levels of untreated and partially treated sewage that had been discharged into local rivers and did not “know” exactly how much pollution was being discharged at any sewage works or how the sewage works it regulated were being operated.

This reliance on educated guesswork is intolerable, for justice and protection of the environment, and needs to change so that regulators, investors and the public have the data they need to know what is happening in the real-world, without fear or favour.

If the regulators responsible for protecting the environment do not have direct, complete and unfiltered access to crucial environmental performance data then they cannot pass on a full picture of what is happening to the economic regulators responsible for setting water company prices, profits and investment plans. The knock-on consequence of not having access to full and independent environmental performance data is that it is difficult for regulators to ensure that water companies are able to make healthy profits without taking unacceptable environmental or financial risks whilst they are stewards of essential public services.

Water Industry : Environmental, Regulatory and Financial Desk Research

The next section of this report investigates the finances and corporate structure of Thames Water in depth and uses a combination of desk research and Freedom of Information requests to summarise the (i) environmental, 36, 37, 38 (ii) regulatory 39 and (iii) financial risks 20, 21, 40, 41, 42, 43, 44, 45, 46, 47, 48, 49, 50 associated with the nine major English water and sewerage companies as of 2015. The water companies have then been ranked from 1st – 9th against each of the nine indicators selected, before being rated on a grading scale from 1 - 20 based on the best and worst levels of quantified performance, in a consistent and proportionate manner. Finally, by combining and averaging the 9 indicators for the nine water companies it has been possible to calculate an overall rating for each company, and to group companies in a new way based on three distinct risk profiles.

Thames Water Financial History

After being floated on the London Stock Exchange with near zero debt in November 1989, Thames Water was bought by RWE for £4.3 billion in September 2000. 23 Thames Water was then acquired by a holding company called Kemble Water Holdings, for a cash price of £5.1 billion, with £2.9 billion of this amount funded by debt and a total price of £8 billion.23

The consortium of investors behind Kemble Water Holdings was led by the Macquarie Infrastructure Fund (“MEIF”) and also consisted of a number of pension funds in 2006, and paid out £1.16 billion of dividends to investors. 10 According to the Financial Times “the debt on its balance sheet has soared from £1.6 billion to £10 billion as it has financed an average of £1 billion a year in capital investment”.79

On 14 March 2017, it was reported by the Financial Times that Macquarie had sold their 26% stake in Thames Water’s parent company for approximately £1.35 billion to the infrastructure arms of a Canadian pension fund and the Kuwait Investment Authority. The financial details of the deal were not disclosed. 80

Thames Water Corporate Structure

There are at least 10 corporate layers between shareholders and the licenced water company, with different subsidiary companies responsible for delivering water services (Thames Water Utilities Limited), raising finance (Thames Water Utilities Cayman Finance Limited), etc on behalf of Kemble Water Holdings Limited (see Figure 8).23 Some of the companies that own and control Thames Water are domiciled and regulated in the UK; others are domiciled overseas and not regulated by the UK.

Figure 8. A simplified illustration of Thames Water’s corporate layers, linking Thames Water Utilities Limited to its shareholders, by Martin Blaiklock “Thames Water Utilities – a financial history, with a few twists” (March 2017). 23

Thames Water Utilities Limited (TWUL) Net Debt

Over the past decade or so Thames Water Utilities Limited (TWUL) has accumulated £9.494 billion 45 and this equates to a gearing of 80.1% (based on a net debt of £9,494.6 million as a percentage of regulatory capital value of £11,848,1 million) (see Table 5).

Table 5. A summary of Thames Water Utilities Limited’s Net Debt and Gearing (2015, 2016). 45

Kemble Water Finance Limited (KWF) Net Debt

One of Thames Water’s parent holding companies, Kemble Water Finance Limited (KWF), has accumulated a net debt of £10.2 billion 21 that is covered by a Compliance Certificate related to the securitisation ring- fence. This higher figure for net debt equates to a gearing of 86.3% for KWF (based on a net debt of £10,229.9 million as a percentage of regulatory capital value of £11,848,1 million) (see Table 6).

Table 6. Kemble Water Finance Limited’s Consolidated Net Debt (31 March 2015). 21 Note the different figures quoted with and without the Compliance Certificate.

The table above also reveals that the same company, Kemble Water Finance Limited, has a total net debt as per accounts at 31 March 2015 of £13.445 billion, 21 with a £3.1 billion sub-ordinated (unsecured) loan from Kemble Water Eurobond Plc 21 accounting for most of this extra debt. KWF’s net debt on 31 March 2015 equates to a gearing of 113.5% for KWF (based on a net debt of £13.445.8 million as a percentage of regulatory capital value of £11,848.1 million) (see Table 6).

This level of debt has enabled significant investments in infrastructure per year (approximately £1.237 billion in 2014/15 46) but left the company vulnerable to changes in market conditions, credit risk ratings and regulation. Both regulators and governments have known about this build-up of debt over many years, but they have also been keen to reduce the annual bills paid by customer over the short term.

High Annual Borrowing

More worryingly, in the case of Thames Water this financing model, and effort to reduce bills, now means that for every £1.00 raised via water bills an extra 30p in borrowing needs to be raised in order for the company to operate in the ways it has agreed to do under its licencing conditions. 46

Interest Rate and Inflation Rate Risks

As the levels of debt have increased, companies including Thames Water have started to rely on sophisticated financial engineering, including inter-company loans, bonds, swaps, derivatives, deferred taxes and currency hedges in order to keep annual bills low and borrow money cheaply from the market. Much of Thames Water’s £10.2 billion in net debt (2015) has been added while interest rates and inflation have been at historic lows. However, the costs of financing business activities in this way could rise steeply, especially if interest rates and/or inflation start returning to their long-term averages.

Inter-Company Loans and Dividends

Although dividends have almost completely stopped being paid by Thames Water in recent years, and Aylesbury Crown Court heard that 81% of the company’s £742 million 17 (2015) operating profit was retained by the company, it is of note that approximately £1.16 billion 24 has been extracted from the company as dividends for investors since the acquisition led by Macquarie Bank’s infrastructure fund in 2006, and that inter-company loans are still incurring substantial interest payments each year.

Figure 9. Where do Thames Water’s dividends go (from “Our Finances Explained”, October 2015). 46

Because of the complicated inter-company loans and dividend payment shown above (see Figure 9) it is difficult to read the accounts of any one company in the group and to come away fully understanding the ways in which profits and losses are being accounted for, and where liabilities may or may not exist. The pursuit of tax efficiency by all of the individual companies within the group has therefore made the accounts of all these related companies, collectively, less transparent and straightforward to interpret overall – especially given that each privatised water utility has used different techniques to generate and finance their debt, structure their companies and present their accounts. 48

Water Industry Trends

When the water companies of England and Wales were privatised in 1989 27, they were listed on the stock exchange 28 and almost debt free. 27

As regulated companies with regional monopolies they still had to agree 5-year investment plans with their economic regulator, Ofwat. Ofwat has a basic responsibility to ensure that water companies are able to fund essential maintenance, investment in new infrastructure 7 and make a healthy operating profit.

Instead of remaining relatively simple and locally-focused businesses, distributing clean water and treating sewage, these companies have morphed into water service companies embedded within complicated international holding companies that have multiple subsidiaries and high levels of complex debt spread around the world. It is not unusual for 10 or more different companies to separate the licenced water company from its ultimate shareholders 23, 24, 30, 31, 32, 33 and for companies within each group to loan each other money, defer tax payments and hold additional debts offshore. 34, 35 Little of this corporate complexity or financial engineering were envisaged when the industry was privatised and the cracks are starting to show up in the tangible form of large amounts of untreated sewage in our rivers.

ERA Risk Ratings

Environmental Rating Agency : Water Industry Risk Ratings by Company

In order to aid interpretation and comparison of the different risks found in the water industry, the ERA selected a basket of the financial and non-financial risk indicators covering from 2013 – 2015 that were consistent and informative enough to be combined to generate a fair assessment of the core risks inside the water industry and to help identify informative patterns (see Tables 7 – 9).

Environmental Risks : Environmental Performance Assessments

The environmental risks included as indicators were taken from the Environment Agency’s Environmental Performance Assessments for 2013 – 2015, 36, 37, 38 (see Tables 7, 8, 9 below). The annual assessments include metrics for the number of category 1 – 3 pollution incidents per 10,000km of pipeline (including less serious category 3 incidents), the number of serious category 1 – 2 pollution incidents per 10,000km of pipeline, % of pollution events that were self-reported and % of permit conditions met. Metrics that quantified minimal variation between years and companies or repeatedly scored between 99% and 100% were excluded.

Regulatory Risks : Prosecutions, Cautions and Fines

Financial Risks : Annual Accounts and Statements

50 Environmental Indicators : Environmental Performance Assessments by Company (2013 – 2015)

Table 7. Summary of water and sewerage companies’ Environmental Performance Assessments (2013). Based on an annual report produced by the Environment Agency. 36 2013

Table 8. Summary of water and sewerage companies’ Environmental Performance Assessments (2014). Based on an annual report produced by the Environment Agency. 37 2014

Table 9. Summary of water and sewerage companies’ Environmental Performance Assessments (2015). Based on an annual report produced by the Environment Agency. 38 2015

Environmental Indicators by Company

Each year the Environment Agency produces environmental performance assessments of the 9 biggest water and sewerage companies that operate wholly or mainly in England. The tables below summarise the results of these assessments from 2013 – 2015. 36, 37, 38 The most serious sewerage pollution incidents are classed as being category 1 – 2. The inclusion of less serious, but more numerous sewerage pollution incidents is captured by the category 1 – 3 pollution incidents. The extent to which discharge permits are complied with and pollution incidents are also of particular interest. The metrics that are consistently close to 100% are less informative. The water companies with the poorest environmental performance will be discussed first, whilst those with enhanced environmental performance will appear towards the end of this section.

South West Water

Overall, the poorest environmental performance was seen at South West Water. In 2013, this company recorded 267 pollution incidents per 10,000km of sewer that were category 1 – 3, 36 followed by 169 in 2014 37 and 171 in 2015. 38 Even the latest 171 pollution incidents per 10,000km of sewer were almost 5x more than Anglian Water’s equivalent figure of 35 for the same period. South West Water also had more than twice the number of serious category 1 – 2 incidents per 10,000km of any other company in both 2013 (10.8) 36 and 2015 (7.6), 38 and was the second worst performer in 2014 (3.3), 37 when Southern Water peaked (5.6). South West Water has also been consistently poor at self-reporting pollution incidents. South West Water self-reported less than half of its pollution incidents in 2014 37 and 2015 38 and only 55% in 2013.36

Southern Water

Southern Water was another very poor environmental performer in 2013 and 2014. Southern Water was responsible for well over 100 category 1 – 3 pollution incidents per 10,000km of sewer in 2013 (148) 36 and 2014 (135) 37 and the most category 1 – 2 incidents in 2014 (5.6). 37 There has been some improvement in Southern Water’s environmental performance in 2015, 38 but it is still in the lower half of companies for category 1 – 3 incidents with 75 per 10,000km of sewer and the second worst performer for serious category 1 – 2 pollution incidents with 3.2 per 10,000km of sewer.

