welsh water: role model or special case?

Utilities Policy 10 (2001) 99–114www.elsevier.com/locate/utilpol

Welsh Water: role model or special case?

Dennis Thomas∗

School of Management and Business, University of Wales, Aberystwyth, Cledwyn Building, Penglais Campus, Aberystwyth SY23 3DD, Wales,UK

Received 15 April 2002; received in revised form 8 August 2002; accepted 11 August 2002

Abstract

This paper examines the issues involved in the conversion of the Welsh Water utility into a debt-funded, not-for-profit company,owned by members and limited by guarantee. The separation of asset ownership from out-sourced service management and oper-ations, combined with debt financing, provides a revolutionary package with implications for the restructuring of the privatizedwater sector in England and Wales. However, the Glas Cymru model currently remains untested and its particular features, togetherwith the circumstances of the Welsh Water acquisition, prevents its presentation as a template for replication by other companies. 2002 Elsevier Science Ltd. All rights reserved.

Keywords: Water companies; Restructuring; Regulation

1. Introduction

After a relatively brief, and ultimately troubled, exist-ence as a multi-utility the Welsh based Hyder Group wasacquired by Western Power Distribution Ltd (WPDL) inSeptember 2000 after a protracted takeover battle withNomura International. Following the acquisition the newowners rapidly pursued their intended strategy of break-ing up the group through a series of disposals. Theseincluded the sale of the Welsh Water utility division toGlas Cymru Cyfyngedig (henceforth referred to as Glas),as a debt-financed, not-for-profits company which hadbeen formed for the specific purpose of acquiring theassets of Welsh Water.1 Limited by guarantee, with noshare capital and owned and controlled by its members,Glas’ activities were restricted to water asset ownershipas separated from the day-to-day management and oper-ation of the business which was out-sourced. However,while revolutionary in form, and a significant landmarkin the post-privatization restructuring of water sector

∗ Corresponding author. Tel.:+44 (0)1970 622514; fax:+44(0)1970 622740.

E-mail address: [email protected] (D. Thomas).1 To avoid confusion the title Welsh Water will be consistently

employed when referring to the former Hyder Group’s water sectoroperations, rather than Dwˆ r Cymru/Welsh Water or Dwˆ r CymruCyfyngedig.

0957-1787/02/$ - see front matter 2002 Elsevier Science Ltd. All rights reserved.PII: S0957-1787 (02)00030-9

operations in England and Wales, it would appear thatthe particular features of Welsh Water’s conversion pre-vents its presentation as an easily or immediately rep-licable model for other water companies. Although theemergence of Glas was in part response to generic watersector problems it was favoured by a number of specialfactors and facilitated by circumstances, and remains tobe fully tested.

The next section of the paper examines the motivationfor the establishment of Glas and its purchase of WelshWater, and outlines the company’s form and arrange-ments. The following section focuses on the regulatoryissues relating to Glas’ acquisition of Welsh Water,which is also placed in a wider context. The concludingremarks summarise the reasons as to why Glas currentlyremains a special and untested case in a rapidly changingwater utility sector.

2. Glas Cymru and Welsh Water

Following water sector privatization in 1989 WelshWater had assumed the assets of the former Welsh WaterAuthority and Hyder was formed after Welsh Water’sacquisition of south Wales based Swalec’s regional elec-tricity supply and distribution business in January 1996.Although enjoying a short period as a stock market high-flyer, the slump in Hyder’s fortunes began in the late1990s amid growing concerns that the group had taken

100 D. Thomas / Utilities Policy 10 (2001) 99–114

on too much debt in the Swalec acquisition, and sincebecoming over-diversified and overstretched, with manyof its non-regulated activities reporting negligible profits.These concerns were compounded by the imposition ofthe government’s utility windfall tax and substantialprice cuts from two separate regulatory price reviews,for electricity and water, set alongside the large capitalinvestment programme required in the water sector, allof which found the Hyder Group particularly exposed.2

Amidst growing investor uncertainty, reflected in plum-meting share prices and an unprecedented fall in creditratings, the group undertook an urgent and wide-rangingreview of strategic options, which included the emerg-ence of the Glas concept as a possible exit vehicle forthe disposal of the Welsh Water utility division.

Originally conceived within the Hyder Group itselfGlas was formed, as a new and independent company,based in Wales and registered under the Companies Act1985, in April 2000. Although dismissed during the take-over battle between Nomura and WPDL, Glas’ interestin Welsh Water was resurrected following Hyder’sacquisition by WPDL who viewed Glas’ plan to runWelsh Water as a debt-financed, not-for-profits companyseparating asset ownership from operation as providinga match with its own intentions. The sell-off of WelshWater, together with the disposal of all Hyder’s non-regulated activities, enabled WPDL to focus on its pri-mary motivation for purchasing the Hyder Group;namely the acquisition of the Swalec electricity distri-bution arm for integration with WPDL’s contiguouslylocated, regional electricity operations in the south westof England.3 Paying a nominal price of £1 the Glas offervalued Welsh Water at approximately £1.8bn., rep-resenting some 95% of Welsh Water’s Regulatory Capi-tal Value (RCV).4 This was to comprise the assumption

2 See Thomas (2001) for an account of Hyder’s brief experience asa multi-utility and international infrastructure services company, anda detailed discussion of the events surrounding, and regulatory issuesinvolved in, the Hyder Group’s takeover.

3 Western Power Distribution (WPD) was the trading name of theformer SWEB regional electricity distribution business based in thesouth west of England, which had been separated from the supply sideas sold off in September 1999. SWEB had originally been acquired in1995 by the Southern Energy (Atlanta) subsidiary of the US basedSouthern Company, with a 25% stake sold to PPL Global, a subsidiaryof Philadelphia Power and Light Corporation, in 1998 and a further26% sold in 1999. The operational and management control of WPD,within WPD Holdings UK, was retained by the Southern Company.

4 The concept of Regulatory Capital Value (RCV) was introducedby Ofwat in 1992, and developed during the Monopolies and MergersCommission referrals for gas and water companies between 1993 and1995, and is one of the critical components underlying price limitdetermination. The RCV starts with a direct measure of the valueplaced on each company’s capital and debt by the financial marketsfollowing privatization (or a broadly similar measure for water onlycompanies which were not floated). This is then rolled forward to takeaccount of new capital investment net of depreciation. RCVs are nowwidely used by the investment community as a proxy for the market

of existing Welsh Water indebtedness and that of newbonds to be issued by Welsh Water in conjunction withGlas, together with an amount of deferred considerationexpected to be paid to WPDL no later than 31 March2005 and dependent on performance. As a skeleton com-pany5 Glas’ ownership of Welsh Water assets wouldinitially be managed, with some adjustments, by thesame team that had run Welsh Water as part of the HyderGroup. The Board of Glas was to be completely inde-pendent of WPDL, with all non-executive directors hav-ing no present or past association with it or Hyder plc.,while the two executive directors who had originallydesigned and developed the Glas model had resignedfrom Hyder prior to Glas’ move to acquire Welsh Waterfrom WPDL.6

Following the announcement (November, 2000) thatGlas had reached agreement with WPDL on the termsof its acquisition of Welsh Water, the Chairman of Glaswrote open letters to the Director General of Water Ser-vices (DGWS) and to the First Minister of the NationalAssembly for Wales (NAW). The letter to the NAW(Glas, 2000a) contained a memorandum stating Glas’commitment to the principles identified by the NAW’sEnvironment, Planning and Transport Committee andthe Economic Development Committee in their previousassessment of the issues involved in the acquisition ofHyder plc. (NAW, 2000a), as they now referred to theproposed acquisition of Welsh Water. In addition, theletter to the DGWS (Glas, 2000b) specifically expressedthe company’s confidence that its proposals met Ofwatrequirements regarding new and alternative ownershipstructures in the water industry (Ofwat, 2000a).

As set out in its document, Glas’ Plans for WelshWater (Glas, 2000c), the company’s proposals werepresented as being mainly concerned with the overalldirection of Welsh Water and, in particular, the way inwhich Welsh Water is financed and governed in the longterm. Glas emphasised the need to provide a stable own-ership structure for Welsh Water and ensure that cus-tomer interests are fully recognised. The companystressed the importance of retaining local stewardship ofWelsh Water as ‘a distinctly Welsh enterprise located inand run from Wales’ with customer and environmentalpolicies having a local focus and be ‘highly responsive

value of the regulated business and, as such, form an important basisfor measuring financial performance having, in some instances,become enshrined in bond covenants. See Ofwat (2002e) and fn. 37.

