Accounting, Auditing & Accountability Journal

The power of accounting: reflecting on water privatization?

Jean Shaoul

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Jean Shaoul, (1997),"The power of accounting: reflecting on water privatization?", Accounting, Auditing & Accountability
Journal, Vol. 10 Iss 3 pp. 382 - 405
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382
Submitted August 1996
Revised January 1997,
February 1997
Accepted March 1997

Accounting, Auditing &

Accountability Journal,
Vol. 10 No. 3, 1997, pp. 382-405.
MCB University Press,
0951-3574

The power of accounting:

reflecting on water
privatization?
Jean Shaoul
Manchester University, Manchester, UK
Introduction
The British Governments privatization programme, introduced with much
fanfare in the 1980s in the face of enormous public opposition, has been
emulated throughout the world in the 1990s. It was justified on the basis of the
greater efficiency and benefits to all that would follow from private ownership
(Moore, 1985). But the outcomes can be likened to those of a childrens game of
Monopoly which, as every parent knows, starts with a few welcome minutes of
peace and quiet on a cold wet Sunday afternoon, and, after some initial squeals
of delight, ends in fights and tears a heavy price for parental passivity. The
privatization of the utilities has resulted in generous dividends to the
shareholders and remuneration to top management, an unsuccessful spending
spree in search of future earnings growth and a 25 per cent fall in employment
for the workforce (Froud, Haslam, Johal, Shaoul and Williams, 1996).
Yet if such outcomes are predictable enough, at least with the benefit of
hindsight given the rules of the game, that suggests that an accounting model
combined with ex post facto financial information can describe and explain how
and why those outcomes occurred and their likely implications. After all,
accounting provides the framework for the profit and loss game and accounting
techniques were employed for the crucial task of restructuring the nationalized
industries as commercially viable enterprises in the private sector (NAO, 1992).
This study uses the case of the privatized water industry for two purposes:
first, to examine the extent to which an accounting model and the financial
numbers in the annual reports and accounts can indeed describe and explain
such outcomes; and, second, to assess whether accounting can assume a
constructive and emancipatory role, by challenging the existing problem
definition, for example, of public sector inefficiency, and posing alternative
questions and solutions.
The work contrasts sharply with much of accounting research in the 1980s.
Accounting scholarship contributed surprisingly little to the initial debate on
the relative merits of private v. public sector provision of services. Some
accounting academics did point out that there had been little careful study of
the issues (Heald and Steel, 1986). Indeed the debate was dominated by
economists who espoused the public choice or property model associated with
Alchian, Demsetz and Hayek. Nor have accounting scholars contributed to an
ex post facto assessment. Their contribution has been concerned largely with

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the reporting changes resulting from privatization (Thomson, 1993) and

regulatory issues (Vass, 1992).
The quiet accountants
It is instructive to consider the background to this silence of the accounting
academics on a key issue of public policy in the formulation of which their
expertise was salient. Since the 1960s, mainstream financial accounting
research has analysed problems and issues in a positivist or technical way in
which the basic values of the model are not questioned. Neither are the
techniques considered in relation to the operational characteristics of the
business activity or the social and institutional arrangements of the sector for
example the current cost debate and the formulation of accounting standards.
That is, the issues are conceived as purely technical problems. In so far as
public sector accounting was part of financial accounting research, the issue
was largely how to make public sector accounting more like that of the private
sector; thus for example, the debate concerned the value of accrual accounting
and the wisdom of charging for capital where there was only public property.
Only recently has research emerged that is critical of the kind of techniques
being advocated and used in the public sector which do not distinguish between
the claims and possibilities of accounting-based reforms (Hopper, 1986;
Hopwood, 1984; Humphrey, 1991). In short, mainstream financial accounting
research considered public sector issues marginal to the discipline and the
public sector itself was viewed as a version of private sector enterprise.
Critical accounting research, emerging in the 1970s, has opposed the
technical approach of the mainstream from several different standpoints. Some
have revisited the theoretical underpinnings of the discipline, critically
analysing the basic concepts of profit, value, efficiency, etc. Others have traced
the genealogies of accounting discourses and their pliability according to the
social context in question. Another strand has explored accountings role as an
ideological weapon in the distributional conflict over wealth, while others have
analysed accounting as rhetoric, examining its epistemic and logical basis.
Despite its diversity, much of this research has led to the conclusion that it is
impossible to use empirical accounting and financial data or social experiences
to explain the world. The end result is that much critical accounting research is
characterized by an analysis of accounting processes to determine the meaning
behind the practices and numbers (the same numbers and practices which have
been so problem-free to the positivists). But this has come at a cost. Instead of
alternative uses of published accounts as evidence to inform about events and
social, economic and political relations, attention is focused entirely on
developing a perspective on accounting informed by social theory. Thus critical
accounting research has turned away from analysing contemporary events or
outcomes of public policy decisions in ways that are useful or helpful to the
broader public, at the very time when the public sector has faced interventions
in which accounting was to play a crucial role.