Southern Water has also demonstrated a decline in its self-reporting of pollution incidents from 77% in 2013 36 to 69% in 2014 37 and 59% in 2015. 38

Northumbrian Water

Northumbrian Water did not stand out as a poor environmental performer in 2013 or 2014, but 2015 has seen a significant deterioration in the number of category 1 – 3 incidents to 97 per 10,000km of sewer 38 (up from 54 in 2014) 37 and the number of category 1 – 2 pollution incidents go up to 3.1 per 10,000km of sewer in 2015 38 (up from 1.9 in 2014). 37

Since 2013 there has been a significant improvement in Northumbrian Water’s self-reporting of pollution incidents, with this increasing from 39% in 2013 36 to 56% in 2014 37 and 82% in 2015. 38 In fact, Northumbrian Water was best company for self-reporting pollution incidents in 2015, although 18% of pollution incidents still had to be reported by members of the public or a third party. 38

Anglian Water

Anglian Water has significantly reduced the number of category 1 – 3 pollution incidents per 10,000km of sewer, from 89 and 90 in 2013 36 and 2014, 37 respectively, to just 35 in 2015. 33 However, the number of more serious category 1 – 2 incidents has remained close to 2 per 10,000km of sewer for all of the 3 years considered, and returned to 2013’s score of 2.3 per 10,000km of sewer in 2015; 38 after improving slightly in 2014 to 1.8 per 10,000km of sewer. 37 In 2015, Anglian Water only self-reported 56% 38 of its pollution incidents, having previously self-reported 76% of pollution incidents in both 2013 36 and 2014. 37 54

Thames Water

Thames Water has mostly achieved year-on-year reductions in its number of category 1 – 3 pollution incidents per 10,000km of sewer (from 90 in 2013, 36 to 76 in 2014 37 and 38 in 2015 38) and category 1 – 2 pollution incidents per 10,000km of sewer (from 3.2 in 2013 36 to 1.8 in 2015 38).

As a result, Thames Water has managed to cut the number of category 1 – 3 incidents per 10,000km to one of the lowest in the industry, although it remains a mid-table performer for the more serious category 1 – 2 pollution incidents compared the rest of the industry.

However, Thames Water has also remained a poor performer at self-reporting pollution incidents, and still only self-reported 61% of such incidents in 2015. 38 This is a level of self-reporting that remains a long way off the 75% target set by the Environment Agency for 2020. 76

It is of note that any potential impact of the flow clipping techniques outlined by Judge Sheridan on the number of pollution incidents recorded per 10,000km of sewer and/or on the reliability of self-reporting figures remains unquantified.

Yorkshire Water

Yorkshire Water’s performance has gone up and down from year to year, but is consistently mid-table.

In 2015, Yorkshire Water was responsible for more category 1 – 3 pollution incidents (72 per 10,000km of sewer) than Thames Water (38 per 10,000km of sewer). 38

However, in the same year, Yorkshire Water was responsible for 0.2 fewer category 1 – 2 pollution incidents per 10,000km of sewer and 15% better at self-reporting than Thames Water. 38

Wessex Water

Wessex Water has consistently been responsible for 40 – 50 category 1 – 3 pollution incidents per 10,000km of sewer from 2013 – 2015, which is at the lower end of the industry range. 38

In 2013, Wessex Water was responsible for 3.5 pollution incidents that were classed as the more serious category 1 – 2 per 10,000km of sewer. 36 However, it managed to reduce this figure to 1.7 pollution incidents per 10,000km of sewer in both 2014 and 2015. 37, 38 Although this represents a decent improvement, the company seems to have plateaued, which prevents it from matching the best environmental performers overall.

Wessex Water has been more successful at steadily improving the percentage of its pollution incidents that are self-reported, from 59% in 2013 to 62% in 2014 and 72% in 2015. 36, 37, 38

United Utilities

United Utilities has been one of the best environmental performers in terms of their number of category 1 – 3 and category 1 – 2 pollution incidents in every year from 2013 – 2015. 36, 37, 38

In 2015, the metric that let United Utilities down was its relatively poor performance in relation to discharge permit compliance. For this metric, United Utilities scores just 97.2% whilst most other companies tend to cluster around 99%. 38

The poorest performer overall, South West Water is the only company that under-performs United Utilities in relation to discharge permit compliance. This result stands out as an intriguing anomaly, especially as

United Utilities was one of the best at self-reporting pollution incidents (with 81% of its pollution incidents being self-reported in 2015).

Severn Trent

Overall, Severn Trent has significantly improved its environmental performance from 2013 to 2015. It has almost halved the number of category 1 – 3 pollution incidents per 10,000km of sewer from 79 in 2013 36 to 47 in 2015 38 and cut the number of more serious category 1 – 2 from 1.3 in 2013 to 0.2 in 2015. 38 This means that Severn Trent was responsible for far fewer serious category 1 – 2 pollution incidents per 10,000km of sewer than any other company in 2015 and explains why its performance is considered to be the best overall. Only United Utilities has come close to this level of performance for category 1 – 2 pollution incidents per 10,000km of sewer, with 0.5 per 10,000km in 2014 37 and 1.2 in 2015. 38

Severn Trent is not the best at self-reporting, but has self-reported between 69% and 77% of its pollution incidents from 2013 – 2015, 36, 37, 38 which is more consistent and better than most other water companies.

Regulatory Indicators: Prosecutions, Fines and Cautions (2014 – 15)

In terms of prosecutions, South West Water (10 court cases) and Thames Water (9 court cases) stand out as English water and sewerage companies that have been taken to court the most times. More positively, Wessex Water stands out for having faced no court cases during 2014 – 2015 (see Table 10). 39

In terms of fines, Thames Water stands out for having received almost £2.4 million in fines, spread across 9 prosecutions. 39 United Utilities received a smaller total amount in fines (approx £1.2 million) but from only 3 court cases. South West Water, Southern Water, Yorkshire Water and Anglian Water were all fined between £500,000 and £1 million, with South West Water facing far more prosecutions than the others in this cohort.

Every company was cautioned for licence breaches, with Yorkshire Water being cautioned the most at 10 times, followed by South West Water (8 cautions) and Anglian Water (8 cautions). Wessex Water received 3 cautions but was not prosecuted like Southern Water (1 caution) and Thames Water (2 cautions). 39

Table 10. Prosecutions, Fines and Cautions per Water and Sewerage Company (2014 – 2015). Sorted by fine totals (£).39, Appendix 2

Company Court Cases Fines (£) Cautions Thames Water Utilities Limited 9 2,373,000 2 United Utilities Water Limited 3 1,183,000 6 South West Water Limited 10 975,500 8 Southern Water Services Limited 3 700,000 1 Yorkshire Water Services Limited 1 600,000 10 Severn Trent Water Limited 4 522,500 4 Anglian Water Services Limited 1 50,000 8 Northumbrian Water Limited 1 30,000 6 Wessex Water Services Limited 0 0 3

Financial Indicators : Summary of Water Industry Finances

Water Industry Net Debt (Post-Privatisation)

After the water industry was privatised in 1989, levels of debt were near zero. Since then many of the UK’s water companies have been taken off the stock exchange and the industry has accumulated a total level of net debt of £40 billion - £50 billion (see Figure 10). 53, 54, 55 Clearly, an industry carrying this much debt carries a lot more systemic risks than one with little or no debt.

Figure 10. Debt and equity in the water industry, 1990-01 to 2014-15. Taken from “The economic regulation of the water sector” published by the National Audit Office on 14 October 2015, page 38. Data source, Ofwat. 53

The slow, but steady, accumulation of net debt by the water industry has taken decades to reach levels that pose a significant risk to the financial resilience of water companies and have the potential to impact their day-to-day operations.

This chronic reliance on debt has made it difficult to trigger concern amongst regulators, such as the Serious Fraud Office or Ofwat, which have allowed the privatised utilities to manage their own finances.

The chart above shows that since privatisation investors have avoided putting their own money (equity) into the businesses they own, but instead used debt to fund long-term investments in assets.

After 30 years of this adding debt in this way, the essential public services that customers rely upon have received considerable investments. However, the entities that owning them have often been financially hollowed out in the process.

This trend is made all the more serious by the fact that water bills are also being supplemented by annual borrowing and these companies therefore have both high levels of net debt and cash flows which provide limited resilience to financial shocks.

Net Debt by Water Company

Over time the levels of net debt sitting within most of the English water companies have increased to the point where they all carry £ billions of debt. Thames Water stands out as being the most indebted, not just because of the £9,494.6 million of net debt that it carried in 2015 (see Table 11). 20 This is approximately £3 billion more debt than the next most indebted company, Anglian Water, which carries at least £6,376.3 million of net debt in the same year. 41, 81

The total amount of debt is not the only metric that matters, as some companies own more assets than others. For example, Anglian Water and United Utilities both carry in the region of £6 billion in net debt, but this represents a higher percentage of the Anglian Water’s official regulatory capital value (79.2%) than it does for United Utilities (63.4%). Wessex Water and South West Water both have low levels of net debt and gearing.

Table 11. Net Debt (2015) and Gearing (%) by Water Company (Source Ofwat 19 annual reports 20, 21, 40 – 50, 81)

Company Net Debt (£ million) Gearing (%) Thames Water (TMS) 9,494.6 80.1

Anglian Water (ANH) 6,376.3 79.2

United Utilities (UU) 5,924.0 63.4

Severn Trent Water (SVT) 4,752.6 60.7

Yorkshire Water (YKY) 4,491.1 77.2

Southern Water (SRN) 3,712.5 78.0

Northumbrian Water (NES) 2,586.6 66.7

Wessex Water (WSX) 1,862.1 62.0

South West Water (SWT) 1,817.5 62.0

Gearing by Water Company

Each regulated water company has an official regulatory capital value (RCV), which was first calculated shortly after they were privatised. These values have since been adjusted upwards on a regular basis, in order to take into account subsequent investments agreed with Ofwat, the price and profit-setting regulator. The extent to which each water service company’s official regulatory capital value (RCV) is leveraged by net debt can then be calculated and expressed as % gearing. The higher this percentage figure is, the greater the proportion of each company’s value accounted for by debt.

Almost all of the water service companies now carry 60% - 80% gearing, 19 with Thames Water Utilities Limited carrying a gearing of 80.1% in 2015. Severn Trent (60.7%), Wessex Water (62%), South West Water (62%) and Northumbrian Water (66.7) carry the lowest levels of gearing, almost 13% - 20% less than Thames Water. It is worth noting that the group and other holding companies that now own most of the regulated water companies responsible for delivering drinking water and treating sewage can have higher levels of gearing in relation to the core water assets, or regulatory capital value, but that this extra financing falls outside the regulatory focus of Ofwat.

Financial Issues

Financial Engineering

It is not just the total level of net debt in £ billions or the % gearing that should give cause for concern. The industry’s recent use of sophisticated financial engineering, including loans or bonds that are index-linked or have a fixed interest, has the potential to result in expensive miscalculations. 34, 49

Interest rates and inflation are out of the control of water companies and thus pose a risk, with even quite small changes in rates able to impose significant increases in financing costs.

The attraction of modern financial engineering is that it makes it possible to spread the cost of major works over decades and to reduce bills today. However, these sophisticated methods of financing also expose companies to long-term risks and liabilities that governments and customers may not even be aware exist.

If interest rates or inflation return to historic levels, high levels of debt could unexpectedly impact customers by pushing up bills very rapidly or – in extremis – forcing taxpayers to bail out insolvent water companies that are simply too important to daily life to allow any disruptions in services.

Some water companies have already lost £100s of millions due to misjudgements in the downside risks associated with these complex financial products, and is likely that any future financial crisis would quickly impact business models that rely upon easy or cheap borrowing to finance their operations.

Asset Stripping

Given that Macquarie Bank and its partners have extracted around £1.16 billion 10 as dividends and added approximately £10 billion of net debt 26, 27, 28 since buying Thames Water for £8 billion in 2006 9, 10, it is of note that The Sunday Times, Greenpeace UK, opposition politicians, think tank E3G and academics have all expressed concern that UK water companies are vulnerable to asset stripping under the present regulatory regime. 82, 83, 84, 85, 86

The vulnerability of Thames Water and other water companies to asset stripping by international investors deserves a wider public debate, given that customers rely upon their water services every day and the serious environmental and social impacts that can occur when water companies run into operational difficulties.

Tax Havens

Several of the UK’s regulated water companies are owned and controlled by funds domiciled in tax-havens e.g. Luxembourg, Guernsey and the Cayman Islands. 34

This arrangement is tax efficient but has forced regulated water companies to have their debts ring-fenced and the additional debts associated with their overseas parent companies to be disregarded by regulators.