5 It was intended that Glas would employ some 120/130 employees.6 Under the chairmanship of Lord Burns (a former permanent sec-

retary to the UK Treasury) the Glas board received independent legaland financial advice during the takeover process, although WPDLrequired information regarding progress and requested that Glas wouldmake no public comment without its consent. Following completionof Glas’ acquisition of Welsh Water, and as previously arranged, athird high ranking Hyder Group manager resigned to join the Glasboard as an executive director.

101D. Thomas / Utilities Policy 10 (2001) 99–114

to local priorities’ .7 Specifically designed and exclus-ively dedicated to own Welsh Water assets, Glas’ Mem-orandum and Articles of Association limited the purposeof the company to the financing of water assets in WelshWater’s area of appointment and the letting of commer-cial contracts for the operation and maintenance of thoseassets, and the delivery of services to customers whichwere to be out-sourced to third party specialists on afully competitive basis. Welsh Water formally remainedas the appointed and licensed water undertaker and,under Glas’ ownership and unaffected by its ‘not-for-profits’ status, Welsh Water would continue to operateunder the same legal and regulatory framework ofenforcement and sanctions as other water companies, asrequired by Ofwat, the Drinking Water Inspectorate(DWI), the Environment Agency (EA) as well as theNAW. The company also committed itself to carry outWelsh Water’s £1175m. capital investment programmeto improve service reliability and water and environmen-tal quality, as agreed with Ofwat, the DWI, the EA andthe NAW’s National Environment Programme forWales.

As specified in its plans, Glas’ dominating prioritywas the achievement of lower bills with the boardbelieving that its proposals enabled lower costs offinancing Welsh Water assets allowing scope toannounce a reduction in customer water bills, prior tothe next regulatory price review, over and above thereductions announced by Ofwat in the current pricedetermination. Furthermore, the board emphasised that,as a company limited by guarantee and owned and con-trolled by members instead of ordinary shareholders, theabsence of dividend payments meant that all financialsurpluses arising from lower costs would be retained andreinvested. Under Glas’ plans, customers would not ownWelsh Water as in a ‘mutualised’ company nor wouldthey be required to meet liabilities, with financial reserves(RCV less net debt) performing an analogous role to anequity buffer in protecting Welsh Water and its customersagainst the risk of adverse trading conditions and finan-cial shocks. The assumption of no new risks would befurther confirmed by Glas’ constitutional prohibition ofdiversification into other activities, while the design ofthe management structure and governance form would

7 The Welsh language title Glas Cymru translates as Green Wales.This caring image, reflective of environmental and social concern, con-trasts with the Hyder brand name which, when pronounced in theWelsh native tongue, translates as ‘confidence’ . The emphasis on thecustomer and its commitment to Wales, together with the ownershipstructure reflecting a cross-section of stakeholder interests, meant thatthe company soon acquired the sobriquet of ‘ the people’s company’ .It should be noted that while Welsh Water serves most, but not all, ofWales (with some of the mid-east served by Severn Trent Water) it isnot exclusively Welsh in its coverage, which extends into some adjoin-ing, albeit limited, parts of England. As such, the company emphasisedthat it would operate in the interests of all customers wherever located.

ensure that the company was open and accountable withmanagement appropriately incentivised. Control by mem-bers who had no financial interest in the company waspresented as producing greater alignment between theinterests of management, customers and the regulator,and thus removing the inherent tensions involved in equ-ity ownership of a regulated public service monopoly.Emphasising the proprietary nature of its intended owner-ship of Welsh Water, the company contrasted its pro-posals with the ‘mutual’ form as incorporated in theKelda Group’s unsuccessful attempt to restructure itsYorkshire Water subsidiary (see later).

In order to display evidence of ‘ informed consent’ ,Glas undertook a public consultation programme seekingviews on its plans, including meetings arranged by theOfwat Customer Services Committee (CSC) for Wales,as well as commissioning independent research to inves-tigate the views of potential future customers.8 For itspart the NAW’s formal and broad cross-party supportfor the Glas proposal was encouraged by the particularemphasis on ensuring that ownership and control ofWelsh Water, as an essential public service, would retaina clear Welsh based integrity and identity. The jointassessment by the NAW’s Environment, Planning andTransport Committee and the Economic DevelopmentCommittee (NAW, 2000b, 2000c) viewed the Glas pro-posals as measuring favourably against the principlespreviously issued by those committees.9 However, reco-gnising that the Glas proposal also raised someadditional, specific issues to those identified at the timeof the acquisition of Hyder plc., the committees empha-sised the need to: balance benefits and risks of the newproposals to customers, demonstrate adequate incentivesfor efficiency, ensure that the members of Glas were ableto hold directors to account on customers’ behalf, andbe satisfied that the procedures for appointing membersof Glas did not pose a risk to the effective operation ofthe company. Welcoming the Glas proposal as ‘new andinnovative’ the First Minister of the NAW claimed thatits consideration should be viewed as the exclusive pre-serve of the NAW in conjunction with Ofwat, and theNAW’s views were communicated to the DGWS as partof the consultation process which had been instigated byhis consultation paper (Ofwat, 2000d).

In presenting the Glas proposal for consultation theDGWS’ preliminary view was that the ‘Glas ownership

8 Attendance by members of the public at two meetings chaired bythe Ofwat’s CSC for Wales was in fact low. See Ofwat (2001a) fordetails of Glas customer consultation and a listing of respondents toOfwat’s consultation paper. Ofwat conceded that, while the degree ofoverall support from customers was harder to judge, those whoexpressed a view tended to favour the proposals.

9 The NAW had previously played a prominent role during the take-over battle for Hyder, persistently favouring the Nomura bid for mostof the period. See Thomas (2001).


model does not, on balance, give rise to any insurmount-able issues, provided that the licence modifications canbe fully implemented and the appropriate investment-grade rating secured’ . Stating that the views of stake-holders would be critical to his final assessment, with aclear emphasis placed on consumer interests and protec-tion, the regulator’s cautious support emphasised theneed to ensure the sufficiency of incentives for Glas toact in a competitive and efficient manner, and the needfor the company to be financially robust with sufficientreserves to cover problems. Despite the reported oppo-sition of central UK government ministries, the DGWSeventually gave conditional approval to the Glas pro-posals in his position paper issued at the end of January2001 (Ofwat, 2001a), stating that it was now ‘ for thecompany to decide whether to proceed and for the mar-ket to decide whether to finance the proposals’ , with pro-gress depending on Glas raising the necessary finance.This qualified approval was tied to strict conditionsrequiring Glas’ compliance on various matters:

� Agreement to licence modifications aimed at ensuringthat Welsh Water: maintained control over its statu-tory duties when services were provided by third par-ties; maintained a proper ring fence around the regu-lated business; followed best practice with regard tocorporate governance; was able to provide Ofwat withthe information required to regulate Welsh Water andcompare it with its peers in England and Wales,including that relating to its contractors.

� Clear public statement regarding consumer benefitsincluding a commitment to reducing customer bills,quantifying potential rebates to customers and settinga time scale for their repayment, subject to the needto first establish adequate reserves.

� Limitation of activities to the single purpose of theprovision of water and sewerage services, and nodiversification into other activities.

� Publication of the remuneration and incentive schemefor the executive management of Glas and WelshWater related to objective measures of performanceon quality and levels of customer bills.

� Arrangements for the appointment and functioning ofthe Members of Glas on the basis of ‘best practice’that ensure that they focus on its commercial success.

� Ensuring that rights given to bondholders do not con-flict with or impede the DGWS’ ability to carry outhis duties under the Water Industry Act 1991.

The DGWS stressed that as a licensed undertakerWelsh Water would continue to be subject to regulationon the same basis and in the same manner as for othercompanies, with price limits to be set by comparisonsbetween all companies with no concessions such as, forexample, taking into account contract prices set byWelsh Water.

