Neil Collins’ Notebook – Polluting the water regulator

While we were all flapping about lockdowns, the UK’s entire system of regulating the prices of utilities was fatally undermined last month. The Competition and Markets Authority over-ruled Ofwat, the water regulator, and awarded higher returns to Anglian, Yorkshire, Northumbrian and Bristol water companies. 

All four companies are owned by the usual opaque mixture of private equity, pension funds and foreign governments, so there is no share price to reflect their good fortune. However, the market was quick to see the cracks in the current regulatory regime for electricity and gas; since the CMA’s ruling was published, the price of National Grid has risen by 11 per cent. 

It is a terrible precedent. From now on, every company negotiating with its regulator will know that there is a higher authority which really calls the shots. Never mind that the CMA lacks the expertise to make a balanced decision, the regulators who are merely staging posts on the route to the final outcome. No point in the company agreeing a tough ruling when it can go on to the CMA.

Ofwat’s chief regulation officer David Black has boiled over, accusing the CMA of running a hurried and botched process which lacked “explanation, reasoning or analysis”. Considering that Ofwat spent the last two years coming to its adjudication, the CMA’s facile analysis from the chair of the enquiry group Kip Meek looks thin indeed. 

The broader point is the shameful way that the water industry has behaved since privatisation. As the quoted companies have been taken over, their starting equity has been steadily replaced by debt, while dividends and rewards to top executives have taken precedence over fixing leaks and cutting pollution. Since only three of the original 10 regional companies remain listed, the industry has successfully avoided much public scrutiny.

Previous prices and targets set by Ofwat had manifestly failed to force better behaviour, and its rulings on this round of pricing were openly designed to address some of these sins of the past. All that is now in jeopardy, with the CMA looking like the plaything – or worse – of the regulated utilities.

Mr Black is considering a judicial review. He needs to launch one pronto, and to win it. If not, the regulator’s credibility will be destroyed, and the effort made to balance the incentives for better behaviour from the water companies against the price consumers pay for water will have been in vain. There is a rulebook designed to ensure harmony between the CMA and Ofwat. The rest of us – and Mr Meek – might read it.

Don’t shoot the auditor

“When a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.” As Samuel Johnson remarked in 1777, so the Financial Reporting Council in 2020. Aware of its forthcoming demise, the FRC seems to have decided to show its teeth. The accounting watchdog has analysed 216 sets of accounts; fully 96 of them were not up to scratch, and in 14 figures needed restating.

In some cases the directors were just too optimistic, and the “frequency of restatements relating to cash flow statements remains a concern”. For an increasing number of companies, this is the most important statement in the accounts, as physical assets give way to brands, patents and know-how. It is also the best forward indicator of trouble; you can make losses, but if you run out of cash, the end is nigh.

It is nigh for the FRC. After the damning verdict of the Kingman report (“a ramshackle house . . . constructed in a different era”) two years ago, the body has not been hanged only because the government has yet to get around to organising its replacement.

Yet despite the FRC’s findings, it seems that the auditors are starting to stand up to company boards. Big accounting firms are fed up with being savaged for not spotting problems, and the existential risk to EY over the failures of Wirecard, NMC Health and Finablr has served to concentrate minds elsewhere.

Thus Deloitte has stepped down from EG Group, the highly-leveraged business owned by the Issa brothers who are trying to buy Asda from Walmart. PWC has quit at Boohoo, the cheap fashion kings with questions to answer about conditions among its suppliers in Leicester. BDO resigned the audit of restructured retailer Poundstretcher after refusing to sign off last year’s cash flow forecast. 

Firms must state why they are resigning, but the reasons are seldom as specific as in the Poundstretcher case. “Governance shortcomings” provides a convenient catch-all, especially in cases like Boohoo and EG. The more convincing answer is simply that the skimpy rewards from auditing are not worth the reputational risk. 

The FRC’s comments will hardly help here. David Rule, its executive director of supervision, told The Times that accounts must “explain not only how the pandemic has affected company performance but also how it might affect a company’s future prospects”. Well, best of luck with that. We’d all like the answer as we peer into the corona virus mists, trying not to catch it.

Auditing has long been the Cinderella of the accounting profession, but as accounts get more complicated for outsiders (Royal Dutch Shell’s p&l, anyone?) that is changing. Audit fees are going up fast, and the audit partners are being invited to the fat-cat ball. As for the poor old FRC, it is promised glamorous new clothes, becoming the Audit, Reporting and Governance Authority. This year, next year, sometime…

Shell shock

Are the executives of BP and Royal Dutch Shell listening to the stock market? Share prices of both companies have more than halved in the last year, a scale of collapse unthinkable in the past. Some of this is due to nerves about the oil price, but mostly it reflects fears that both companies will squander their assets in their stampede to go green.

In fact, neither company has the expertise to make decent returns from renewable energy. They are world leaders at finding, extracting and selling oil and gas, a business which will be essential for energy supply for at least another decade. Rather than pour this wonderful competitive advantage down a green drain, far better to get costs down and dividends back up, and allow the owners of the businesses to decide where to put their money.