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A recent research study (Edwards and Shaoul, 1996) found that relatively few
academic researchers have examined contemporary corporate events or
scandals, or made use of the primary data the accounts to unmask
undesirable, irrational or socially irresponsible corporate behaviour. There are
few accounting studies of corporate performance using primary sources (see
Adcroft, Cutler, Haslam, Williams and Williams, 1991; Berry, Capps, Cooper,
Hopper and Lowe, 1985; Cooper and Hopper, 1988). In general, analysis of
corporate reporting has been left to journalists and investment analysts,
writing to inform potential investors (Griffiths, 1986; Smith, 1992) and trade
unionists (Hurd, 1983). In an earlier period, Briloff and Chatov were the foremost
accounting critics of corporate behaviour in the USA; in the UK there was
Stamp and, more recently, Sikka (see Mitchell, Puxty, Sikka and Willmott, 1992;
Mitchell and Sikka, 1993; Russell, 1991; Stamp and Marley, 1970; Stamp, Dean
and Wolnitzer, 1980). While their work was concerned with accounting and
auditing failures rather than with any broader social analysis, it nonetheless
raised several issues of broader corporate accountability. But by way of
contrast, these same financial accounts are seen as valid source material for
historical accounting research.
Frustration with the limitations of both mainstream and critical accounting
is expressed by another school of research: corporate social reporting (CSR).
CSR is concerned to limit what are seen as the excesses of corporate behaviour,
at the expense of other social groups, ethics and the environment (Gray et al.,
1987, 1996). The general solution of the academics of this school is to limit
corporate power by including other social groups in management, improving
social responsibility via regulation, making changes in the formal accounting
systems and requiring the disclosure of other types of information. That is, CSR
is concerned largely with what companies should do in the light of ideas about
public and social accountability. But this requirement for more disclosure does
not make good the failure of accounting researchers systematically to use and
interpret the accounting information that is currently available.
Filling the gap
This paper seeks to fill that gap. It sets out a value-added, cash-flow model and
applies it to publicly available information on the privatized water companies.
It examines the different ways that the model may be used to:
understand the financial characteristics of the activity and the scope for
management action to expand revenues and cut costs within the firm or
sector; and
describe, explain and predict the financial and social outcomes of the
firm or sectors activities and thereby evaluate business and public
policy decisions from a wider perspective.
A measure of the power of accounting is the extent to which it can challenge
the rationales for privatizations in the light of their subsequent effects.

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The accounting model has been used elsewhere to understand the issues
confronting car manufacturing (Williams, Haslam, Johal and Williams, 1994),
manufacturing in industrial countries facing low-wage competition (Williams,
Haslam, Williams, Johal, Adcroft and Willis, 1995), the privatized utilities
(Froud et al., 1996); the financial context of the BSE crisis (Shaoul, 1996b); to
raise questions about the assumptions underlying the introduction of charging
for capital and assess the implications for the workforce, provision of services
and the capital infrastructure, in the NHS hospitals (Shaoul, 1996a); and to
assess the effectiveness of the regulation of the water industry (Schofield and
Shaoul, 1997).
Thus the model can be used in two important ways:
(1) It can be used to look at how the surplus within the organization is
generated, the scope for management action, and the implications for
outsourcing, the workforce, consumers, etc. It can be used therefore to
distinguish between different companies and sectors, in different time
periods, and to show how and why they differ. The availability of
national statistics for each business sector in a similar format enables
broader comparisons to be made. From the perspective of this study it
permits an assessment of the transformatory power of private sector
management.
(2) The model can be used to look at how the surplus is distributed to the
different external stakeholders. This enables a social analysis of the
particular form of stakeholder conflict to be made as the revenues, costs
and size of the capital base change. From the perspective of this study, it
permits an assessment of privatization because the new owner has
financial objectives and requirements different from those of the former
owner.
The paper is divided into six sections. The first section describes the accounting
model. The second explains the background to the water industry. The third
section outlines the data sources. The fourth section analyses the performance
of the water industry before and after privatization, while the fifth analyses the
particular form of the distributional conflict in the industry. The final section
assesses the emancipatory power of the accounting model in terms of some of
its practical outcomes, and draws out its potential to contribute to the wider
economic, political, social and intellectual debates.
The accounting model
Surplus creation and distribution within the firm
This study uses a model which focuses on how a financial surplus is created by
the firm and then distributed to the different stakeholders. Production entails
the employment of workers, using capital equipment to convert raw materials,
components and bought-in goods and services into commodities. The gross
value added is the value created by the efforts of the employees of the firm
which can be measured by sales revenues less all purchases.