At the end of February the Department of Trade and

Industry (DTI) announced that, in accordance with therecommendation of the DGWS and the Director Generalof Fair Trading (DGFT), the proposed acquisition ofWelsh Water would not be referred to the CompetitionCommission, with the DGFT advising that the proposal“has no adverse effects on competition in the water andsewerage industry” (DTI Press Release, P/2001/120, 1March, 2001). The statutory notice for the modificationsof the conditions of appointment of Welsh Water wasissued in March (Ofwat, 2001b, 2001c).10

Having acquired a bridging loan arrangement to buyback Hyder debt, and despite initial City doubts, Glassuccessfully completed a £1.9bn. bond issue in May2001, enabling confirmation of the company’s acqui-sition of Welsh Water. Organised by Dwr CymruFinancing, as a special purpose vehicle, the bond issuewas some 70% oversubscribed following a month-longmarketing campaign.11 Comprising of 11 sterlingtranches and one dollar tranche, of various rating categ-ories, the multi-part bond issue covered a variety andrange of maturities and structures, including the firstpublic issue of Limited Price Indexation (LPI) bonds.Designed to appeal to a wide range of potential investorsa particularly significant feature was the ‘credit wrap-

10 These licence modifications included amendments which had orig-inally been agreed in principle with WPDL prior to its takeover ofHyder plc., together with further modifications specifically arising fromGlas’ ownership and financial structure. The DGWS had receivedassurances from WPDL, prior to confirmation of its acquisition ofHyder plc., that it would ensure that Welsh Water would consent tomodifications of its conditions of appointment. As these changes werealso agreed by Glas in advance of its purchase of Welsh Water, thenecessary amendments to Welsh Water’s licence were not introducedfollowing the original ownership change, with the changes to WelshWater’s licence eventually finalised in January 2002 (Ofwat PressNotice, PN 09/02). See Ofwat (2001c) for full details regarding thelicence modifications. In addition to those amendments required byOfwat, Glas also sought modifications to the conditions in Welsh Wat-er’s licence which allowed for the resetting of price limits betweenPeriodic Reviews, claiming that these would emphasise the business’low risk nature to investors. These related to; reinsertion of a symmetri-cal relevant change in circumstances for capital price inflation;reinsertion of a symmetrical ‘shipwreck’ clause; modifications of theinterest cover test for interim determinations to reflect the debt financ-ing of Welsh Water. While Ofwat was content to allow the third ofthese requested amendments, as a necessary rewording of a conditionwhich would otherwise be unworkable for a wholly debt-financed com-pany, it did not approve the other two at that stage with a view toconsider both as part of a wider water company review aimed at ration-alising supply licences with the intention of ensuring greater consist-ency between the companies and also help companies to secure lower-cost financing by providing greater certainty for investors (see OfwatPress Notice, PN 39/01, August, 2001).

11 The Glas transaction was led by the Royal Bank of Scotland andSchroder Salomon Smith Barney. See Glas’ Bond Prospectus (Glas,2001c) for full details regarding the bond issue. The Glas/WPDL dealwas named the ‘most innovative’ of the year’ by the International Fin-ancial Review, involving the best financial package and viewed as thetop European securitisation and bond issue (Glas Cymru News, 11December, 2001).


ping’ of the highest rated categories, amounting to some£1m. As arranged with the US monoline insurers MBIA,this provided an underwritten financial guarantee for thebonds involved.

In July Ofwat reported that Glas had met the six con-ditions for its ownership approval, as detailed in an openletter by Glas’ chairman and presented at the company’sfirst AGM (Glas, 2001b, 2001d; Ofwat, 2001e). At thatstage the Glas board also provided details of projectedcustomer rebate targets amounting to £23m. over the lasttwo years of the current five year regulatory period,12

representing a distribution of around one sixth of thesavings that the company expected to make in thoseyears in the cost of financing Welsh Water’s assets. Theremaining savings would be reinvested in the businessand would be used to build up the financial reserves. Inaddition to confirming that Welsh Water’s capital invest-ment programme was guaranteed to proceed as planned,the board identified the possibility of carrying outadditional future investment, which had not beenallowed for by Ofwat in Welsh Water’s current pricelimits, if there was strong evidence that this was whatcustomers wanted and if there was prior agreement withOfwat that such additional investment would beapproved, as capable of incorporation into the com-pany’s RCV at the next regulatory price review. Beyond2004–2005 it would be the company’s intention to growthe customer rebate at least in line with the rate ofincrease in the Retail Price Index, with the qualificationthat this would depend in part on the outcome of thenext regulatory review. It was confirmed that decisionson customer bills would be made on a year by year basis,and would be announced at least one month before theycame into effect, with the policy on rebates updated anddisclosed each year at the company’s AGM. While theamount of currently planned customer rebates might bereduced in the event of the financial targets not beingmet, there was also the possibility that proposed rebatescould be increased if financial performance exceededexpectations.

In November 2001, Glas announced a £41m. rein-vestment of targeted savings on Welsh Water’s capitalinvestment programme, while the company’s first halfyear results, for the six month period to 30 September,reported an underlying profit of £11.8m., to be retainedin the business, with earnings before interest, tax,depreciation and amortisation of £95m. (Glas CymruNews, 19 November, 2001). Although these profits andearnings figures exceeded expectations at the time of thebond issue they could not be directly compared with pre-

12 The bill rebates were targeted as £11m. in the financial year begin-ning April 1 2003 and £12m. in the financial year beginning April 12004, estimated as equivalent to some £10 each year per householdcustomer.

vious results for Welsh Water as part of the Hyder Groupdue to the different structures involved.

2.1. Debt finance

Fundamental to Glas’ plans to reduce prices and payrebates to customers, while securing continuing invest-ment funds, was the ability to finance Welsh Water’sassets with long maturity, strong investment grade bondson attractive terms. By replacing shareholder equity bydebt finance the company believed that it could reduceits financing costs by up to a quarter, compared to thoseunderlying the regulatory price assumptions as theyreferred to shareholder owned companies. This wouldinvolve an estimated reduction in the cost of capital tobetween 4 and 4.5% in real terms, compared with a 6.5%industry threshold set by the regulator. The envisagedcost savings were based on the fact that the cost of pay-ing a return on capital raised to finance assets was WelshWater’s single biggest cost, absorbing nearly a third ofits annual revenues and accounting for a similar pro-portion of customer bills. These anticipated savings,worth some £50m. a year, would be translated into lowerprices to the extent that the regulator’s assumptionsregarding other costs could be equalled or exceeded.

Given the prevailing market view regarding water sec-tor investment in general, and the particular need to re-establish Welsh Water credentials as a monopoly pro-vider of an essential service with stable cash flows,13

Glas’ fi nancial strategy necessitated the design of plansand structures to display significant risk reduction andachieve appropriate credit ratings.14 While the purchaseof Welsh Water at 95% of its RCV was an importantfactor, the successful implementation of Glas’ strategyrequired a package of other features to improve its riskprofile. Set up as a self-standing, single purpose waterand sewerage business, constitutionally forbidden todiversify into other activities, the required licencechanges reinforced the independence and ring fencingof Welsh Water. Additionally, the creditor protectionsprovided by the current regulatory and legal frameworkwere reinforced and supplemented by a variety of loancovenants. These included a requirement to maintainminimum levels of reserves to cover the financial costof possible shocks, and the provision of various ‘step-in’ rights and powers to remedy underperformance e.g.allowing lenders to trigger an independent review anddemand dismissal of executive directors if financial cri-teria were breached.

The purchase of Welsh Water’s assets at a discount

13 Welsh Water’s credit rating had been downgraded to an unpre-cedented BBB.

14 See Utility Week, 9 March 2001, for a financial rationale for Glas,as provided by Chris Jones, its Finance Director and former directorof Welsh Water and Hyder.


to its RCV generated immediate, implicit, financialreserves, in terms of Glas’ borrowing capacity, of around£150m. Acting as a liquidity buffer to meet unantici-pated capital needs and providing a measure of protec-tion against cost shocks, these reserves were projectedto increase through the retention of trading surpluses upto a target of £350m. by 2004–2005.15 Once the financialreserves reached £300m., as the minimum required byloan covenants, and assuming that no contingencies hadarisen, Glas proposed to pass on part of the annual sav-ings as rebates on customer bills. In Glas’ view the mini-mum reserve required to meet emergencies provided amore secure cushion than volatile equity funds, andWelsh Water would continue to be financed by substan-tial ‘at risk’ capital due to the continuous scrutiny byratings agencies which would publish credit ratings forWelsh Water bonds and provide an explanation for theirunderlying rationale.

2.2. Ownership, governance and remuneration

The legal ownership structure of Glas and itsboard/committee structure are described in Figs. 1 and2 respectively, as presented in Glas’ Corporate Govern-ance Reference File (Glas, 2001e) which also containsthe company’s Memorandum of Association and the Art-icles of Association, including details of membershipprocedures and the appointment, retirement and removalof directors as well as their permitted interests, togetherwith a statement of remuneration policy.

Although the boards of Glas and Welsh Water aretechnically separate entities their composition is identicalin order to minimise the risk of conflict of interestsbetween responsibilities. Unless otherwise determinedthe number of directors should not be less than five normore than 11 with the independent, non-executive direc-tors appointed to the board, as approved by the DGWS,required to be in the majority at all times. The boardsets the policy and targets for executive management andis publicly accountable for performance, with the avail-ability of information on key parameters allowing theboard to judge the performance of executive manage-ment relative to that of other companies in the sector,with the board also having the powers to sack managerswho failed to meet performance targets.