This arrangement may be necessary to maintain creditworthiness, but stores up trouble in the event that parent companies prove unable to service all of their debt, rather than just the debts that have been “ring- fenced”. 23

Thames Tideway Tunnel : Super Sewer

Another possible impact of water companies being so burdened with debt is that it could hinder their ability to invest in the infrastructure needed to meet present and future demand. For example, London’s Victorian combined sewage and drainage system is now unable to contain the effluent flows generated by storms, and was responsible for sewage discharges equivalent to 4000 Olympic swimming pools as far back as 2009. 87

As a result of this pollution, the Court of Justice of the European Union issued of infraction notice to the UK in 2012 under the EU’s Urban Waste Water Directive, following years of warnings, 88 and the country is at risk of fines if this problem is not addressed.

The proposed solution, the Thames Tideway Tunnel is a much-delayed 25km-long super sewer that will run from West to East London and act as a massive storage tank during storms. 89

This project has a budget of £4.2 billion, and should be just the sort of long-term investment you might expect Ofwat to support. 90, 91

However, with over £10 billion of debt already on its balance sheet, Thames Water has proven unwilling to build this much-needed infrastructure on its own. Consequently, the UK government has had to establish a joint venture with Thames Water in order to get this scheme funded and built. 90

Although the UK government has said that any transfer of risk is unlikely, the National Audit Office has already said that under a “reasonable worst case scenario” liabilities of up to £6.6 billion could have to be picked up by taxpayers.92

It is of note that the former boss of Ofwat, economist Ian Byatt has recently called for Thames Water to be broken up so that it might better address the different issues it faces inside and outside of London, 93 and meet its responsibilities to urban and rural customers, and this perspective may gain momentum as the challenges of integrating the Thames Tideway Tunnel into its operations become more apparent.

Reducing Systemic Risks

If governments do not want to fund essential investments in infrastructure via national debt, which has to be acknowledged on the national balance sheet or by raising taxes, then they ought to have a conversation with the public about the alternatives.

These alternatives include letting bills rise by as much as is necessary to maintain standards and provide profits, forcing water companies to compete for more business, developing stricter regulations in relation to debt, financing or environmental performance, and less reliance on self-regulation to monitor pollution or de-risk debt.

If it turns out that any of our water companies already carry too much debt then how would we know this ahead of massive pollution events or insolvencies? Would it be worth drawing up some criteria ahead of any serious trouble?

ERA Methodology for Ranking and Rating Water Companies

Ranking

The simplest method for comparing the performance of the nine companies was to rank them from best (1) to worst (9) for each indicator. This ranking approach is useful for quickly identifying basic trends, but lacks precision.

For the individual environmental indicators the annual data for water companies (2013 – 2015) was averaged and then ranked from best (1) to worst (9). Where averaging annual environmental data across the 3 years resulted in the same mean, companies were given the lowest rank number possible and the next number in the ranking sequence was skipped.

For the individual regulatory indicators (court cases, fines and cautions) data from 2014 – 15 were added together for each company, so that the companies could be ranked from best (1) to worst (9).

For the individual financial indicators (net debt and gearing) the latest data from 2015 were used and ranked from best (1) to worst (9).

When the various (i) environmental, (ii) regulatory and (iii) financial rankings achieved by each company have been charted together, it is possible to compare the consistency of performance within each category.

The final step for the rankings was to calculate an overall mean ranking for each company across all nine indicators. For clarity, the mean rankings have been present in isolation, and then in combination with all nine of the constituent indicators. Overall, Wessex Water had the best mean ranking (2.55) and Thames Water had the worst mean ranking (7.00) (see Figure 11, 13, 15, 17 and 19).

Rating

A more sophisticated method for comparing the performance of companies is to identify what best practice looks like and then create 20 grades between the best 5% of performers (1) and the worst 5% (20) of performers. This method of rating companies from 1 – 20 resulted has been used to calculate rating grades for individual indicators, and then an overall mean rating for each company based on all nine indicators, which was more proportionate to the range of measured performance than the simple rankings allowed.

For the individual environmental indicators, the best score achieved by any company from 2013 to 2015 was used to define the top of best grade (1) and the worst score was used to define the bottom end of worst grade (20). The annual scores that each company scored, for each of the individual environmental indicator across all three years, were first averaged and then given rating grades from 1 – 20.

For the individual regulatory indicators (court cases, fines and cautions) data from 2014 – 15 were added together, and the company totals for each indicator given rating grades from 1 – 20.

For the individual financial indicators (net debt and gearing) the latest data from 2015 was used to calculate rating grades from best (1) to worst (20)

When the various (i) environmental, (ii) regulatory and (iii) financial rating grades achieved by each company have been charted together, it is possible to compare the consistency of performance within each category.

The final step for the ratings was to calculate an overall mean ranking for each company across all nine indicators. For clarity, the mean ratings are presented in isolation, and then in combination with all nine of the constituent indicators. Overall, Wessex Water had the best mean rating grade (3.33) and South West Water had the worst mean rating grade (12.33) (see Figure 12, 14, 16, 18 and 20).

Risk Profile Groups

When each company’s ratings for the nine individual indicators are displayed with the overall mean ratings it is possible to see that three distinct risk profiles exhibited by England’s nine largest water companies (see Figure 21).

The first group [1] of companies exhibits low to moderate risk ratings across all major indicators, including no serious financial risks. This group consists of Wessex Water, Severn Trent, Northumbrian Water and United Utilities. Wessex Water stands out as the strongest company overall, having achieved very low risk ratings for the majority of its indicators.

The second group [2] of companies appears to have slightly lower ratings in general, but stands apart from group 1 because the companies all have much worse financial risk ratings due to high gearing. Out of this group, Yorkshire Water has the best financial ratings and Thames Water the weakest financial ratings.

The third group [3] consists of just one company, South West Water. This company exhibits remarkably good grades for financial risks (both gearing and net debt) but has much weaker environmental and regulatory ratings. Although Thames Water has a similar overall rating to South West Water, these two companies control their risks in very different ways. South West Water has rather good financial risk ratings, but poor ratings in most other areas of its business, whilst Thames Water reports moderate environmental ratings that are undermined by poor financial and regulatory risk ratings. It is notable that these two companies demonstrate the weakest self-reporting and have had the most court cases.

These three risk profile groups are not visible when investment analysts consider traditional financial metrics alone. The ERA’s ratings therefore offer an additional method for investors and regulators to identify which companies are (i) managing all forms of material risk well, (ii) managing most material risks relatively well, but taking financial risks or (iii) managing their financial risks whilst struggling to control most other risks. The implications of these novel results will be discussed in more detail in the conclusions.

62 ERA : Charting Environmental, Regulatory and Financial Risk Ratings Figure 11. Water Company Environmental Risk Rankings (2013 – 15). 36, 37, 38 Rankings 1 (best) – 9 (worst) over 3 years.

Best Water

nking Ra

Worst Water

Wessex Severn United Yorkshire Northumbrian Anglian Southern South Thames Water Trent Utilities Water Water Water Water West Water Water

Figure 11 shows the ranking of each company from 2013 – 2015 based on 4 separate environmental indicators. The best-performing company was ranked 1 and the worst-performing company ranked 9. In terms of serious category 1 – 2 pollution incidents, United Utilities ranked as best (1), followed by Severn Trent (2) and Yorkshire Water (3); by contrast Southern Water (8) and South West Water (9) ranked worst. When less serious pollution incidents were included (category 1 – 3), United Utilities still ranked best (1), but Wessex Water (2) did better than Severn Trent (3); at the weaker end Northumbrian Water (7), Southern Water (8) and South West Water came bottom (9). Wessex Water (1) and Severn Trent (2) were ranked the best at discharge permit compliance; with Thames Water (8) and South West Water (9) ranked worst. Yorkshire Water ranked best for self-reporting licence breaches followed by United Utilities (2) and Severn Trent (3), with Thames Water (8) and South West Water (9) getting the worst rankings. Overall there can be quite big variations on ranking depending on the environment indicator considered, although Severn Trent ranked consistently well and South West Water consistently ranked poorly.

Figure 12. Water Company Environmental Risk Ratings (2013 – 15). 36, 37, 38 Rating Grades 1 (best) – 20 (worst) over 3 years.

Best Water

Rating

Worst Water Wessex Severn Northumbrian United Yorkshire Southern Anglian Thames South Water Trent Water Utilities Water Water Water Water West Water

Figure 12 shows the rating of each company from 2013 – 2015 based on 4 separate environmental indicators. Most companies have ratings that suggest decent performance across all indicators. South West Water scores poorly across all environment indicators and the self-reporting of pollution incidents looks like it is an issue at Wessex Water, Northumbrian Water, Thames Water and especially South West Water. 63 Figure 13. Water Company Regulatory Risk Rankings (2014 – 15). 39 Rankings 1 (best) – 9 (worst) over 3 years.

Best Water

nking Ra

Worst Water

Wessex Severn United Yorkshire Northumbrian Anglian Southern South Thames Water Trent Utilities Water Water Water Water West Water Water

Figure 13 shows the ranking of each company from 2014 – 2015 based on 3 separate regulatory indicators. Wessex Water ranks especially well as it was not prosecuted or significantly fined during 2-year period covered by our Freedom of Information request, although it did receive a few cautions. Yorkshire Water, Northumbrian Water and Anglian Water made up the next best tier of companies in terms of court cases. Thames Water (8) and South West (9) were ranked the worst in terms of court cases. Wessex Water (1), Northumbrian Water (2) and Anglian Water ranked the best for the low level of fines they received, but United Utilities (8) and Thames Water (9) ranked the worst. Companies seem to rank well for cautions, when they ranked poorly for court cases and/or fines and poorly for cautions when they ranked well for court cases and/or fines.

Figure 14. Water Company Regulatory Risk Ratings (2014 – 15). 39 Rating Grades 1 (best) – 20 (worst) over 3 years.

Best Water

Rating

Worst Water Wessex Severn Northumbrian United Yorkshire Southern Anglian Thames South Water Trent Water Utilities Water Water Water Water West Water

Figure 14 shows the rating of each company from 2014 – 2015 based on 3 separate regulatory indicators. When the original data is used to help differentiate the range of performance using rating grades it becomes more apparent that the majority of companies are not being taken to court on a frequent basis or receiving high fines or many cautions. By contrast, it is clearer that Thames Water and South West Water are being taken to court much more often than other companies and receiving medium to high levels of fines. Interestingly, Thames Water received relatively few cautions despite a high number of court cases and serious fines, whilst South West Water was cautioned many times and prosecuted the most, but was fined to only moderate levels overall.

64 Figure 15. Water Company Financial Risk Rankings (2013 – 15). 20, 21, 40 – 50, 81 Rankings 1 (best) – 9 (worst) over 3 years.

Best Water

nking Ra

Worst Water

Wessex Severn United Yorkshire Northumbrian Anglian Southern South Thames Water Trent Utilities Water Water Water Water West Water Water

Figure 15 shows the ranking of each company from 2013 – 2015 based on 2 separate financial indicators. In terms of net debt, South West Water (1), Wessex Water (2) and Northumbrian Water (3) rank the best and carry the least debt in £ billions. United Utilities (7), Anglian Water (8) and Thames Water (9) ranked the worst for net debt in £ billions. In terms of gearing, Severn Trent (1) carried the least debt in relation to regulatory capital value, followed by Wessex Water (2) and South West Water (2). By contrast, Southern Water, Anglian Water and Thames Water ranked the worst for gearing. Having ranked very poorly for the environmental indicators and regulatory indicators it is of note that South West Water ranks well in terms for both of the financial indicators net debt and gearing. By comparison, Thames Water ranks poorly in environmental, regulatory and very poorly for the net debt and gearing financial indicators.

Figure 16. Water Company Financial Risk Ratings (2013 – 15). 20, 21, 40 – 50, 81 Rating Grades 1 (best) – 20 (worst) over 3 years.

