The subtle brilliance of the UK water business
Published October 4th, 2018
How much does Nash equilibrium cost the global water sector each year? 20% - 30% on the cost of water? Or is it 50%? It is not something I have thought of before, but we have been doing some research for a UK utility comparing value for money across the European water sector, and it suddenly became clear to me that the true genius of water privatisation in the UK lies deeply embedded in game theory.
For those who have not seen the film A Beautiful Mind, Nash equilibrium is a situation where the rational choice of each participant leads to a sub-optimal outcome for everyone. In the case of the water industry the game is procurement, and the asymmetries of information typically mean that utilities end up paying too much but still never get the best outcome, and despite this, the suppliers barely make any money.
It happens for three main reasons. The first is because in a low-bid competitive tender, contractors make the most money from their client’s mistakes. The game is to bid low to secure the deal, then make a margin from renegotiating the price through unavoidable contract variations. The second is because utilities never really know what might be the best solution to a particular challenge before they have to formalise their requirements in a tender specification, and once that is specified, large avenues of innovation are immediately closed off. The game for suppliers is not to offer the best solution: it is to meet the specification. The third reason for sub-optimal outcomes is because although utilities want the solution with the lowest lifecycle cost, they generally ask for the lowest up-front capital cost, and they have to take the operating cost implications on trust from the bidders. The game is to understand how the client will assess technical and financial envelopes, rather than think creatively about the lowest lifecycle cost.
The solution which UK private water companies have discovered – under extreme financial pressure from the regulator – is to create total transparency right through the supply chain. It has been an absolute game-changer which has dramatically cut the lifecycle cost of running a utility. Here are some of the learning points:
Know where the money is: The UK utilities absolutely know how their suppliers make their profit. They will allow a fair margin for fair risk, but they won’t put up with suppliers who think that they can make a dime from dissembling about the true cost of what they do.
Get Japanese on the supply chain: When Toyota builds a new model of car, it brings its whole supply chain into the design, working out how each one can contribute to improving the customer proposition. The UK private utilities have started doing this when they need to develop a big project. It has delivered innovation at every level.
Don’t become a risk sink: Public utilities can’t go bust, so they tend not to price risk correctly. Instead they soak it up, and it is a tremendous drag on their performance. The UK private utilities can go bust, and they make sure that they are better at pricing risk than anyone who might pass it on it them.
Live the lifecycle: The UK private water sector is regulated in five-year periods, and in the past, the companies have tended to bring together large procurement consortia in framework agreements to deliver all of their capital programme for each five-year period. Now, an increasing number of utilities are looking to tie in their framework partners for ten years or more. It means that the dividing line between the utility and its suppliers has become increasingly invisible.
The time for cowboy outfits has passed: Macquarie Bank practically invented the infrastructure fund concept, promising to buy and hold investments delivering a steady long-term yield. It was a compelling proposition for pension fund investors, but it turned out that Macquarie was just another cowboy investment bank flipping assets and charging dubious fees with no real interest in long-term investment. It led the consortium which bought Thames Water in 2006 and sold its stake down in stages from 2011, took truckloads of money out of the company, and failed to make any serious attempt to address the company’s sky-high leakage rates. This behaviour has completely changed the narrative in the sector. People are not talking about the fantastic achievements that privatisation has brought about in terms of driving down the cost of procuring water infrastructure. Rather they are considering renationalisation. The good news is that there isn’t really any space in the market for an investor like Macquarie to take controlling stakes in UK water utilities any more. The short-term outlook, with the probability of a tough regulatory review, rising interest rates, tighter leverage limits, and Brexit, has scared off the cowboys. Those who want to stay typically have time horizons of 30 years or more. For the first time, it has created an intellectual alignment among investors, their utility leadership, the regulator, and utility customers.