As a company limited by guarantee Glas is controlled

15 Glas’ fi rst half-year results reported that financial reserves werenow targeted to reach £400m. by 31 March 2005, compared with theoriginal forecast of £340m. (Glas Cymru News, 19 November, 2001).See also the company’s investors reports (Glas, 2001f, 2002a). In thefirst new financing deal completed since the original bond issue GlasCymru secured a £120m. lease financing facility for water and sewer-age infrastructure assets with a leasing subsidiary of Lombards, a partof the Royal Bank of Scotland Group, as a contribution to the newfunding requirements to finance capex/refinance maturing bonds in theperiod to 31 March 2006 (Glas Cymru News, 19 March, 2002).

Fig. 1. Glas Cymru Cyfyngedig: Legal ownership structure. Note:Glas Cymru Cyfyngedig, trading as Dwr Cymru Welsh Water (‘WelshWater’ ), was established in April 2000, under the Companies Act 1985,as a company limited by guarantee with no share capital, for the spe-cific purpose of acquiring and owning Welsh Water. Glas Cymru(Securities) Cyfyngedig was established in December 2000 as the spe-cial purpose vehicle through which to acquire Welsh Water (achievedon 11 May, 2001). Dwr Cymru (Holdings) Limited was established asa non-trading company in January 2001 to ringfence ownership ofWelsh Water in the Hyder Group. Dwr Cymru (Financing) Limitedwas established in the Cayman Islands in February 2001 as the specialpurpose investment vehicle, not otherwise trading in its own capacity,through which bonds were issued as part of the financial restructuringof Welsh Water. Welsh Water Utilities Finance PLC is a special pur-pose investment company which issued bonds in 1992, to part financeWelsh Water’s activities at the time; these bonds were all redeemedas part of the financial restructuring of Welsh Water prior to its acqui-sition by Glas Cymru. Source: Corporate Governance File, AnnualGeneral Meeting (Glas Cymru, 2001).

by members who carry out the normal corporate govern-ance duties of shareholders, but unlike shareholders donot receive dividends nor do they have any other finan-cial interest in the company. The appointments would bemade by the board following nomination by an inde-pendent panel employing an open selection processbased on best-practice Nolan principles which apply toappointments to public bodies.16 The corporate govern-ance role of members involves overseeing the running ofthe company, monitoring and setting performance targetswhich dictate salaries, and approving the conduct of theboard, with the power to dismiss and select replacementdirectors if targets are not achieved. In implementing thisrole members are assisted by an annual ‘members report’on the performance of the company and a bi-annualmembers’ conference. Although members are appointedin a personal and unpaid capacity the full membership

16 Members are appointed in accordance with the Membership Pol-icy, after completing a written application, and on the discretion of theBoard who can invite any person to become a member at any time,provided that the total membership should not at any time exceed 200,with the target originally set at 50 by the end of 2001. The membershipappointment panel would consist of one Glas non-executive directorand a number of independent appointees, including the panel chair andwould consult with a wide range of organisations. See Glas (2001e)for a detailed statement of the membership policy.


Fig. 2. Glas Cymru Cyfyngedig: Board/Committee Structure. Note: All the directors of Glas Cymru are also directors of Welsh Water, and viceversa. This identity is designed to ensure that the risk of conflicts of interest between the responsibilities of the two boards is minimised, and thesame directors also form the Board of Directors of Dwr Cymru (Financing) Limited. There are three committees which are (joint) committees ofboth Glas Cymru and Welsh Water boards—the Audit, Remuneration and Nominations Committee—with their roles and responsibilities reflectingthose to be found in most large companies, and their terms and references viewed as generally promoting best practice corporate governancestandards. The Quality and Environment Committee is a committee of the Board of Welsh Water only, with its establishment proposed by GlasCymru to meet regulatory concerns in the new ownership structure and incorporated in the new licence obligations for Welsh Water. The termsof reference for this committee draws together a number of responsibilities for quality and environmental performance previously undertaken bythe board of Welsh Water. An independent non-executive director chairs this and all other committees. The Executive Management Board of WelshWater meets more frequently than the full Board and is chaired by, and is the vehicle through which, the Managing Director exercises control ofthe day to day management of the water business. All matters are delegated to the Managing Director, save for those set down in a ‘schedule ofmatters reserved for determination by the Board’ . Source: Corporate Governance File, Annual General Meeting (Glas Cymru, 2001).

profile is intended to reflect a broad range of stake-holders served by, and involved with Welsh Water, sup-plemented by ordinary members of the public, anddesigned to ensure immunity to ‘capture’ by interestgroups.

In addition to being subject to the Companies Actframework Glas is obliged to act at all times as thoughlisted on the London Stock Exchange and operate as ifit was a publicly listed company in all respects as regardscorporate governance and reporting. This aspect of cor-porate governance is reinforced by strict oversight of thecompany’s performance by the bondholders, with accessto quarterly financial and performance reports, and loancovenants providing bond investors with powers andrights. Externally, the board is formally and regularlyheld to account by Ofwat’s CSC and scrutiny by theNAW.

According to Glas’ incentivisation programme execu-tive directors, and as many company employees as poss-ible, were to be remunerated in accordance with a newperformance-dependent structure, with directors’remuneration linked to service performance in line withobligations imposed on utility companies under the Util-ities Act 2000. While a significant proportion ofmaximum pay was to be linked to performance in com-parison with the rest of the water industry, as well asfixed or historical benchmarks, considerable weight wasgiven to Glas’ success in fulfilling its commitments togenerate financial surpluses, cut customer bills, improveservice and achieve quality standards. With particularrespect to Glas’ claims for strong incentivisation, and inorder to quantify the potential benefits to customers andput pressure on the company to perform, the DGWSrequired Glas to provide an explicit policy statement ontarget reduction in bills for the final two years of theregulatory review period (see above). Given that, accord-ing to Ofwat’s comparative analyses, Welsh Water was

shown to have been one of the least efficient water andsewerage companies, the DGWS noted that there wereclear opportunities to demonstrate significant improve-ments (Ofwat, 2001a).

2.3. Procurement plan

In response to Ofwat’s demand for a detailed procure-ment programme Glas presented its plan in January 2001(Glas, 2001a), describing the implementation of a com-petitive procurement strategy under which specialist ser-vice providers would carry out much of the day-to-dayoperation of its water and sewerage assets and delivery,as well as customer billing and customer contact man-agement. Glas emphasised that this built on currentexperience within Welsh Water, as inherited from itsprevious existence as part of the Hyder Group, whichinvolved a substantial out-sourcing structure with in-house service level agreements between it and otherHyder subsidiaries operating alongside fully commercialcontracts with other service providers.17 As well as for-malising existing working arrangements Glas’ procure-ment plans would increase the level of out-sourced workfrom an equivalence of some 60% of total costs toaround 85%.18 To the extent that the extended procure-

17 Welsh Water had already introduced an internal separation ofassets from operations and been operating an internal out-sourcingstructure for some two years, following the creation of the coreLicence-co in April 1999, through detailed service level agreementsbetween it and other subsidiaries of Hyder plc. (Hyder Operations andHyder Services). Under these operating arrangements, and liaisingclosely with the DWI and others, Welsh Water had achieved ISO9002quality management accreditation for water production and water net-works.

18 Glas justified this extension of out-sourcing of day-to-day oper-ations of assets under medium- to long-term contracts, awarded follow-ing competitive tender, as a common feature of the way in which thewater industry is organised and managed elsewhere. In particular it


ment strategy involved measured transfer of financialrisk from Welsh Water, as the asset owner, to the serviceproviders, the plan was also presented as an importantcontribution to the risk reduction enabling Glas to cutWelsh Water’s cost of capital.

Glas emphasised that Welsh Water’s fundamentalduty of providing safe and reliable water supply andsewerage services in accordance with Welsh Water’slicence and legal obligations would not be compromisedby the implementation of the procurement plan, with theboard of Welsh Water retaining full and final responsi-bility for the actions taken, or failures by, the contractors.Service providers would be required to comply withWelsh Water’s procedures and policies which them-selves reflect ‘best practice’ requirements includingthose set out by the DWI and the EA. AdditionallyWelsh Water would retain the right, and the capability,to ‘step-in’ to take control of out-sourced operations inthe event of any risk of serious shortfall in performance.All information and data relating to the operation of thebusiness would continue to be owned and controlled byWelsh Water, and would be available to Ofwat and thequality regulators. Maintenance expenditure was prior-itised, with Welsh Water retaining control over the main-tenance budget, and targets would be set with progressreported annually to Ofwat. Emphasising the need foropenness and transparency in procurement activities theGlas plans also embodied ‘open book’ partnershiprelationships with service providers who would them-selves be appointed as ‘best in class’ companies.