Best Water

Rating

Worst Water Wessex Severn Northumbrian United Yorkshire Southern Anglian Thames South Water Trent Water Utilities Water Water Water Water West Water

Figure 16 shows the rating of each company from 2014 – 2015 based on 2 separate financial indicators. It is notable that all of the water companies carry moderate to high levels of net debt. Wessex Water and South West carry the least, while Thames Water, Anglian and United Utilities carry the most net debt. The ratings of the water companies based on gearing more clearly split the water companies into two groups with Wessex Water, Severn Trent, Northumbrian Water, United Utilities and South West Water carrying low levels of gearing, and Yorkshire, Southern Water, Anglian Water and Thames Water all carrying relatively high levels of net debt according to their ratings.

65 Figure 17. Water Company Mean Risk Rankings (2013 – 15). 20, 21, 36, 37, 38, 39, 40 – 50, 81 Mean Rankings 1 (best) – 9 (worst) over 3 years.

Best Water

nking Ra

Worst Water

Wessex Severn United Yorkshire Northumbrian Anglian Southern South Thames Water Trent Utilities Water Water Water Water West Water Water

Figure 17 shows the mean ranking of each water company from 2013 – 2015 based on 9 separate environmental, regulatory and financial indicators. The multi-year ranking of each company from 1 (best) to 9 (worst) was calculated for each of these indicators and overall mean rankings were then calculated for each company across all 9 indicators (see above). The results show Wessex Water had the best mean ranking for its overall performance, with Severn Trent a close second. South West Water had the worst mean rankings overall, with the others somewhere in the middle.

Figure 18. Water Company Mean Risk Ratings (2013 – 15). 20, 21, 36, 37, 38, 39, 40 – 50, 81 Mean Rating Grades 1 (best) – 20 (worst) over 3 years.

Best Water

Rating

Worst Water Wessex Severn Northumbrian United Yorkshire Southern Anglian Thames South Water Trent Water Utilities Water Water Water Water West Water

Figure 18 shows the mean rating of each company from 2013 – 2015 based on 9 separate environmental, regulatory and financial indicators. For each indicator, the best score achieved by any company from 2013 to 2015 was used to define the best grade (1) and the worst score equated to (20). Having identified the range of possible scores, each companies had they 2013 – 2015 average rated from 1 – 20 for all 9 indicators. The mean ratings achieved by each company across all 9 indicators are shown above. The results show Wessex Water and Severn Trent were the best overall, again, and that South West Water and Thames Water were still the worst based on actual scores for each indicator rather than just rankings. However, Northumbrian Water and Southern Water look more impressive when rated on the basis of their original data, rather than ranking against peers; United Utilities and Anglian Water less so.

66 Figure 19. Water Company Mean & Individual Environmental, Regulatory & Financial Risk Rankings (2013 – 15). Mean Rankings 1 (best) – 9 (worst) over 3 years. 20, 21, 36, 37, 38, 39, 40 – 50, 81

Best Water

nking Ra

Worst Water

Wessex Severn United Yorkshire Northumbrian Anglian Southern South Thames Water Trent Utilities Water Water Water Water West Water Water

Figure 19 shows the ranking of each company from 2013 – 2015 based on all 9 separate environmental, regulatory and financial indicators, and the mean overall rankings that result from these rankings being averaged. Although it is clear that all companies display a wide range of rankings, the best rank well for multiple indicators e.g. Wessex Water and the worst tend to rank poorly for multiple indicators e.g. South West Water and Thames Water. Wessex Water’s poorest rankings are for two of the most serious environmental indicators: category 1 – 2 pollution incidents and self-reporting. South West Water ranks well based on the financial indicators, the most common criteria used by investors, but poorly against all other indicators, and this suggests the value of considering more than finances.

Figure 20. Water Company Mean & Individual Environmental, Regulatory & Financial Risk Ratings (2013 – 15). Mean Rating Grades 1 (best) – 20 (worst) over 3 years. 20, 21, 36, 37, 38, 39, 40 – 50, 81

Best Water

Rating

Worst Water Wessex Severn Northumbrian United Yorkshire Southern Anglian Thames South Water Trent Water Utilities Water Water Water Water West Water

Figure 20 shows the mean rating of each company from 2013 – 2015 based on 9 separate environmental, regulatory and financial indicators, and the mean overall ratings that resulted from these ratings being averaged. Viewed this way, Wessex Water, Severn Trent, Northumbrian Water and United Utilities stand out for having the most low risk ratings. The next group of companies, Yorkshire Water, Southern Water, Anglian Water and Thames Water achieved fewer low risk ratings but were really distinct because they have very poor financial risk ratings due to their high gearing. South West Water had the highest number of high risk ratings, but as different to the other companies with poor overall risk ratings because it had unusually good risk rating for net debt and gearing.

Environmental Rating Agency : Water Industry Grouped Risk Ratings by Company

When all of the financial and non-financial risk indicators that we have assembled are combined, we can see three distinct risk profiles exhibited by England’s nine largest water companies (see Figure 21).

The third group [3] consists of just one company, South West Water. This company exhibits remarkably good grades for financial risks (both gearing and net debt) but has much weaker environmental and regulatory ratings. Although Thames Water has a similar overall rating to South West Water these two companies control their risks in very different ways. South West Water has rather good financial risk ratings, but poor ratings in most other areas of its business, whilst Thames Water reports moderate environmental ratings that are undermined by poor financial and regulatory risk ratings. It is notable that these two companies demonstrate the weakest self-reporting and have had the most court cases.

Figure 21. Water Companies Grouped by Environmental, Regulatory & Financial Risk Ratings (2013–15). Mean Rating Grades 1 (best) – 20 (worst) over 3 years.

Best Water

Worst

By placing the nine major water and sewerage companies in England in descending order of their overall mean risk rating it is possible to see these companies in a new light. The fact that the top 4 companies have no individual rating grades in the lower third of the rating range tells the viewer that the best companies are able to manage all of their risks and maintain high standards of performance across all of the selected indicators. The next four companies are slipping in their overall rating primarily because they are taking on increasing financial risks; initially in the form of increased gearing but also progressively greater net debt as well. In this second group Thames Water stands out as the weakest performer with poor net debt, gearing, fine and court case ratings. The third group, consisting of just South West Water, mimics the good financial ratings awarded to the highest performing companies, such as Wessex Water, but rates very poorly for most of the other indicators, and especially all of those related to the environment and court cases. 68

Conclusions Overview

The conclusions below will attempt to draw together the lessons learned from the conviction of Thames Water at Aylesbury Crown Court, including the intrinsic limitations of self-regulation and the use of techniques such as “flow clipping” that allow crucial regulatory data to be manipulated.

The environmental risks discussed below are relatively visible, and even possible to smell when things go wrong. A key challenge is how to raise environmental standards when regulating regional monopolies that have been allowed to self-regulate their operations to a high degree.

The financial risks within the water industry have taken many years to develop so it is difficult to say that precise moment when risks that have not mattered for decades, will suddenly matter. However, the systemic financial risks have unambiguously mounted and these deserve wider consideration and debate.

The regulatory risks have become more apparent since the great financial crisis highlighted the costs and risks associated with regulators leaving difficult problems to fester for too long. Effective regulation relies on regulators asking hard questions and being equipped to see problems before they manifest in disastrous forms. It therefore does not help for both the economic and environmental regulators to be relying on environmental performance data that is collected by those being assessed and which has proven in court to provide a false impression of performance. The sophisticated financial engineering that has been applied to the water industry, especially the use of complicated corporate structures and financial derivatives, creates novel risks that could leave regulators looking flat-footed in the event of a crisis.

The ERA’s first attempt at ranking and rating the environmental, regulatory and financial risks of England’s major water and sewerage companies has provided a more rounded view of the material risks than is generally relied upon by investors or regulators, and raises questions about how regulators and investors are being gamed by the use of simplistic financial indicators of strength or weakness.

The unified risk profiles we have identified proved particularly informative in showing that an over-reliance on financial risk metrics can obscure the significance of material regulatory and environmental risks that the courts are in the process of making much more expensive.

Although others may place different emphasis on the indicators selected by the ERA, and new data will become available over time, it is hoped that the ERA’s initial attempt at repurposing the best available data up until 2015 will help to encourage new forms of due diligence and applications of fiduciary duty. Such an enhanced assessment of risks would better equip investors to align their investments with the best interests of the public and the environment. By considering more of the known and quantified risks in this way, investors would gain added assurance of the long-term profitability and solidity of their investment.

Environmental Risks

Poisoning and Polluting Rivers

It is clearly a risk to shareholders, the environment and the public for a water company to be illegally discharging billions of litres of sewage into rivers.

Sewage pollution not only poisons flora and fauna, and disrupts ecosystems; it also poses a risk to public health and exposes companies to increased regulatory and financial risks.

In water companies that undertake basic maintenance, make sensible investments, empower staff and have competent management it is possible for sewage to be contained and treated to a consistently high standard.

There are therefore likely to be deep-seated problems with the priorities of water companies that are polluting the environment - the raw material of their business - on a regular basis or on such a scale.

Basic Failures in Maintenance and Operations

During the prosecution of Thames Water, their Little Marlow Sewage Treatment Works was estimated to have discharged 200 litres per second of sewage for a year, without full treatment, due to problems with pumps that were blocked with “rag” debris such as nappies, condoms and tampons. 1 This equates to 4,000,000 litres of untreated sewage every day or around 1.4 billion litres over the course of a year. 1

At Aylesbury Sewage Treatment Works, a grand total of around 2.8 billion litres (of which 0.5 billion litres was untreated sewage) is thought to have been illegally discharged, a volume equivalent to 1146 Olympic pools or 14 supertankers. 1

These are significant illegal discharges of sewage, which appear to have resulted from basic failures in operations and maintenance, and their occurrence should be of concern to any responsible manager or investor.

“Flow Clipping”

During the prosecution and defence hearings it had been unclear why so much sewage had been illegally discharged into rivers, via storm tanks and wildlife areas, before it had been fully treated.

During the sentencing the judge expressed his belief that “flow clipping” “was deliberately done and gave a false impression of the sewage treatment works’ performance and undermined the operator’s self-monitoring process.”

Only Thames Water know why exactly they might want to create a false impression of compliance in the way the judge has suggested, but it might be important that Ofwat consider the level of compliance with environmental permits when determining how much water bills must go up or down, how much companies must invest in maintaining or upgrading their assets and how much operating profit can be allowed. By fully treating only a fraction of the sewage that a works is designed to handle it is possible to do a better job with the treated fraction, whilst not reporting the discharge of large volumes of untreated sewage into rivers.

Given that the fines for environmental offences have typically been so much lower than any of the sums involved in pricing, profits and planning decisions, it seems credible that “flow clipping” allows a water company to create a favourable impression with Ofwat. If sewage works appear to be doing a good job it is also less likely that companies will need to go to the expensive of significantly upgrading or replacing works.

Given that the Environment Agency relies on water companies to monitor their own pollution levels prior to discharge and also to report any major pollution incidents, it is not difficult to see that it might until recently have made economic sense for water companies for clip their effluent flows and wait to get caught, then pay a modest fine. This may be cynical but it makes economic sense.

The extent to which Ofwat’s potentially very high-cost permit compliance requirements and the Environment Agency’s relatively low-cost abilities to detect and prosecute pollution incidents have been gamed is unknown, but this has the potential to be an industry-wide issue.

To Self-Report, or Not To Self-Report

From the Environment Agency’s Environmental Performance Assessment in 2015, we can see that South West Water only self-reported 48% of their pollution incidents, with the rest having to either be found by the Environment Agency or reported to them by the public. During the same period, Southern Water and Thames Water self-reported 59% and 61% respectively of the pollution incidents known to the authorities.

By contrast, the best self-reporters of pollution incidents in 2015 were Northumbrian Water (82%) and United Utilities (81%), a full 20% more often than Thames Water.

Overall, these results suggest that 100% self-reporting may be difficult, based on the present state of the industry’s core technologies and monitoring / reporting systems, but that some companies are reporting themselves to their regulators much, much more often than others.

The ERA recommends that core technologies and monitoring / reporting systems, which regulators rely upon, be upgraded so that 100% reporting of pollution incidents becomes possible and that the Environment Agency has direct access to this data. This would allow the Environment Agency to do its job without delay and remove any conflicts of interest that exist today.

