Michael Harrison's Outlook: Time for the water regulator to stand firm, not produce another stream of excuses

Cairn turns on the options gusher; Five to one on a housing crash?
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The Independent Online

"Speak softly but carry a big stick" was Teddy Roosevelt's maxim. Well, the water regulator, Philip Fletcher, certainly has a quiet manner about him. Whether he has the will to put some stick about is quite another matter.

The last time Ofwat set water prices in 2004, it was far too soft on the industry and far too generous in its settlement. Mr Fletcher allowed the 22 water companies in England and Wales to raise prices by an average of 18 per cent to pay for a £17bn investment programme over the next five years.

Since then, profits have grown much more quickly than Ofwat expected without much to show in return for customers. Collectively, the industry has under-invested to the tune of £1bn, the three biggest water suppliers in the country have all missed their leakage targets - in the case of Thames by a country mile - and a further two are under investigation by the Serious Fraud Office for falsifying their customer satisfaction records. Not exactly a glowing report card.

And yet it is boom time once again for investors in water companies who have seen their capital repaid in full many times over since the industry was privatised in 1989. Thames has just been sold (again) for £1bn more than it was expected to fetch, Anglian is about to be bought for a similarly eye-watering premium and the remainder of the quoted water companies are trading at price levels way above the value of their assets on the assumption that they too will soon be swallowed up by rich foreigners.

If the takeover premiums these businesses are able to command is any guide, then investors expect Mr Fletcher to give the industry a similarly easy ride when he next sets prices in 2009. Indeed, three years before he needs to wrap a wet towel around his head and come up with a figure, he has already warned householders to expect another "significant" increase in bills. The investment banks must be lapping it up.

Mr Fletcher says that only with hindsight is it possible to argue that prices were set too high in 2004. At the time, he used the best evidence available to him. Since then, two things have happened to swell the value of the sector. First, long-term interest rates have remained lower than expected, reducing the industry's borrowing costs and fattening its profits. Second, boring old infrastructure businesses such as water companies have suddenly become the kind of ultra-fashionable assets that everybody wants, not least pension funds who can match their long-term liabilities against the predictable income streams that regulated utilities are able to deliver.

Both of these things are true. And yet that is not the whole picture. The fact is that Mr Fletcher began the last price review from a position of weakness. He acknowledged from the outset that bills would have to rise substantially if the industry was to have sufficient incentive to undertake the necessary capital expenditure. His predecessor, that old bruiser Sir Ian Byatt, was too canny to fall into such a trap. He made the industry invest £15bn while simultaneously forcing it to cut bills, knowing that there is always more fat to trim in monopoly businesses such as water.

Mr Fletcher must not commit the same tactical error again. His tone can remain as dulcet as he likes. But next time around, he needs a bit less carrot and a lot more stick.

Cairn turns on the options gusher

Cairn Energy has arguably been the stock market success story of the decade. Since 2001, the company's value has risen by more than 500 per cent thanks to a hunch on the chief executive's part that there was a lot more black gold buried beneath the dusty plains of Rajasthan than Shell thought possible. Sir Bill Gammell bought the rights and the rest is history. Today, Cairn is sitting on the biggest oil find in India's history and Sir Bill and his colleagues have made a whole pile of money for themselves and investors who were lucky enough to get in on the ground floor.

Now he has decided to cash in some of those chips. Next month, Cairn India will list on the Bombay stock exchange with a conservative valuation of at least £2.7bn. The float will raise about £1bn, of which about £600m will be returned to shareholders in the parent company. The remainder will be split between Cairn India and a rump company, Capricorn, which will retain Cairn's remaining assets in Bangladesh, Nepal and northern India. The management of Capricorn will be incentivised to go and do it all over again, though it is hard to see them quite repeating Cairn's original success.

But the largesse does not end there. The chief executive of Cairn India, an Indian investment banker called Rahul Dhir, will receive share options worth some £9m, of which £6m come without any performance conditions whatsoever attached. His chief operating officer, Lawrence Smyth, will also cash in, although he will net a more modest £2m.

As Cairn itself admits, granting executives share options which they can exercise simply by getting out of bed is unusual. But in this case it was deemed necessary to get their man.

Sir Bill took a huge gamble and was rewarded when it paid off. Mr Dhir, for all his undoubted deal-making skills, is not risking very much since all the hard work has been done. His job is the operational task of getting the oil out of the ground and into the market. Seemingly, the remuneration arrangements have been run past Cairn's big shareholders and have not prompted a revolt. Strange how times change.

Five to one on a housing crash?

There are already plenty of good mortgage brokers around who can secure you a loan which is the equivalent of five times salary. Now Abbey, the country's second biggest mortgage lender, has made that part of its standard terms. A measured response to the remorseless rise in house prices or a sign that the property bubble is about to burst?

If you are trying to buy a house in London from scratch, that is probably the kind of multiple required, given the way the market has been artificially inflated by City bonuses.

It sounds an alarmingly high burden of debt to service, especially for a first-time buyer who will find half his or her net income disappearing on the monthly mortgage payment without the cushion of any equity to help them sleep at night.

But for the housing market as a whole, it is less worrisome. A rising tide lifts all boats. Today, thanks to soaring house prices, two-thirds of homeowners have more than £100,000 of equity in their properties and the average loan-to-value ratio has shrunk from 90 per cent a decade ago to under 80 per cent. Meanwhile, mortgages remain affordable. Last year, the average mortgage burden represented 16 per cent of income. In 1990, it was 27 per cent, even though people borrowed much less as a multiple of their incomes.

Of course, the ship is only kept afloat because of low real interest rates. The Bank of England's Mervyn King maintains that a rate rise later this month is not a done deal. A quarter-point increase would put the heat under some borrowers, but it would still take a lot more than that to cause a full-scale meltdown.

m.harrison@independent.co.uk

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