Amongst the advantages which Glas believed that itsprocurement plan provided were the ability to obtain andaccess best value and best practice in distinct activityareas, and the achievement of predictable costs, trans-parent market pricing, and fair rewards based on out-performing targets for service delivery and costefficiency set by regulators and Welsh Water. The com-pany claimed that apart from pressure for good perform-ance through the implementation of step-in rights andthe replacement of under-performers, the contractorsthemselves would necessarily be incentivised by con-sciousness of the implications of their performance fortheir general reputation and credit standing as well astheir prospects for winning future contracts with WelshWater and/or other water enterprises. In addition toefficiency benefits associated with service and cost levelsstemming directly from the competitive processemployed by Welsh Water in selecting and retaining ser-

claimed that the plans were substantially equivalent to the long estab-lished ‘affermage’ model employed in France and in many of therecent privatizations of water management, for example in the USAand Australia. Glas also noted that its plans had parallels with the wasteand wastewater PFI schemes awarded by the Scottish water industry inrecent years, while outsourcing was also widely practiced by variousEnglish water companies.

vice providers, it was claimed that efficiency pressurewould also be provided through equity shareholdingownership of the service providers.

While the contract arrangement for customer billingand contact management was envisaged to continue intothe long term, the intention with regards to re-tenderingof the initial four-year operations and maintenance con-tract was to create six separate contracts, comprisingthree to four water supply contracts and two or threewastewater contracts, each one defined by geographicscope. Although claiming that this would provide anappropriate balance of scale and competition betweenservice providers Glas expressed awareness of the dang-ers of excessive fragmentation of activities, and theconsequent risk of diluting or blurring responsibilities.In response Glas emphasised that Welsh Water’sresponsibilities would be clear-cut with the number ofinterfaces limited. Denying comparisons with the railsector, Glas emphasised that there would only ever beone company providing the full range of operating ser-vices in any geographical area, with a single line ofresponsibility to Welsh Water (Glas Cymru, PressRelease, 10 January, 2001).

The two out-sourcing contracts were determined inMarch 2001, prior to the formal confirmation of WelshWater’s sale to Glas, with the award of contracts toUnited Utilities (operations and maintenance) andThames Water (customer services). As specified by Glasthese agreements had been reached following a competi-tive tendering process, but only after a change to initialplans which had involved a private agreement betweenWPDL, as the then owner of Welsh Water, and UnitedUtilities for the award of a contract that would allow thelatter to take over the management and operations ofHyder’s Welsh Water supply business. Opposition to thisoriginal arrangement was led by Severn Trent claimingthat the deal was anti-competitive and contravened EUpublic procurement law and that a public tendering pro-cess should have been held giving other companies thechance to bid for the work. A successful High Courtchallenge produced the judgement (October, 2000) thatthe pre-arranged agreement between WPDL and UnitedUtilities breached European procurement law, and aninjunction requiring the contract to be put out to compe-tition. This ruling was viewed as having widespreadimplications for water companies intending to out-sourceoperating contracts to existing, or specially created, in-house operating arms, regardless of any future sell-offsto independent operators, or through convenient arrange-ments with an independent operator.19

19 See Severn Trent plc. v Dwr Cymru Cyfyngedig (Welsh WaterLtd.) [2001] C.L.C. 107, Langley, J, QBD (Comm Ct). Ofwat hadstated that EU procurement law was not a matter for their concern butrather an issue to be dealt with by the companies and the courts. Brightand Blewett (2000) provide a detailed examination of the High Court


3. Issues and implications

The acquisition of Welsh Water in Glas form wasparticular to the former’s circumstances, and possessedits own internal dynamics which had originated withinthe Hyder Group. However, the basic impetus forrestructuring reflected a general and growing pressure onwater sector companies in England and Wales to respondto changing circumstances. As such, the nature and formof the Glas arrangement, and the regulatory issuesinvolved, were of potentially widespread significance.

Since the 1999 Periodic Price Review several watersector companies have been increasingly and variouslyforced to consider the options for restructuring theirappointed business, with a particular focus on investigat-ing alternative arrangements to finance capital invest-ment programmes which far exceeded internal cashflows. Facing mounting pressure on their earnings andstruggling to meet stringent regulatory price cuts, thecompanies’ generally experienced falling share prices,with declining shareholder interest reflected in the bondmarket which displayed poor credit ratings. In this con-text reducing the cost of capital for asset ownership,below that assumed in the regulator’s calculations forprice reductions during the regulatory period, became akey issue. While strong balance sheets offered the possi-bility of higher gearing levels by increasing debt, moreradical restructuring options involved separation of theasset company from other activities, but kept under com-mon ownership and ring fenced and refinanced, or fulldemerger or sale of the asset company entirely enablingthe creation of a separate, debt-financed, asset owningorganisation. From the regulator’s viewpoint such cor-porate responses to the pressures imposed by the pricereview were to be welcomed to the extent that theyreflected innovative attempts to maximise efficiency andbeat regulatory price assumptions for the cost of capital(Fletcher, 2001), and it is in this context that the Glasmodel needs to be considered.

3.1. Regulatory issues

Ofwat’s consultation document on new ownershipstructures, published in June 2000, examined the consti-tutional and regulatory issues arising from any proposalsto separate the ownership of assets and licence fromoperations and the impact of new ownership structures(Ofwat, 2000a). The document emphasised the concernsregarding customers’ interests, concentrating on betterand lower-priced delivery of service, and proper mainte-

procurement ruling and its wider implications. The authors point outthat, while the judgement was important in emphasising the need toensure that out-sourcing arrangements were procurement-compliant, itfailed to provide a precise delineation between what sorts of arrange-ment would, or would not, be within both the spirit and wording ofthe rules. See also Wilkinson (2000).

nance of assets. Specifically, the key issues that wouldhave to be addressed to obtain regulatory consentcovered the following:

� The need for the appointed business under a newownership form to stand comparison with other watercompanies and be genuinely competitive,

� Whether customers would bear a disproportionate riskin relation to the potential for lower bills as a resultof restructuring and refinancing,

� Whether incentives for efficiency would be main-tained for a mutual, or other not-for-profit body in theabsence of shareholders,

� How managers can be made publicly accountable sothat the board is commercially focused and acting incustomers’ interests at all times,

� How the DGWS can be sure that the managers andboard can be replaced if they fail to act in anefficient manner,

� Whether a truly competitive market for contracting-out of services exists and, if so, what services couldbe put out for tender and over what timescale.

The first formal and concrete application of these cri-teria brought the rejection of the Kelda Group’s plansregarding its regulated Yorkshire Water subsidiary(Ofwat, 2000b, 2000c). Under Kelda’s proposals theinfrastructure assets of Yorkshire Water Services Ltd.would be sold to an organisation owned by its customersin the form of a debt-financed Registered CommunityAsset Mutual (RCAM) operated on a not-for-profitsbasis and retaining the licence. Services would be out-sourced initially to a Kelda subsidiary but eventually viacompetitive market-tested contracts with an outside sup-plier. According to Kelda such restructuring would allowcapital to be borrowed at a lower cost, with any surplusesreturned to consumers or reinvested in the business. Thefour key issues highlighted in Ofwat’s assessment of theKelda proposal related to the failure to: set out clearlyhow customers would benefit from the change of owner-ship, properly inform Yorkshire Water customers aboutthe proposal and consult with them, ensure that the DWIand EA were able to rigorously enforce the requiredquality standards, and demonstrate clear independenceof, and no continuing links between, the proposed mut-ual and Kelda. In sum, the then DGWS (Sir Ian Byatt)was unconvinced of potential benefits to consumers or,indeed, for the need for major restructuring, given thecompany’s strong balance sheet, stating that similaradvantages could be achieved within the existing equitymodel. The DGWS judged that short-term shareholdergains would be at the expense of customers, without anyreduction in the risks for the business as a whole,although some would arise for the asset owner from thetransfer of risks to operating companies. He emphasisedthat the minimisation of risks to consumers required a


financial cushion over and above the cost of borrowing.20

Although the DGWS indicated that he was not againstmutuality or other new ownership forms in principle, norfundamentally opposed to the idea of separating owner-ship and operations, he clearly signalled concern regard-ing the motives of proprietary owners in employingrestructuring moves as a mechanism for evading regu-lation.21

The Glas proposal contained many similarities to thatof Kelda’s with the obvious difference that the new own-ership structure for Welsh Water involved Glas as acompany limited by guarantee rather than ‘mutualisa-tion’ . In presenting its proposal Glas had seemingly, orpresumably, learnt from the Kelda experience, andattempted to display ‘ informed consent’ , while its designinvolved more detail regarding the nature and size ofthe cash reserve cushion. However, the basic regulatoryissues remained to be addressed. Fundamentally, theserelated to the questions as to whether a wholly debt-financed, non-profit making company made up of mem-bers would be sufficiently robust financially and capableof taking risks of managing water assets, which wouldnot be passed on to customers, and provide the necessaryincentives to increase efficiency, compared with a con-ventional shareholder owned company. Additionallythere was concern as to whether the complete outsourc-ing of its operations would leave Welsh Water in a pos-ition to maintain adequate and proper control over itsfunctions.