The Environment Agency could then pass on full and complete pollution data to Ofwat, so that it can properly play its part by setting realistic prices, profits and investments plans based on reliable and meaningful environmental performance data, which genuinely corresponds with what is happening in sewage works as well as upstream and downstream of them.

Use of Storm Tanks

Where high standards are maintained, pollution incidents ought to remain rare and legal storm discharges, when these cannot be avoided, should benefit from considerable dilution due to heavy flows.

The ERA recommends that the inappropriate use of storm tanks during non-storm conditions and the manipulation of sewage effluent flows to create a false impression of permit compliance, should be completely eliminated.

In particular, measures should be taken to ensure that storm tanks are only used when permitted i.e. during storm conditions, and it should be impossible for water companies to use storm tanks during non-storm conditions at any other time, without a valid reason that has been approved by a regulator.

Permit Conditions

One of the issues that emerged in court was that sewage works were not by default being operated to the level they were designed to operate at, with Aylesbury being operated to treat 300 litres per second of sewage, rather than the 680 litres per second it was designed to treat.

In future, the permit conditions attached to individual sewage works should clearly specify the exact volumes of untreated sewage that they are expected to treat per second. This is already done for some sewage works e.g. 1,442 litres/second at Little Marlow and 331 litres/second at Didcot, but needs to be done consistently for all sewage treatment works. 3

The absence of specified volumes for the quantities of sewage to be treated before discharge to storm tanks at Aylesbury and Henley 24 does not excuse the use of illegal discharge points or use of storm tanks during non-storm flows. However, this issue did come up in court and from now on regulators will have to state clearly what might previously have been considered by them to be self-evident. It might also be worth offering a one-off amnesty for any undeclared outfall pipes, capable of discharging untreated or partially treated sewage effluent into rivers. 71

Alarming Alarms

In the sentencing remarks, we heard that between 28 January 2013 and 7 July 2013 there were 3,502 A1/P alarms,24 which require immediate attention or attention within 2 hours, which were communicated to Thames Water Central Control as well as hundreds of further alarms requiring attention over 4 – 24 hours. 24

This seems to be an incredible number and suggests that these alarms should also be automatically shared with the Environment Agency, so that they can help to ensure effective and timely responses become the norm.

If a company tolerates 100s - 1000s of environment-related alarms over the course of months, it is perfectly reasonable to ask what else is it ignoring!

Environmental Monitoring Data

The ERA recommends that the Environment Agency has direct access to independently-sourced and informative environmental monitoring data, including the alarms, within sewage works (as well as upstream and downstream of them) so they can have a real-time situational awareness of how the sewage works and pumping stations are really being operated.

Better access to meaningful data and clearer separation in the roles of the regulator and the regulated companies would allow both to focus on performing their roles to the highest standards possible.

It would also make it possible to hold companies accountable for their actions without months or years of delays and before any board members or shareholders move on.

Enhanced Use of Technology and Transparency

With enhanced use of technology and transparency, it may prove necessary to upgrade or replace far more sewage works to a higher standard than is currently the case and to change the associated monitoring, maintenance and investment arrangements.

In order for the next generation of equipment to come into use the government needs to be prepared to have an honest conversation with the public about the genuine cost of providing clean drinking water supplies and modern sewage treatment works and sewers. Consequently, debris can be more effectively removed within sewage works and the public can be educated to avoid disposing of items such as nappies, tampons or condoms down the toilet because they can clog sewage works and their pumps.

Regulatory Risks

The £20 million in fines and costs imposed on Thames Water at Aylesbury Crown Court, alongside the new sentencing guidelines and support from the Court of Appeal, have significantly increased the regulatory risks facing every company that pollutes the environment. This is especially true for the water industry, which has some of the strongest impacts on the environment of all industries.

“Flow Clipping”

The “flow clipping” exposed in court has made a mockery of the water industry’s self-regulation, and highlights the conflicts of interests associated with expecting any company to mark its own regulatory homework.

Economic Regulation versus Environmental Regulation

Every 5 years, Ofwat has the power to determine the prices, profits and investments that water companies are able to make, and £100s of millions if not billions are at stake whenever this happens.

It should therefore come as no surprise that water companies have had a strong financial incentive to manipulate self-monitored pollution data, using techniques such “flow clipping”, or to leave pollution events unreported if they have only had to pay environmental fines in the £1 - £2 million range (equivalent to a few days’ profits) and can wait to get caught.

Using Available Treatment Capacity

In court, the ERA learned while the Aylesbury sewage works was only treating half the sewage it was designed to handle, it was illegally discharging 100s of millions of litres of untreated sewage into rivers via storm tanks.

It was also diverting partially treated sewage to unlicenced and unmonitored discharge points, which it took months for regulators to spot and further years to be prosecuted and fined.

Polluter Pays

After decades of prosecutions and 100s of convictions for pollution incidents, Aylesbury Crown Court has attempted to send a signal to Thames Water’s shareholders and stated that it “should not be cheaper to offend, than take appropriate action” and the pressure is now on the industry to show that it can respond accordingly. Having increased the scale of fines for environmental offences by a factor of 10, this court has indeed helped to establish the basic principle that a polluter should pay, rather than profit.

An End to Wishful Thinking

Our primary recommendation is that today’s environmental self-regulation needs be backed up by stricter, regulation of performance standards from the state.

The regulatory regime for environmental protection needs to be clear-eyed, hard-headed and ready for the worst, not based on wishful thinking.

Essential Public Services, Multiple Complex Risks

During this investigation the ERA has discovered that the water industry has gradually accumulated multiple forms of off-balance sheet and externalised risks since privatisation, and that regulation has not kept pace with these constantly evolving risks.

The ERA is concerned that the multiple complex risks now inside the water industry could allow financial and/or environmental problems to cascade through an essential public service that millions of people rely upon every day and which could potentially push the entire industry into insolvency.

Market Failures

During the privatisation of the UK’s water industry in the late 1980s it was assumed that it would be straightforward for profit-seeking private investors to help fund and modernise the provision of these public water services; with the minimum of state regulation and a significant reliance on self-regulation.

Thirty years on it is possible to see that the optimistic model of self-regulation adopted for this industry was flawed in its basic assumptions and contained fundamental market failures, which now need to be addressed.

Self-Reporting versus Independent Reporting

By relying on private companies to self-regulate and work in the public interest, even when it costs them time, money, profits and dividends and to self-report and self-monitor their environmental pollution levels - as if they were impartial observers - fundamental flaws were baked into the regulatory system at creation.

The present form of self-regulation still depends upon saint-like honesty from companies and their uninhibited willingness to share self-incriminating and potentially costly disclosures with regulators.

However, the available scientific evidence and the latest convictions at Aylesbury Crown Court demonstrate that self-regulation has not worked as intended, with billions of litres of sewage being illegally discharged into rivers, and that a more robust form of independent reporting that is objectively able to maintain legal standards is required.

The Hidden Costs of Self-Regulation

As a result of relying on the present form of unreliable self-regulation applied to the water industry it has taken the Environment Agency up to 5 years to investigate and prosecute unreported sewage discharges in and around Thames Water’s sewage works, Ofwat has not known the prices, profits and investments needed to operate works legally and investors have been left exposed to increased regulatory risk.

Gaps in data and delays in problem solving associated with weak self-regulation impose real costs on the environment and public health, which are difficult to capture using financial indicators alone, but which increasingly expose managers, shareholders and lenders to regulatory risks that have material costs.

More Effective State Regulation

The state’s regulatory framework has failed to empower regulators to protect the environment from pollution and investors from undisclosed risks, and has relied upon operators to set aside their short-term financial self-interests. State regulation deserves to be modernised so that it is fit for today’s purpose.

The Environment Agency

The Environment Agency has been handicapped in its ability to regulate the water industry by not having direct, complete and unfiltered access to the mission-critical environmental data that it needs in order to identify wrong-doing and/or to protect the environment before pollution incidents become serious or normal.

Ofwat

Similarly, Ofwat has lacked access to hard-hitting environmental metrics that it can be 100% sure provide an unvarnished and complete picture of companies’ real-world environmental performance. As a result, Ofwat has agreed the latest round of regulated prices, profits and investment plans with companies, without access to important environmental information, and been left to see the industry through rose-tinted spectacles. Ofwat even asked Thames Water to cut its water bills by 1% per year (excluding the anticipated bill increases associated with the Thames Tideway super sewer).

Independent Environmental Data

The ERA recommends that the environmental data relied upon by regulators, to protect the environment and set prices, and by investors in the market, should be independently gathered, analysed and audited beyond the influence and control of the water utilities being assessed.

This data needs to be 100% reliable, to offer a complete view how sewage works are being operated and to be verified with spot checks to ensure that it is totally independent of company interference.

The protection of the environment, public health and investors should not be left to chance or rely upon expensive court actions to send signals to shareholders several years after serious pollution incidents, or even insolvencies, have occurred.

Pricing Imperatives Over-Ruling Responsible Regulation

Pricing imperatives that promise to reduce water bills year-on-year play well politically, but look deeply unrealistic based on the sewage works that have been caught polluting the Thames and its tributaries, which were described by the judge as being “in a deplorable state” and exhibiting “diabolical operational practice”. It also makes it hard to see how companies will ever be able to clear their mounting debts. 1

A more responsible approach to funding the water industry is required which sets rigorous environmental standards and provides the funds required to ensure that they will be met.

Private companies will always have financial incentives to extract as much money as possible as profits, dividends, inter-company loans or other payments. Economic regulation therefore needs to anticipate this and be robust enough to ensure that funds end up going into the assets and operations they were supposed to fund and are not extracted by shareholders until after core business requirements have been fulfilled.

Undisclosed Risks

If it turns out that an over-reliance on self-regulation has allowed decades of under-investment in critical infrastructure to go unnoticed then the debts and risks already inside the industry could significantly limit the ability of these companies to finance necessary investments, and expose investors to undisclosed financial and regulatory risks.

Corporate Responsibility

According to research by the Financial Times, Thames Water has gone through 30 board members since 2014. 24 This situation makes it difficult to attribute personal responsibility within boards and corporate responsibility to companies.

The ERA recommends that government considers the following:

• Holding board members personally responsible for decisions taken during their tenure; • Requiring companies to assist with the collection of independent data and share alarm alerts with regulators; • Requiring companies to share independently collected and audited environmental metrics with the market.

Financial Risks

The most basic risks facing the water industry are the £ billions of net debt and the high levels of gearing that many companies have acquired over recent decades.

Several companies now have over 70% of their regulated capital value accounted for by debt and these levels go even higher if you have limited confidence in the meaningfulness of a compliance certificate in a crisis.

The ERA is also concerned that these public utilities have started to exploit increasingly sophisticated forms of financial engineering and complex corporate structures, which expose shareholders to debts, liabilities and pension deficits that are difficult to price.

Complex corporate structures make it difficult to see what a parent company is doing via regulated and unregulated subsidiary companies all over the world; whilst complex financial products, such as derivatives, mean that even modest changes in interest rates, inflation or currency valuations could have disproportionate consequences for essential public services and even push them into insolvency.

Excessive Debt

With £40 billion - £50 billion 53, 54, 55 of debt sitting inside the water industry, and gearing of 60% - 80% throughout the industry it is possible that a single bankruptcy could force the sudden and mass nationalisation of several water companies.

Water bills are already insufficient to fund all annual debt payments and operations of some companies, without their borrowing up to 20% of their annual turnover from financial markets. This may be fine under benign market conditions, but leaves little resilience against increases in costs resulting from unexpected changes in market conditions and/or regulatory risks.

Highly Leveraged and Complex Finances

In the case of Thames Water Utilities Limited the company was bought for £8 billion in 2006, now carries around £10 billion in debt (within its securitisation ring-fence), has extracted £1.16 billion in dividends between 2006 and 2015 and found itself with a pension deficit of £260 million following unexpected movements in gilts.

Not only does this company have the highest net debt and gearing in the UK water industry but it has just received a record UK fine for its environmental offences and is about to commence building one of the biggest building projects in Europe.

