Can investors really "require" a 5% return?

  • Published: May 29, 2013
  • Author: Peter Kenway
  • Category: Services

NPI’s recent report on the water industry, and, in particular, the attention it paid to the 30% share of turnover accounted for by operating profits, has not gone down well with the companies’ voice, Water UK.

“What the report has not taken full account of”, complains Water UK, “is the £108 billion that water companies in England and Wales have invested to improve water and sewerage services over the nearly 25 years since privatisation – that’s over £10 million per day, every day. This investment has been made possible by private investors, who require a reasonable return on their money, currently about 5% – that’s £5 a year for every £100 they put in, very different from the figures quoted by the New Policy Institute”. 

Although our report paid plenty of attention to investment, it did not express profit as a rate of return on investment. So where does Water UK’s 5% leave our 30%? Does one number knock out the other? If Water UK is right – as surely it must be – then must we be wrong?

The answer to these questions is ‘no’, for the simple reason that we and Water UK are measuring different things. The main difference lies in what the profit is being divided by to reach the percentage quoted. In our case, we are dividing annual profit by annual turnover. In their case, they are dividing annual profit by the money investors have put in over a period of years.

Since privatisation, water has been marked by the very high levels of investment by the industry - between 40% and 50% of turnover every year. Coupled with the negligible level of retained profit, this means that the total amount of money put in by investors is now bound to be several times larger than annual turnover. That is how our 30% and their 5% can both be right. Tellingly, Water UK’s carefully crafted final sentence restricts itself to the observation that the numbers are ‘very different’.

Even so, Water UK’s statement that private investors currently ‘require’ a 5% rate of return is helpful in taking the argument beyond where our report went. For while ‘30% of turnover’ may sound high, whether profit is reasonable can only properly be judged on the Water UK basis, that is, when it is expressed as a rate of return on capital. So what should we think of 5%?

Answering this depends upon an assessment of the financial risk associated with owning a water company in England or Wales. The business itself is very predictable: everybody needs water; there are no substitutes; there is no competition. The financial risks, such as they are, arise from the regime of regulation which governs these monopolies. As financial risks go, water is at the low end. The best benchmarks for water are therefore long-dated Treasury Bonds.

At the moment, a10 year Treasury Bond is yielding about 2% while a 30 year bond is yielding 3%. These bonds, though offer no protection against the damage that inflation will do to the real value of the original investment. How far water investments are protected against future inflation is uncertain. But since privatisation, the price of water has gone up roughly threefold while prices in general (‘inflation’) have only doubled. If water returns are proofed against inflation, the better comparison is with Treasury Index-linked Bonds – where the current yield (on 30 year bonds) is actually negative (-0.5%).

Owning a water company is not risk free and there should certainly be a premium over the ‘risk-free’ rate. Nevertheless, there is an enormous gap between -0.5% and 5%. Say the additional risk was estimated at 3%. That would mean that the return on investment in the water industry should be 2.5%. This would put profits at half their current level. In that case, water bills would be 15% lower, a saving of more than pound a week for the average household.

We are not ‘calling’ for such a cut; at the moment, this is just an illustration of the fact that at this time of austerity, there is a lot of scope for lower water prices. Instead of telling us that their investors ‘require’ 5%, the water companies need to explain to the public and the politicians why they should earn this. After all, if you marched into the bank and simply announced the rate of interest you ‘required’, you know what the answer would be.

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