The new DGWS (Philip Fletcher) was more support-ive of Glas’ plans than his predecessor had been of Kel-da’s, accepting that Ofwat’s key concerns could be over-come provided that certain undertakings were accepted.As regards financial robustness the DGWS believed that

20 See Kelda’s response to the DGWS’ consultation paper (Kelda,2000), and Spencer (2001) for an insider’s view of the rationale for,and form of, the proposal. Lawrence (2000) provides a detailed exam-ination of the Kelda proposal and its intended implementation, togetherwith the regulatory issues involved. Shaoul’s (2000) critical examin-ation presents a financial analysis of the Kelda proposal, with her esti-mated financial cash flows indicating that the proposed debt-financedRCAM was unaffordable without either price increases or cutbacks inthe investment programme. More generally, Shaoul claims that the turntowards mutual-style ownership is testimony to the failure of privatiz-ation and, to the extent that equity is viewed as more expensive thandebt finance, is a tacit admission that the private ownership of a capitalintensive network industry is unviable.

21 The idea of mutualisation in the water sector had been previouslyexamined by the Scottish Office (1997). In addition to the efficiencyincentives, the objections which were raised focused primarily on theability of the regulator to ensure that the mutual operated efficiently,together with concerns regarding the ability of the members of themutual to be fair, representative and interested. In highlighting thecomplexity and inherent difficulties involved in demerging a regulatedbusiness and successfully separating asset ownership from operations,the DGWS’ fi rm and explicit ruling on the Kelda case effectivelyhalted progress on other restructuring plans by Pennon, for its SouthWest Water subsidiary, and AWG for Anglian Water Services Ltd.

the intended cash reserves would be sufficient to over-come any cost shocks, noting the enhancement of bor-rowing capacity by the discount of purchase price onRCV and the stipulated commitment to add to reservesthrough retention of trading surpluses. Attention wasdrawn to the ‘credit-wrapping’ of a large proportion ofthe bond issue, and risk reduction through prohibitionof diversification. With respect to the absence of equitypressure the DGWS emphasised that a number of factorswould mitigate some inevitable incentive loss. TheDGWS identified various built-in mechanisms within thedebt-finance model, particularly the performance-relatedmanagement remuneration scheme, the presence of amajority of non-executive directors on the board, bond-holder scrutiny and the rights and powers embodied incovenants, as well as membership arrangements toensure that members remained focused on commercialsuccess. Regarding concerns relating to the extent towhich Glas would be able to control its out-sourcingstrategy, the DGWS noted the proposed licence amend-ments, particularly those that would prohibit WelshWater from delegating responsibility for its statutoryduties to any other party. He also emphasised therequirement to produce a procurement plan detailinghow the company would retain proper and effective con-trol over contractors’ operations and ensure Welsh Wat-er’s ability to carry out its business, and requiring Glasto adhere to guidance on internal controls as issued bythe DGWS.22 Overall, the DGWS accepted that Glas’debt finance could potentially achieve a significant initialreduction in its weighted average cost of capital com-pared to water companies generally, given that financingcosts accounted for about one third of customer bills,and despite offsetting costs such as those reflecting riskto be borne by contractors as embodied in fixed priceoperating contracts. However, while the DGWS acceptedthat Glas’ fi nancing plans appeared satisfactory in theshort run, so long as appropriate trading surpluses wereachieved, he noted greater uncertainties regarding thelong-term success of Glas which could only be testedover time.23

In contrast to the views of the DGWS and the NAW,the Glas plan was viewed more cautiously and criticallyby the Office of Gas and Electricity Markets (Ofgem)and at central UK government level, with the DTI, theTreasury and the Department of the Environment, Trans-port and the Regions (DETR) all concerned at the poten-tial precedent involved. Considering the issues as they

22 See Utilities Journal (2000, 2001a) for a contemporary assessmentof the Glas proposal and Ofwat’s judgement.

23 Various concerns were expressed by analysts and practitionersalike as to the outperformance levels required to reach Glas’ targetreserves. One estimate, for example, suggested that it was equivalentto something in the order of 10% savings in the entire OPEX andCAPEX programme (Utilities Journal, 2000).


could potentially relate to the gas and electricity marketsOfgem reiterated its serious concerns regarding newownership structures of price-regulated monopoly com-panies, as previously expressed in response to Ofwat’sconsultation paper (Ofgem, 2000a, 2000b). Ofgem wasparticularly sceptical that efficiency incentives, in theabsence of shareholder pressure or threat of takeover,could be maintained with the risk that “any incentive tooutperform regulatory targets will be lost or significantlymitigated” . It expressed doubts regarding possible alter-native motivations for members not motivated by finan-cial returns, including the risk that they would be cap-tured by sectional interests whose motives and goalswere not necessarily coincident with those of consumers.Mindful of the principal objective to protect consumerinterests, Ofgem emphasised that any additional returnswhich companies are seeking by structural means canonly come from a redistribution of risk and, unless theoverall level of risk can be reduced, companies can onlygain at the expense of customers, or possibly other com-panies. Ofgem also observed that while out-sourcing andhigher gearing may both be consistent with achievinggreater efficiency and lower cost, they do not guaranteethis. Viewing the cost of capital issue as a ‘mirage’Ofgem’s critical examination of the argument noted thatunless out-source contractors were more efficient thanthe regulator’s assumptions implied, the licensee’s disco-vered costs were likely to be higher than the targets,allowing for the contractors’ profit margins.

Ofgem’s concerns regarding the Glas proposals werereflected in the apparently concerted opposition of theDTI, the Treasury and the DETR, all of whom espousedthe equity-based utility company model and each ofwhich also emphasised aspects of specific concern. TheDTI insisted that the Glas model of raising capitalthrough bonds was flawed because it might not reach thetarget reserves to cover ‘shock’ events or the proposedcuts in bills, and also expressed the concern thatincreased out-sourcing of supply contracts carried thepossibility of a small group of large water companiesdominating the industry. In addition, to the extent thatthe emergence of ‘mega-service providers’ , from out-side24 as well as within the utility sector, had the poten-tial for price-fixing cartel behaviour in servicing utilityoperations, there was the danger that the ability of regu-lated companies to negotiate competitive contracts couldbe reduced (Lawrence, 2000). This aspect of vertical dis-integration would further complicate water industrystructure and its regulation.

For its part the Treasury was particularly concernedthat the loss of the equity cushion could leave it as the

24 For example, the Amey Group operated across a number of sec-tors, from business process out-sourcing to infrastructure managementand maintenance, and had recently launched an utility division.

‘ lender of the last resort’ . However, in contrast to theDTI’s preference for ‘common carriage’ as the mech-anism for generating more competition in the waterindustry, the Treasury was rather more supportive ofwater company restructuring because of the potential forincreased competition for contracts to manage the net-work and, hence, for lowering prices. A specific concernof the DETR related to the possible implications of frag-mentation arising from the separation of asset ownershipfrom out-sourced operation and management, with thelatter threatening confusion and blurred managerialresponsibility and accountability in critical areas, as wit-nessed in the rail sector, at the expense of safety, waterquality and service standards (DETR, News Release 043,31 January, 2001). This potential for fragmentation wasalso a matter of specific concern for the water qualityand environmental regulators who had no comment tomake on the proposed change of ownership of WelshWater to Glas, which was viewed as being outside theirremit. While both the DWI and the EA emphasised theimportance of appropriate licence conditions to ensure acontinuing basis for effective regulation, they remainedconcerned regarding the proper financing of Welsh Wat-er’s environmental and water quality commitments andthe potential for increased regulatory complexity asso-ciated with increased separation of functions involved inout-sourcing arrangements (EA, 2000).