Financially, this company appears to the ERA to be thinly stretched - before anything unexpected happens - even if you only consider the net debt acknowledged inside the securitisation ring-fence.

Thames Tideway Tunnel

Although the senior management have assured journalists that these financial risks are manageable, it is of note that the UK government has had to change the law and set up a joint venture with Thames Water, funded by the bills of Thames Water customers over the next 125 years, 94 in order to build the Thames Tideway Tunnel super sewer.

This extra capacity is considered necessary to address London’s long-term infraction of the Urban Waste Water Directive, 95 but that the National Audit Office has recently said that this project alone could result in the transfer of risk amounting to £6.6 billion under reasonable worst-case scenarios.

Profits and Value for Money

There is nothing wrong with companies making healthy profits. Indeed profits are vital if private companies are to operate successfully, invest in their assets and remain creditworthy over the long term.

However, when paying for essential public services, the public has a right to expect that these profits will be fairly earned and that private businesses will provide value for money over the long term.

Clearly, profit-driven private owners have brought innovation and financial savvy to the water industry, which the risk-averse public sector has become reluctant to seek or fund directly.

However, the government should not be surprised that these same private companies have also applied a considerable proportion of their creative genius to extracting additional returns, and need to be prepared to regulate accordingly.

Protecting Essential Services from Financial Insolvency

Easy ways of extracting money from companies providing essential public services include loading the company with debt, extracting money as dividends (or interest payments) and minimising investment in operations and assets.

The regulation of profits, debts and investments therefore needs to be worldly enough to limit any asset- stripping techniques to levels that do not imperil the delivery of vital services or expose essential public services to the risks and disruption posed by insolvency.

Reducing Corporate and Financial Complexity

The next big problem facing regulators (and potential investors) of the UK’s water companies is the hugely complicated corporate structures and complex financial engineering that these companies have acquired since privatisation.

Ownership Transfers: Nationalised Industries, Listed Companies, Private Equity

Over recent decades, the major water and sewerage companies in England have morphed from being (i) under-funded nationalised industries, with strict and risk-averse governance, to (ii) public limited companies listed on stock exchanges that had to provide basic transparency to the market, to (iii) private companies owned and controlled by international private equity firms, pension funds and sovereign funds via opaque groups of companies.

Regulations that Protect Investors and the Public

Although considerable levels of innovation and investment have been injected into the industry since privatisation, with beaches being much cleaner than they used to be, it is notable that debts have mounted as ever more sophisticated investors have become involved in the sector.

At the same time, the regulations and enforcement capacity that markets and the public rely upon to protect their interests have failed to keep pace as numerous new and complex financial, regulatory and environmental risks have grown and diversified.

Simplification of Corporate Structures and Finances Required

Today, it is impossible to fully understand the finances of most of the companies supplying water and treating sewage in the UK by simply reading their annual company accounts.

Instead, you need to read the accounts of their parent company, and potentially several other holding or financing companies, in order to understand the variety and implications of all of the loans, bonds, currency hedges, pension deficits, inter-company loans, dividends and other liabilities that exist and flow within a large group of inter-connected companies, which are often owned and regulated in multiple jurisdictions.

Each water company has used loans, bonds and derivatives in different ways, so it is also difficult to compare them in a consistent fashion, but the ERA strongly recommends that regulators and shareholders stress test these emerging and inter-connected risks under a range of realistic scenarios.

The ERA recommends that regulators should require the simplification the corporate structures and finances attached to essential water utilities.

If water companies want to fund investments using debt this may be fine, within limits.

However, the ERA recommends that more be done to ensure that the water bills fully fund the delivery of basic services, and are not compromised by servicing a mountain of discretionary debt.

In addition, the ERA recommends that regulators and shareholders undertake independent assessments and stress tests of the water industry’s existing finances, including their vulnerability to insolvency whenever long-term interest rates or levels of inflation return to their historic levels.

Stress Testing the Securitisation Ring-Fence

Even a forensic accountant capable of piecing together all of the sophisticated financing now sitting inside the water industry is likely to find it difficult to establish all of the conditions attached to exotic derivatives or to know how well a “securisation ring-fence” will hold in the event of a financial shock.

Although legal, the ERA is concerned that considerable unsecured debts have accumulated inside the companies that own vital public services, which have been discounted for official compliance certification purposes but which could still be material in the event of a crisis.

This matters because at the base of all this financial risk-taking lie essential water utilities that are “too big to fail” and the UK government would almost certainly have to nationalise these if they became insolvent.

Direct and Indirect Costs of Fines

By recalibrating the level of fines that will be applied for environment offences, Aylesbury Crown Court has created a set of regulatory risks that no board or senior management responsible for major impacts on the environment can afford to ignore.

These higher fines not only impose direct costs, but could also impose additional indirect costs on these companies.

The judge requested that the shareholders bear the cost of their company’s environmental offences, but this is difficult to ensure and something that awaits consultations with Ofwat.

It is possible that the company’s official regulated capital value will be reduced, as was done following a separate fine for the misreporting of sewer flooding data. 96

It is also possible that any future environmental offences could cause fines that lead to significant downgrades in credit risk rating, to non-investment aka “junk” status. This could be particularly serious for

the water industry, as existing debt conditions and important investors, such as pension funds, often require companies to remain investment grade.

These direct and indirect costs do not mean that companies should be allowed to pollute the environment to their hearts’ content, but instead mean that they need to take these issues more seriously and to change accordingly.

Moral Hazards

The fact that the banks were rescued because they were considered “too big to fail” means that a similar moral hazard now exists in the water industry and that shareholders and managers need to know what will happen in the event of a major insolvency.

Our investigations have found high levels of debt, in exotic forms, in most of the UK’s major water companies, and we are concerned that these liabilities could prove difficult and expensive for hard-pressed governments to absorb.

ERA Risk Ratings

A Broad Basket of Risk Indicators

The broad basket of risk indicators selected for inclusion in this report have made it possible to assess water companies on the basis of how they perform on their own and in comparison to their peers in greater depth than financial indicators alone allow.

The indicators chosen all reflect issues that are fundamental to the ability of these essential public utilities to operate their water-related activities, to comply with the law and to manage their finances.

Avoiding Environmental Disasters, Regulatory Fines or Reputational Harm

Investors need to take some risk if they are to make money, but also need to control their exposures to risk if they are to avoid losing money following environmental disasters, regulatory fines or reputational harm.

Importantly, significant variations in environmental, regulatory and financial performance have been encountered during the investigations underpinning this report and it is the opinion of the ERA that these variations in performance, and the associated risk-taking, deserve greater public debate given the critical importance of the water industry to daily life.

There have been considerable improvements in environmental performance since the industry was privatised 30 years ago, and this has to be acknowledged. However, the variations in environmental performance amongst peers remain significant.

ERA Risk Rating Groups

The ERA’s risk ratings indicate that although clearly important, a narrow focus on financial performance can provide analysts and shareholders with a false impression of how well some of these companies are managing all of their material risks.

In the case of South West Water it performs well in terms of its net debt and gearing, but poorly against almost every other indicator, and perhaps it should not be so unusual that a variety of environmental and regulatory risk factors is given greater importance.

In the case of Yorkshire Water, Southern Water, Anglian Water and Thames Water it is not obvious that their relatively high levels of gearing have resulted in better performance overall. This raises the questions of 79

where this money has been going and why these heavily leveraged companies are not performing significantly better across the board.

Interestingly, the companies with the highest overall performance appeared to be good at managing all of their risks, with self-reporting or net debt being amongst the first indicators to slip within this high- performing group.

Additional Groups

According to the method used to rate companies in this report, Thames Water and South West differ greatly in their approach to net debt and gearing, but rate equally poorly overall and stand out for being prosecuted the most. This finding suggests that additional ways of categorising the companies and considering key risks exist. The indicators included have all been given equivalence for the sake of this report and it is possible that an investor with a strong dislike of court cases would view companies differently. It is hoped that by showing the relatively scores for the individual indicators in the environmental, regulatory and financial charts readers can identify such trends that might matter to them.

Future Assessments

Future assessments could use more recent data to compare companies using the same methods and it is the hope of the ERA that it will be possible to automate some of the necessary data collection and analysis over the years ahead, so that ratings can be continuously updated.

Gaps in Analysis

Gaps in this analysis remain and it would be helpful if the accounts of companies within given industries were more standardised and consistent. Financial information for topics such as pension deficits and exposure to derivatives were reported in ways that proved too complicated to include with confidence.

With so many subsidiary companies making payments and loans to each other within groups of holding companies it seems unduly complicated to know exactly where companies stand financially, and how worried or relaxed water customers can afford to be about high levels of leveraged or unsecured debt. This is especially the case when the interpretations of company accounts are so complicated and conditional on specialist, fragmented or confidential information. Fully independent environmental data is not available at the moment and this fact weakens every assessment of the water industry, including this one.

New Insights

Overall, the rankings and ratings that the ERA has developed - based on a combination of environmental, regulatory and financial indicators - reveal that the best performing water companies tend to have low debt levels, fewer problems with regulators and high environmental performance, whilst the opposite tends to apply to the most polluting water companies.

Investors and regulators might like to explore these relationships in greater detail over the years ahead, and extend their assessment of purely financial metrics and self-reported / self-monitored environmental metrics currently relied upon by regulators and the market.

In some companies, pollution incidents may simply be the result of a reluctance to spend the required money on maintaining old equipment or upgrading equipment and sites on a sufficient scale. In other companies, the culture and/or business models adopted may send signals which permit pollution incidents to be ignored, justified or to become normal, sometimes for months on end. We could therefore encourage regulators, shareholders and customers to engage with these companies and form their own views as to the most pertinent drivers within each given company.

The Future Ownership of Water Utilities

Essential Public Services… More than Ownership

Whoever owns England’s water and sewerage utilities, the services they provide clearly play a vital role in society and in protecting the environment.

Funding

A key challenge facing both ownership models is how to fund the maintenance and enhancement of clean water supplies and sewage treatment, to a high standard, as populations expand and pressures on the environment increase over the years ahead.

In the late 1980s it became apparent that the government was struggling to fund the water industry to the necessary levels, in part because it had so many other calls on its time, money and attention. A decision was therefore made by the state to offer attractive terms to private investors. The resulting model of privatisation has allowed the new owners to self-regulate their financial and operational affairs to a considerable degree and offered healthy returns to a diverse pool of investors at very low risk.

Protecting the Public Interest

Over the subsequent 30 years considerable investments have been made, but much of the funding has come either directly from water bills or from the businesses taking on ever more debt. As a result, these essential public utilities now carry net debts that are sometimes equivalent to 80% of their value, and a great deal of risk has been transferred to the public, as they would have to rescue these companies in the event of insolvency. Increasingly, the public is also being expected to underwrite the cost of major construction projects, further undermining one of the main arguments for privatising these services in the first place.

Today, wealthy families, pension funds, sovereign funds and private equity firms own a large proportion of the essential water infrastructure of England. Many of these owners are located overseas and have opted to load their companies with large amounts of complex debt, in ways that were barely imagined 30 years ago.

It is therefore time for an honest assessment of how well privatisation has worked, how well today’s risks are being factored into regulation, whether the public interest is being sufficiently protected and whether the risks investors have taken merit the returns they have received.

Problems with Self-Regulation

Having looked at the environmental, regulatory and financial risks inside the privatised water industry in some detail the ERA is concerned that the present form of self-regulation is no longer fit for purpose.

The industry has become loaded with high levels of net debt, gearing and financial complexity while still failing to deliver basic standards of operational competence.

Pros and Cons of Privatisation and Nationalisation

Apart from leaving things as they stand, the two big options for society are whether:

(i) to regulate private water companies more strictly, so that they work in the public interest by offering high quality services, value for money and protecting the environment; or

(ii) to nationalise the water companies, so that the state has ultimate ownership and can eliminate the overhead paid out to shareholders as profits.

The final section of this report discusses the pros and cons of both of these options. 81

Privatised Utilities

The most successful aspect of water privatisation is that it has injected new thinking, new technologies and new money into a traditional industry.