Doubts regarding radical restructuring and refinancingwere not confined to regulators and government, beingforcibly expressed from within the water sector itself,with Severn Trent and United Utilities appearing as highprofile adherents to their own versions of the equity-based utility model. Although having extended its reachbeyond its regulatory core, and particularly into thewaste business, Severn Trent remained as a recognisablyintegrated water and sewerage company, and committedto the view that the absence of equity merely reallocatedrisk to consumers.25 For its part United Utilities’ multi-utility strategy, with a focus on core skills in asset man-agement and customer relationship management,remained faithful to equity financing as the most effec-tive means of delivering efficiency.26 These companiesalso shared regulatory concerns that the cost of capitaladvantages associated with high gearing were notcostless, with excessive gearing potentially reducingfinancial flexibility in the long run.

25 See Utility Week, 6 October 2000, for reference to SevernTrent’s view.

26 See Utility Week, 19 January 2001, for reference to the UnitedUtilities view. The company’s presentation of its multi-utility experi-ence contrasted with that of the Hyder Group, stressing the differentissues involved and the need for appropriate identification of core skillsand attempting growth in activities companies understood in order toensure successful multi-utility operations.


3.2. Special case or role model?

In giving conditional approval to the Glas proposalsthe DGWS strongly signalled that it would be very dif-ficult for other water companies to get similar schemesapproved. Although he would continue to consider otherrestructuring proposals on their merits, he pointed to spe-cial factors in the Welsh Water/Glas case which hadinfluenced the decision, and which would be difficult forothers to replicate. Specifically, Glas was independentfrom WPDL as the seller of Welsh Water, and wouldbe completely independent of the contractor chosen torun the network, and, influentially, the proposal had thebacking and broad support of a democratically account-able body in the form of the NAW.27 The agreed pur-chase was negotiated in circumstances which helpedconfirm the independence of Glas from WPDL, and thefact that Glas could buy Welsh Water assets at a signifi-cant discount to RCV established an immediate reserveto combat emergencies and a head start in building uptargeted reserves. This discount was viewed as a crucialfactor in enabling the purchase of infrastructure assetsby a Glas type company. Any reluctance to sell at sucha discount would be likely matched by unwillingness ofpotential purchasers to buy at a price close to RCV, andthis would seem to be borne out by the initially unsuc-cessful attempts by Scottish Power to sell off its South-ern Water Services subsidiary28 and the failure of Kel-da’s revised strategy of selling off Yorkshire Water dueto an apparent lack of bond market interest.29

The DGWS stated that a model which appears suitablefor the particular circumstances of Welsh Water wouldnot necessarily be appropriate for other parts of the water

27 In welcoming the DGWS’ approval of the Glas scheme the FirstMinister of the NAW pointedly stated his pleasure that the DGWS had‘ recognised the importance of the democratic accountability providedby the Assembly’ and interpreted the regulator’s statement as indicat-ing that the issues raised by the Assembly’s joint committees and itsadministration had been fully considered. (NAW Press Release,WO1116-Ind, 31 January, 2001). To the extent that the Glas ruling, andthe support provided by the NAW, may be viewed in some quarters asa test of Welsh devolution and an example of devolved regionalgovernance making a difference, it may be more than idle speculationto consider whether the NAW’s direct and continuing involvementthrough rights of inspection and other statutory responsibilities mighteventually involve the assumption of ultimate responsibility by default.

28 Scottish Power had originally experienced difficulty in sellingSouthern Water Services Ltd. due to the apparent difficulty of sellingat a price close to RCV, which was unattractive to buyers, and ScottishPower’s reluctance to sell for as little as 95% of RCV.

29 In March 2002 Kelda abandoned a second restructuring plan thatwould have involved selling the regulated water assets to a group ofbondholders and returning at least £1bn. to shareholders, after itbecame clear that there was little appetite in the bond markets. Initiallyinvolving the sale of 90% of Yorkshire Water to bond investors, retain-ing a 10% minority stake, the eventual intention was to dispose 100%,at or close to its regulatory value of £1.4bn. (See The Independent, 1March, 2002).

sector in England and Wales, where he viewed the equityshareholding model as having performed well indelivering improved efficiency savings and levels of cus-tomer service, whilst enabling the companies to deliverlarge environmental improvement programmes. How-ever, while emphasising that the conventional modelshould not be replaced by a more risky structure thathad not been tested, the DGWS conceded that precedentshould not be the dominating criterion in making anassessment. Nevertheless, the DGWS did state that hewould share the UK government’s concern if significantnumbers of water companies were to seek to pursue theGlas route, before the model of a wholly debt-financedout-sourced company had been fully tested. He empha-sised that companies that rely wholly on debt financeand contract-out services were as yet untried in Englandand Wales, although there were extensive precedentsboth within and outside the water industry for out-sourc-ing as well as a general pattern of increased gearing.

Following the Glas judgement the DGWS has consist-ently maintained that it is not his job to dictate the oper-ational or capital structure of the water industry, statingthat a centrally imposed model which seeks to workagainst the markets, rather than with it, would alwaysrun the risk of failure (Fletcher, 2001). In his viewrestructuring remains a company decision with compa-nies free to choose and take to the market their preferredcapital structure for financing their legal obligationsmore efficiently, provided that customers are protectedfrom taking on additional risks. Emphasising that cheapfinancing does not always, or necessarily, depend onownership change or radical restructuring, it has beenindicated that thin-equity structures are more likely togain regulatory approval, as companies retain account-ability to shareholders, with restructuring proposals morelikely to achieve appropriate investment-grade credit rat-ings if they involved gearing-up balance sheets ratherthan separating asset ownership from operations. Withregard to the latter, the general possibilities for watercompany refinancing, without ownership change,seemed to be exemplified by the Sutton and East Surreywater-only company’s successful credit wrapped, index-linked sterling bond issue (March, 2001) to refinanceexisting debt and fund future capital expenditure, withgearing increased to 75%.30

Regardless of the appropriateness, and feasibility, ofthe full Glas model for other companies, the Glas acqui-

30 See Utilities Journal (2001b) for details regarding Sutton and EastSurrey Holdings’ restructuring plan involving Sutton and East SurreyWater. The article also contains details regarding a more radical moveby Mid Kent Holdings to restructure its Mid Kent water-only company,involving an investment bank financed management buyout, to producea significant increase in the proportion of debt. Technically involvinga change of ownership the plan triggered a Ofwat consultation on theissues involved (Ofwat, 2001d).


sition of Welsh Water seemed to demonstrate that themarkets had an appetite for bond issuance and indicatedthe potential for low cost debt-funding of capital expen-diture commitments. There were however, particular, ifnot necessarily unique, features in the Glas case involv-ing an appropriately structured bond issue supported bya variety of default risk mitigants including a packageof loan covenants. As such, while lessons could belearned from Glas’ fi nancial structure, it would appearthat there is no ‘magical formula’ guaranteeing completerisk mitigation in all cases with success depending onindividual circumstances. Furthermore, regardless of thequality of any company’s bond issue and its risk profile,analysts have pointed to possible ‘fi rst-mover’ advan-tages with later converts to higher debt-funding liable tobe exposed to potential supply constraints in terms of‘credit wrapping’ capacity and a ceiling on bond inves-tor interest.

However, whatever the qualifications, it would appearthat following a brief hiatus after the Kelda case, thepost-Glas reappraisal generated a renewed momentumfor water company restructuring which became manifestin the latter part of 2001 and early 2002. Apart fromKelda’s new, and abandoned, plans for Yorkshire Water,Pennon reported its intention to ring fence and gear upthe regulated asset base of South West Water, while con-crete restructuring proposals for Anglian Water ServicesLtd. and Southern Water Services Ltd., by AWG andScottish Power respectively, were formally presented forOfwat scrutiny (Ofwat, 2001f, 2002a, 2002b). In AWG’scase the restructuring involved an organisational revisionwith the creation of two distinct businesses; AnglianWater as a regulated, single purpose and ring fencedwater business, and an infrastructure management busi-ness.31 AWG would retain full ownership of AnglianWater, with both water company assets and operationskept within AWG but separately managed with assetslargely debt-funded. The refinancing involved the trans-fer of all group debt to the regulated water subsidiarywith more debt raised to lower its cost of capital. Follow-ing restructuring the total net debt held by Anglian Waterwould be approximately £3.2bn., significantly increasingthe gearing ratio equivalent to some 85% of its RCV. Inthe case of the Scottish Power proposals for SouthernWater the former would remain as the equity owner,with a reduced shareholder stake, with the latter effec-tively becoming a separate operation funded solely by

31 With the intention of focusing on its multi-utility asset manage-ment strategy, offering key asset capabilities in providing support ser-vices for out-sourced activities, AWG’ plans fell far short of the orig-inal intentions to demerge into an asset owning company operationand an asset management business. In addition the proposal containedthe intention, subject to market conditions, to progressively out-sourcewater operations and customer service functions to third party special-ist service providers over the next three years.

debt. Subject to market and other conditions the restruc-turing would result in approximately £1.9bn. of ringfenced borrowing in Southern Water, representing a sig-nificant increase in its gearing with indebtedness risingto some 90% as measured against RCV.32

Both of these refinancing proposals for highly geared,thin-equity structures were not as radical as the Glasmodel and, as neither involved a change of ownership,Ofwat was only required to consult on proposed licencemodifications. Emphasising that shareholders and lend-ers remained responsible for judging the financial andbusiness risks, and for them to decide whether to providethe financial support required to implement these pro-posals, the DGWS indicated that ‘no insurmountableproblems’ arose in either case. While at the time of writ-ing (June, 2002) AWG continued to proceed with itsrestructuring proposal,33 that of Scottish Power has beenrecently and suddenly abandoned with the company hav-ing reverted to, and achieved, its original intention tosell off Southern Water.34,35

32 Southern Water’s earnings would be ring fenced to repay bond-holders and finance capital investment. The plan was aimed at achiev-ing an overall lower cost of finance, and improved return on equityfor Scottish Power, which was strategically resolved to focus on itscore energy business.

33 In March 2002, AWG confirmed that it had agreed with Ofwaton licence amendments necessary to restructure, and that rating agenc-ies had confirmed investment grade ratings for Anglian Water ServicesLtd. Ofwat’s subsequent position paper concluded that there were noobjections to the AWG proposals and that the company should beallowed to proceed to test whether it could secure the required financ-ing, and subject to the satisfaction of certain conditions (Ofwat,2002g).

34 Scottish Power dropped its plans to restructure the regulated busi-ness of its Southern Water subsidiary with the announcement of itssale to First Aqua (for £2.05bn.), as a newly formed holding companyowned by a consortium of institutional and private investors andbacked by Vivendi International of France, specifically set up as afinancial vehicle to purchase Southern Water. By this sale, ScottishPower reverted to its initial, and preferred, option which had previouslybeen abandoned due to the failure to find a willing buyer (see fn. 28).See Ofwat’s consultation paper (Ofwat, 2002f) on First Aqua’s pro-posed takeover of Southern Water Services Ltd., which raises manyregulatory issues similar to those which had been previously identifiedin relation to Scottish Power’s proposed refinancing of Southern Water(Ofwat, 2001f, 2002a). Vivendi International agreed to purchaseSouthern Water in May 2002 in a deal by which it would retain themajority of the voting shares in First Aqua. Although Ofwat did notobject in principle to the acquisition the deal required approval by UKand European Union competition authorities. (See the Financial Times,8 May, 2002).

35 Pennon announced the abandonment of its latest plans for finan-cial restructuring in May 2002. (See the Financial Times, 31 May,2002).


4. Concluding remarks

The establishment of a new ownership and financialstructure for Welsh Water involved a range of significantissues covering constitutional, regulatory and politicalaspects. However, while providing lessons for otherwater sector companies in terms of its financial engineer-ing and attempts at risk mitigation, the particular featuresof Welsh Water’s conversion into Glas prevents its pres-entation as a full template for others to replicate. Thetransformation was facilitated by a coincidence of needs,opportunities and force of circumstances, enablingWelsh Water assets to be purchased at a significant RCVdiscount, and incorporating a variety of features which,along with the political backing of the NAW, enabled itto be treated as a special case.36 Although the Glas pro-posal had a lengthy gestation period it would also seemto have benefited from fine-tuning possibilities followingthe previous regulator’s assessment of the Kelda pro-posals, to produce an improved version of a ‘not-for-profits’ ownership model which could be favourablyassessed by a new DGWS who appeared to be moreamenable than his predecessor.

The Glas model raises issues relating to efficiencyincentives, risk mitigation and distribution, and theimpact of functional separation of water utility business.While all aspects remain to be fully tested the immediatequestions relate to Glas’ continuing ability to raise cheapfinance and the actual extent of net reduction in its fin-ancial costs, and the delivery of its promised out-per-formance to achieve projected customer rebates and fin-ancial reserves. However satisfactory the financing planmay currently appear there are inevitable uncertaintiesregarding the future, with question marks relating to theability of the new arrangements for Welsh Water to pro-vide sufficient flexibility or incentives to respondefficiently to future developments in the water industry.For the present ‘ regulatory risk’ can be contained to theextent that Ofwat is committed to retaining the mediumterm regulatory framework, with no intention of raisingits gearing assumption (Fletcher, 2001). While Glas, andother companies who successfully refinance their oper-ations, can display cost of capital advantages comparedwith equity-based companies, over the remainder of thecurrent regulatory review period, the crucial juncture inassessing Glas’ progress and its continuing potential willcome at the next price review. This will depend on theextent of adoption of highly leveraged structures across

36 At the risk of indulging in semantics it should be noted that whilethe DGWS suggested that Glas should be viewed as an uniquely Welshsolution to a Welsh problem, the company itself preferred to downplaythe Welsh element describing Glas as “ less a case of a Welsh solutionfor Welsh Water...more a unique solution for the Welsh Water businessgiven where it is” (See Utility Week, 9 March, 2001).

the sector and their implications for the allowed returnon capital.37

Although the full Glas model remains ‘special’ thewater utility sector is changing rapidly, with its structuraland financial arrangements significantly different tothose prevailing at privatisation. In the context of amulti-structured water sector covering various forms,embodying vertical disintegration and horizontal con-solidation by function, and possessing an ever increasingforeign ownership presence,38,39 the Glas model may beviewed as another piece of evidence regarding the break-up of the consensual privatised utility settlement. In itsown terms Glas denies its presentation as a role model,preferring to present itself as ‘a new piece of diversity’within a scenario of many different companies of vary-ing structures and different ‘corporate brands’ , with eachvariant market tested in turn, and all competing to seewho can provide the best service in an alternative formof competition to ‘common carriage’ and providing anew basis for comparing efficiency and quality of watersupply operations.40 However, although one may acceptthe need for diversity there remains the danger of piece-meal and unmanaged change in the water utility sector,and concern regarding the absence of a clear policyframework and guidance in advance of any reactive orex post response once new organisations and structureshave been tried, tested and seen to succeed, or not.

37 In September 2001 Ofwat announced that it had commissionedwork to update rather than overhaul its price-setting model, havingappointed Cap Gemini Ernst & Young to develop a new computerisedfinancial model to be used to set water companies’ price limits (OfwatPress Notice PN 44/01, 20 September, 2001). In March 2002 Ofwatpublished its aims and objectives for 2002–03 to 2004–05 in its For-ward Programme (Ofwat, 2002c). This included the timetable for thenext periodic review that will set price limits for water companies fromApril 2005 to March 2010, which will begin with the publication ofthe methodology paper in October 2002 with the new price limits tobe announced in November 2004. In separate documents Ofwat alsopublished a consultation paper on the approach to depreciation for thePeriodic Review 2004 (Ofwat, 2002d), and the future RCVs for eachwater company (Ofwat, 2002e). This latter move was a change fromestablished procedures which had only disclosed historical RCVs, andin response to pressure from the investment community for greatertransparency in the calculations and judgements involved. See fn. 4.

38 Another recent ownership development during the first half of2002 involved the sale of Wessex Water by its US parent Enron, fol-lowing the latter’s collapse as an energy trading company, to YTLPower International Berhad, the Malaysian energy and infrastructurecompany. See Ofwat’s consultation paper on the proposed acquisition(Ofwat, 2002h) which was cleared by the Office of Fair Trading inMay 2002. Ofwat’s Annual Report for 2001–02 provides a full listingof merger and restructuring activity during the period (Ofwat, 2002i).

39 For the most recent summary of the DGWS’ views regarding con-solidation, restructuring and ownership patterns in the water sector seehis address to the Sixth Annual Utility Congress in July 2002(Fletcher, 2002).

40 See Utility Week, 9 March, 2001.


Acknowledgements

The author wishes to thank the editor and an anony-mous referee for their careful reading of the originalmanuscript and their helpful comments. All errorsremain the sole responsibility of the author.

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