The least successful aspect of water privatisation is that it has created private companies that are “too big to fail” and effectively have their financial and environmental risks underwritten by the public.

The underwriting of private risk-taking by the public did not matter much when the original public service ethos was strongest, immediately after privatisation, but has become more of a material issue as these private companies have secured ever larger debts against essential public assets, and more diverse ownership models have experimented with increasingly complicated corporate structures and sophisticated financial engineering.23

Diversified Ownership Models

Today, there are at least four types of privatised water utility in the England and Wales: 97

(i) Family-owned private companies (e.g. Wessex Water) (ii) Publicly traded companies, listed and traded on stock exchanges (e.g. South West Water) (iii) Private companies owned by private equity firms, pension funds and sovereign funds (e.g. Thames Water) (iv) Single-purpose companies putting all profits back into the company (e.g. Welsh Water)

Simplified Corporate Structures

Each of the water companies mentioned above has a different corporate structure, often including multiple holding companies, financing companies and parent companies owned and controlled from abroad.

This situation means that each water utility has quite different owners, priorities and time horizons for their returns on investment.

Such a fragmented, diverse and complicated ecosystem of companies means that it is now difficult for the state to regulate all of these companies in the same way and that the regulator needs to be empowered to regulate investors with very different appetites for risk.

At the very least, the state has to be clear about what private companies are expected to do and to be prepared to ask challenging questions about how they operate and finance their activities and perhaps require simplified corporate structures that are fully regulated from within the UK. The break up and re- organisation of the industry would be another possibility. 93

Reduced Financial Complexity

The high levels of net debt, gearing and sophisticated financial engineering now common in the water industry make it difficult to simply understand the financial affairs of many water companies. The use of multiple subsidiaries, tax havens (outside UK regulation), exotic loans, bonds, derivates and currency hedges also introduce risks that were not even imagined when the industry was first privatised.

At present, it is not obvious how the water industry’s financial complexity and lack of rigorous, independent environmental data benefits end users, apart from lowering upfront water bills and pushing less visible costs to customers into the future. Regulators may well decide that reduced financial complexity is advantageous.

Aligning Risks and Rewards with the Public Interest

As another example, Thames Water customers will be paying for the Thames Tideway Tunnel super sewer for the next 125 years, 98 even though today’s water bills are officially being reduced by 1% per year excluding this cost.62 This is possible because the Bazalgette Consortium, consisting of German insurer Allianz, Swiss Life Capital and Damore Capital, will own, manage and finance the Thames Tideway Tunnel project during construction, and supply sewerage services to Thames Water on a 125-year concession.98

Significantly, the National Audit Office has warned that under reasonable worst scenarios this same project could transfer risks that could cost up to £6.6 billion to the public, 26 even though the project is currently expected to cost £4.2 billion to deliver.

As was the case with banking prior to the financial crisis of 2008, the UK government has a duty to ensure that the innovations that accountants and lawyers can think up are aligned with delivering tangible social and environmental benefits, as well as profits and value for shareholders; and that excessive risks are not being taken at the expense of essential public services, taxpayers or the environment.

Proactive Regulation

If the state wants private companies to run water utilities, and do so responsibly, then it has to make sure that this is the most profitable option and that financial incentives and regulatory penalties re-enforce the same message, with enforcement that is reliable and robust enough to guarantee full compliance.

The fact the courts have had to increase fines for environment offences into the £10s of millions, indicates that day-to-day regulation of the industry is not proactive enough and that the courts have had to take on the role of protecting the public interest, after problems have occurred.

Ideally, the state should be informed and proactive enough to create regulations and business decisions that avoid pollution incidents before serious environmental or financial harm are done.

Independent Data

If the state wishes to proceed with the privatised models the ERA recommends that stricter financial and environmental regulation be considered and that there is a frank discussion about the quality of services that customers expect and standards of environmental protection that society expects, and how these will be paid for. Appropriate forms of modern regulation and independent scrutiny can then be designed to protect the public interest and the environment.

Although some information may always need to remain confidential, the ERA would further recommend that whoever owns the assets and provides the essential services, should not be relied upon to self-report pollution incidents or allowed to keep operational data away from scrutiny by the public, regulators and/or investors.

Independent Regulation

Rather than simply focus on whether or not the water industry should be privatised, the ERA believes that greater attention should be given to how the water industry is regulated, under any ownership model, and the extent to which the priorities of any owners are aligned with the wider water needs of society and the environment.

Regulation needs to be independent, well resourced and robust in its ability to protect the public from present and future risks.

Nationalisation

The main advantages of nationalisation are that it allows essential public services to be funded, integrated and planned for in the public interest, over the long term, in ways that are difficult for private companies to achieve.

Governments are able to borrow money more cheaply than private companies and tend to follow both the letter and spirit of existing laws when administering nationalised industries. They may, however, be reluctant to tighten laws or raise future standards.

The main disadvantages of nationalisation are that governments tend to be extremely risk averse and to find it difficult to adopt new ideas or ways of working. This matters most when it comes to paying the market rate for the best people and investing in new technologies.

Nationalised industries also come under more direct political pressure from politicians due to their 3 – 5 year electoral cycles, and frequent reshuffles, which can make it difficult for civil servants to think longer than a few years ahead. 99

Routes to Nationalisation

Having examined the finances of the major water companies in England it is possible to foresee two possible routes to their nationalisation:

(i) Financial insolvency is a possibility for some of water companies carrying the most net debt and the highest levels of gearing (i.e. 70% - 80%).19 Water companies are generally assumed to be “too big to fail” but have often accumulated high levels of debt since privatisation and experimented to varying degrees with the use of exotic loans, bonds and currency hedges, which could become unaffordable following unexpected changes in interest rates or inflation.

(ii) State nationalisation might occur if the UK government decides to buy the shares in essential water utilities outright, so that customers do not have to pay a profit overhead and any major investments in national infrastructure could be funded as cheaply as possible.

Financial Insolvency

Although the levels of net debt and gearing inside the water industry have slowly crept up over decades, they now represent a significant portion of these companies’ regulatory capital value.

In some cases, additional debts exist within the companies that own these essential public services that have been accepted by regulators but pose an off-balance sheet risk in relation to the underlying public services.

Although perfectly legal, this combination of high levels of debt, gearing and corporate / financial complexity has the potential to lead to unintended consequences in the event of unexpected changes in market conditions or new owners not fully understanding all of the debts they have acquired when buying more prized water assets.

The consequences of this financial engineering could cascade through the entire industry, if even one company gets into difficulties with creditors. With a total of £40 billion - £50 billion 53, 54, 55 in net debt inside the industry, any hasty nationalisation following insolvency could prove very difficult and expensive for taxpayers. 100

As water companies, rather than financial institutions, it is possible that these public utilities have misjudged their ability to finance complex bonds, loans and derivatives. This may be especially true if interest rates or 84

inflation start to return to their historic norms, which is statistically probable but largely discounted as a possibility at present.

Given that water bill prices are already regulated and capped it is possible that even small changes in market conditions could prove difficult to fund and afford.

It is noteworthy that some UK councils, such as Newham, have been adversely affected by so-called “LOBO” (lender option borrower option) loans, 101 which initially offer loans at low “teaser” rates but which have can become very expensive as interest rates change or even go down.

The expansion of the water companies into ever more sophisticated corners of the accountant’s financing tool-box therefore raises risks, which deserve to be considered.

As the ownership, governance and financing models of water companies have evolved since privatisation in the 1980s it has become increasingly difficult to regulate companies cheaply and simply.

Gaps in regulatory oversight that did not matter many years ago are now important and it is harder to be confident that methods of operator self-monitoring and self-reporting, relied upon by regulators and the market, provide the complete, accurate and reliable assessments of assets and equipment needed or reflect the levels of funding really required to maintain services and protect the environment. 36, 37, 38

State Nationalisation

If a future government 102 or the public start to feel that water companies are not providing value for money, modern services or effective protection for the environment then it is possible that calls for nationalisation of the water industry by the state will increase.

However, nationalisation of water company assets and all of the complex liabilities could prove difficult and expensive given the diverse forms of business model, debt and derivative currently sitting inside the industry – sometimes away from regulatory oversight.

If the state decides to spend all of its resources on taking over ownership it is not clear how much further funding would be set aside to invest in assets or services, and whether the state would put the greatest emphasis on providing value for money, cutting bills or imposing stricter regulation.

In the past, the state has struggled to fund necessary investments in water infrastructure and to comply with environmental legislation, so these issues deserve serious consideration before billions of public spending is committed.

Key issues to consider include the emphasis placed on funding short-term versus long-term costs, the extent to which water bills and/or borrowing should be used to fund operations or investments, and the rigour with which the environment should be protected from pollution.

The public sector is liable to refocus services on providing value for money and enhancing environmental protection, 103 but it is unclear how it would fund future investments and deal with long-term infractions to the EU’s Urban Waste Water Directive after decades focused on regulation rather than operations. 95

In the absence of competition for investors or the majority of their customers it is possible that nationalised water companies would suffer from the principal-agent problem because they have little incentive to be more efficient. This problem tends to take years to materialise but is worth considering when setting up any new ownership model, perhaps by providing incentives or penalties for poorly performing regions.

Nationalised industries can also suffer from the moral hazard associated with any state organisation that knows it will be bailed out by taxpayer subsidies if it fails to reduce losses or inefficiencies. 85

The water industry may also struggle to compete for limited government funds against areas such as health, education and defence, as was the case in the 1980s, so the government might need to consider ways of insulating the industry from this risk by creating new rules and funding models for this form of public debt.

The government also needs to consider what debts and liabilities it might acquire if it makes an outright purchase of all the existing water companies.

Although the water industry has invested approximately £108 billion 99 according the Ofwat (and the industry claims up to £130 billion has been invested) 54 in maintaining and improving assets and services this includes net debts of £40 billion - £50 billion,53, 54, 55 many of which were created under special and finely tuned terms that made economic sense to those creating these liabilities.

It may be difficult for the public sector to follow the assumptions and practices used by those creating these liabilities, especially if the government wishes to simplify the industry and bring all corporate entities onshore and place them under full UK regulation.

It is also of note that a recent report published by Greenwich University, 55 Dr Kate Bayliss of School of Oriental and African Studies claimed “The owners of the nine [English regional water and sewerage] companies — many of which are overseas investors, including sovereign wealth funds — paid out £18.1bn in dividends in the 10 years to 2016, even though post-tax profits amounted to £18.8bn during the decade, according to the researchers’ analysis of their financial reports” 54 and that three companies “Anglian Water Group, Severn Trent Water and Yorkshire Water Services — have paid out more in dividends than their total pre-tax profits over the past decade.” 54 This analysis emphasises the cost to customers of relying on private companies to operate essential public services, especially when a high proportion of this investment is funded by debt, and suggests that private ownership adds £2.3 billion per year to water bills. 54

The Best of Both Worlds

Just as private companies have an innate instinct to maximise returns for their shareholders and minimise costs to themselves, state utilities have an innate instinct to minimise bills and enable politicians to remain popular with voters – primarily by not taking on national debt or raising taxes.

Both public and private ownership models struggle to fund necessary investments, by putting up either water bills or taxes.

Finding a sustainable funding model for essential public utilities is therefore a central challenge for the industry over the years ahead, which requires fresh thinking and a willingness to challenge long-held assumptions.

World-Class Services, World-Class Prices

Put simply, the present business model for the water industry aspires to provide world-class services at ever lower prices.

This means that any real improvements in environmental and public service outcomes are likely to involve either offering

(i) world-class services at world-class prices or (ii) poor quality services at low prices.

Whether or not the state ends up nationalising the water industry, it is worth the country devoting serious time and effort to thinking about how it wishes to finance future investments in public utilities and how to manage the conflicts of interest associated with allowing private companies or the state to regulate their own polluting activities. 86

Increasing Resilience

Various options exist for improving the resilience of the water industry.

Government could buy companies outright, break up regional monopolies or allow companies to compete for all of their customers based on price, performance and innovation.

Increasing Competition

Approximately 1.2 million businesses, charity and public sector customers have recently been allowed to purchase water from new entrants that buy water wholesale from the present incumbents, and it remains to be seen whether businesses will be able to buy better services at a better price. 104

The larger market for 20 million domestic households has not yet been opened to serious competition and it is possible that the costs and benefits of adding a competitive layer to the existing model of asset ownership will struggle to deliver cost-effective savings for customers (e.g. £8 per household per year). 105

Hybrid Solutions

Although dramatically increased competition amongst private companies and stricter regulation by the state have so far been avoided, it is possible that hybrid solutions that play to the respective strengths of the public and private sectors could provide both value for money and effective regulation.

(i) The state could borrow money at reduced cost and lend it to companies for specific investments. (ii) The state could reward private companies with bonuses for hitting challenging objectives. (iii) Publicly owned utilities might be allowed to pay competitive salaries for the best managers and experts in the world. (iv) The public sector might nationalise regional water assets and allow public sector companies to compete to provide different water supply, water treatment, commercial or domestic services. (v) Prices could be set at levels that protect consumers and the environment, allow necessary investments and allow private companies to make profits based on independently collected and analysed metrics.

New Models of Capitalism

Prime Minister Theresa May has proposed intervening in the energy market 106 with price freezes and price caps for companies that provide necessities such as electricity, when the market isn’t working 107 and is looking at new models of capitalism.

In the energy sector this approach has led to the appearance of competition and consumer choice, which tends to benefit a motivated minority, and it is a constant battle to encourage competition whilst maintaining standards.

The Prime Minister has not yet proposed doing anything similar for the water industry, but it likely to be aware of the problems at the Little Marlow sewage works which sits inside her Maidenhead Parliamentary constituency. 108

Responsible Regulation

Whoever owns the assets it is essential that there are clear and simple lines of accountability, sufficient funding to do the job(s) required and rigorous standards for funding and enforcing independent regulation.

Government might also like to take the precaution of being ready to nationalise the industry in case this proves necessary for strictly financial reasons. 87

Self-regulation has not changed at nearly the same rate as financial innovation has taken place inside the water industry. As a result, the safeguards relied upon to protect the environment; society and investors are no longer based on full and frank assessment of modern realities. As a thought experiment it is worth considering how the priorities of Chinese, Canadian and Middle Eastern investors 109, 110 might differ from those of local investors, or those of private equity owners might differ from those of customers and regulators.

Set for Success

If the public want reliable and high quality water supplies and sewage treatment they will need to be prepared to pay for them. Businesses are not charities and it is foolish to treat them as being more high- minded than everyone else in a capitalist society who is trying to maximise their returns and minimise their costs.

The ERA recommends that the government takes a fresh look at the tools and information regulators need in order to guarantee their success, and considers all of the financial risks inside the companies that own and control critically important water services and how the heavy debts and exotic liabilities inside them could be stressed by realistic macro-economic scenarios.

Markets are capable of many things, but cannot perform miracles without being equipped with the data, funding, incentives, penalties, regulations and enforcement needed to deliver desired outcomes.

Waiting for bankruptcies or environmental disasters to happen is not a viable option when these developments could affect millions of people.

Hope for the Best, Prepare for the Worst

Today, the regulator responsible for protecting the environment, the Environment Agency, and the economic regulator, Ofwat, are limited in their ability to perform their respective roles, simply because they do not have unfiltered access to the accurate and complete environmental or financial data they need to protect the public interest.

Those within Thames Water and the other water companies that collect their own environmental monitoring data face conflicts of interest that are difficult to avoid without the use of empowered third parties, beyond the influence of those they monitor.

Prior to privatisation, the nationalised water companies also polluted Britain’s rivers on a considerable scale, and were massive polluters of the sea. This means that it is not a simple matter of who owns these companies, but how well the industry is funded and how strongly these companies embrace their duties to protect the environment and public health, and serve the public interest.

Both privatised and nationalised models of utility ownership have proven to have difficulties with raising the funds required to deliver high quality services whilst also regulating their own behaviour, so it is likely that new collaborative methods for dealing with upfront costs and sharing risks will be required.

The private and public sectors have different cultures, priorities and attitudes to money, and these differences deserve to be acknowledged before heading in any bold new direction.

However ownership is assigned, the regulation relied upon to protect the public and the environment needs to be independent, robust, well-funded, holistic and flexible enough to protect the public from the worst excesses of profit-seeking investors and popularity-seeking governments.

Contact the Environmental Rating Agency to find out more:

Email : [email protected]

Tel : +44 (0)7789 854737

Environmental Rating Agency

The Environmental Rating Agency (ERA) provides unique and independent ratings of corporate environmental risk and performance for investors.

The ERA rates companies using scientific metrics, benchmarks and insights to help investors to make better informed investment decisions.

We see the reliance on corporate self-reporting and voluntary disclosures as an endemic failure in the financial system.

Our mission is to change the way investors invest, to revolutionise how the environmental risks in businesses are analysed and to give life on Earth a business model.

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97 Appendix 1. Volumes of untreated or inadequately treated sewage discharged into the River Thame and River Thames from the Aylesbury and Little Marlow sewage treatment works

The table below gives an estimate of the minimum volume of untreated or inadequately treated sewage that was discharged into the River Thame and the River Thames unlawfully from the above works during the indictment period. The headline figures below are those calculated by the prosecution expert witness from the data and information that was available to the prosecution and of which there is a high level of confidence.

The headline figures do not include further volumes which certain evidence indicates were likely to have been discharged into the River Thame and River Thames. Further, the figures below relate to only two of the five sewage treatment works and the one pumping station before the court. The actual figures discharged into the Thames Catchment would therefore have been substantially higher than the figures below.

Total quantity of untreated or Aylesbury Little Marlow inadequately treated sewage discharged from Aylesbury and Little Marlow STWs only

2.8 billion litres 1.4 billion litres 4.2 billion litres [of which 0.5 billion litres was [All untreated sewage] [of which 1.9 billion litres was untreated sewage] untreated sewage]

Equivalent to: Equivalent to: Equivalent to: 1146 Olympic pools 562 Olympic pools 1708 Olympic pools 14 supertankers 7 supertankers 21 supertankers

Note: Most of the volume from Little Marlow STW is not included above because it falls in the “lower level of confidence” (see section 2. Appendix 2). To achieve a higher level of certainty the Environment Agency requested flow to treatment and flow to storm data for Little Marlow STW but were informed by Thames Water that they do not retain any records of flow to treatment data nor did they retain any flow to storm data [exhibits JPO31, JPO35 and JPO76]. We were provided with flow to storm data for Aylesbury STW and that enabled us to quantify the volume discharged with high certainty.

98 Appendix 1.1 – Aylesbury STW – Volumes of untreated discharged unlawfully

1. Untreated sewage discharged unlawfully via storm tanks when inlet pumps intentionally set at around 300 l/s (Aylesbury STW was designed to treat 680 l/s)

High level of confidence on 34 days only between 07/01/13 – 18/06/13 (c. 5 month period) - 0.5 billion litres (0.517 rounded down to 0.5) - 200 Olympic swimming pools (206.8 rounded down in submissions to the court to 200) - 2 supertankers (200,000 tonne tankers)

Note 1: The expert was asked to examine only 34 days within the above period by the Lead Investigator selected because of evidence (telemetry, log book entries etc.) which indicated unlawful discharges from the storm tanks on those particular days.

There is evidence of a further volume of untreated sewage discharged unlawfully via storm tanks on the above 34 days of which the expert has a lower level of confidence. Lower level of confidence on 34 days only between 07/01/13 – 18/06/13 (c. 5 month period) - 0.14 billion litres - 56 Olympic swimming pools - 0.7 supertankers (200,000 tonne tankers)

2. Diverted inadequately treated sewage discharged unlawfully from unpermitted / unmonitored discharge points

There is high level of confidence that over 94 days (i.e. 80% of 118 days between 20/02/13 – 18/06/13) sewage was not discharged via the prescribed treated effluent sample point at all times as required by the permit. It was instead discharged inadequately treated from an unpermitted / unmonitored discharge points. High level of confidence on the 94 days referred to above: - Over 2.3 billion litres - Over 946 Olympic swimming pools - Over 11.8 supertankers (200,000 tonne tankers)

Note 1: Thames Water’s explanation (which we do not accept) is that the diversion was to reduce the impact on the river of suspended solids (suspended solids are one of the constituents of the final effluent required to be within prescribed limits by the permit).

Note 2: In addition there is evidence that on at least 14 days before and after the period (20/02/13 – 18/06/13) there was a diversion of flow occurring. No volumes for those days have been included in the calculations.

99 Appendix 1.2 - Little Marlow STW – Volumes of untreated sewage discharged unlawfully

1. Untreated baseflow sewage discharged illegally via storm tanks when inlet penstock intentionally set around 800 l/s which is approximately 642 l/s below the Little Marlow STW treatment capacity/permit requirement (1442 l/s) – High level of confidence

Summary: High level of confidence on 89 days within the periods assessed below between 29/11/2012 and 21/04/2013: - 1.4 billion litres - 562 Olympic swimming pools (approx. 6.3 per day) - 7 supertankers (200,000 tonne tankers) - This only represents shortfalls of up to 286 l/s in base flow while Flow to Full Treatment (FFT) was limited to c.800 l/s and less.

1.1 Detail: High level of confidence on 34 days from 18/03/13 to 21/04/13: - 0.84 billion litres - 336 Olympic swimming pools (approx. 10 per day) - 4.2 supertankers (200,000 tonne tankers) - It equates to an average rate of discharge of untreated sewage of 286 l/s over the 34 days.

1.2 High level of confidence on 18 days from 10/02/13 to 27/02/13: - 0.26 billion litres - 103 Olympic swimming pools (approx. 6 per day) - 1.3 supertankers (200,000 tonne tankers) - It equates to a continuous discharge of untreated sewage over the 18 days averaging 166 l/s. 1.3. High level of confidence on 6 days from the period 14/12/12 to 21/12/12: - 0.032 billion litres - 12.7 Olympic swimming pools (approx. 2.1 per day) - 0.15 supertankers (200,000 tonne tankers) - It equates to a continuous discharge of untreated sewage over the 6 days averaging 61 l/s.

1.4 High level of confidence on 15 days from the period 29/11/12 to 13/12/12: - 0.17 billion litres - 67 Olympic swimming pools (approx. 4.4 per day) - 0.8 supertankers (200,000 tonne tankers) - It equates to a continuous discharge of untreated sewage over the 6 days averaging 130 l/s.

100

1.5 High level of confidence on 16 days from 22/12/12 09:00 to 06/01/2013 09:00: - 0.11 billion litres - 43.5 Olympic swimming pools (approx. 2.7 per day) - 0.54 supertankers (200,000 tonne tankers) - It equates to an average rate of discharge of untreated sewage of 79.8 l/s over the 34 days.

2. Untreated storm flow discharged illegally via storm tanks when inlet penstock intentionally set around 800 l/s which is approximately 642 l/s below the Little Marlow STW treatment capacity (1442 l/s) – Lower level of confidence Summary: Lower level of confidence estimate that between 17/05/2012 and 13/05/2013 the additional volume of storm flow discharged was: - 2.6 billion litres - 1,039 Olympic swimming pools (approx. 6 per event on average) - 13 supertankers (200,000 tonne tankers) - This represents shortfalls in storm flows of up to 642 l/s over and above the shortfalls of up to 286 l/s in base flow,calculated in section 1 above, while FFT was limited to c800 l/s and less.

101 Appendix 2. Individual prosecutions, fines and cautions by water company (2014 – 2015)

Anglian Water Services Limited £50,000 fines; Northumbrian Water Limited £30,000 fines; Severn Trent Water Limited £522,500 fines

102

South West Water Limited £975,500 fines; Southern Water Services Limited £700,000 fines

103

Thames Water Utilities Limited £2,373,000 fines; United Utilities Water Limited £1,183,000 fines

104

Wessex Water Services Limited £0 fines; Yorkshire Water Services Limited £600,000 fines

105