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The surplus or net value added is the amount realized for the commodities or
services over and above that paid to and for labour, after allowing for bought-in
goods and services. This surplus must meet the claims of all the stakeholders:
the production requirements of capital, (its consumption, reinvestment in new
plant, products, etc.) plus the financial requirements of the State (tax), the
providers of loans (interest) and, under private ownership, the providers of
equity capital (dividends and dividend growth). The owners require a rate of
return on their capital at least equal to that which can be obtained elsewhere.
Therefore the greater the quantity of capital employed in the business, the
higher the absolute amount of surplus required to maintain a constant (if not
rising) return on capital, assuming that all the other claims remain the same.
The failure to generate a sufficient surplus to cover all these requirements
means that the owners of the firm must eventually attempt to exit from the
business sector. The pressure to exit is felt particularly in those modern
industries where the costs of developing new products and of maintaining and
enhancing plant and equipment are very high.
Although the distribution of profit to the shareholders appears in the
accounts as a residual claim to be met after all the other claims have been
satisfied, in practice this is the bottom line which drives the operation of the
enterprise. The distinctive feature of capitalism as a form of ownership is that
achieving the bottom line is the main objective, and it is the other claimants
share that must somehow be reduced.
While the concept of value added is widely used in economics and reported
in the national economic statistics for each business sector, it is infrequently
used in accounting. It appeared briefly and in a number of ways in the
accounting literature after the publication of The Corporate Report (ASSC,
1975) and an elaboration of its uses (Cox, 1979). But the way in which the
concept was employed at that time was marked by calculative uncertainty and
variability, and was linked to an interest in industrial relations reform and the
concern with its effects on national economic performance (Hopwood, Burchell
and Chubb, 1994). It was used largely as a bulwark against trade union
demands for higher wages since it showed that the lions share of value added
already went to labour. Interest in the concept, as reflected in the number of
companies publishing value-added statements, had all but disappeared by the
mid-1980s (Gray et al., 1987) with the decline in the rate of inflation and the
negotiating strength of the trade unions.
Identification of value added using published accounts
Since the value added by a capitalist enterprise is not reported as such in the
annual report and accounts, it must be calculated either by subtracting
purchases and bought-in services from sales revenue or by adding the labour
conversion costs (wages and any associated costs such as insurance, pensions
and welfare provisions, etc.), the depreciation of assets used in the process of
production, renewal and maintenance expenditure, and the operating profits

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before interest and tax. Since purchases also are not reported as such in the
accounts, in practice value added is calculated additively.
Value added
The amount of purchases relative to sales (P:S) is crucial in determining the
value added. Activities well up the value chain, such as water and the extractive
sector, will usually have low purchase:sales ratios whereas downstream
activities may have much higher ratios, for example manufacturing at 60 per
cent, retailing at 80 per cent, and warehousing and screwdriver assembly plants
at 90 per cent. These ratios are determined by the businesss position in the
value chain and also by the degree to which it is vertically integrated.
Consequently within any one sector in the value chain, a company that depends
on outsourcing will have a higher P:S and therefore, a lower value-added fund
than one which carries out all activities in-house.
Labours share of value added
In general labours share of the value added in a manufacturing enterprise is
about 70 per cent plus or minus 10 per cent depending on the point in the trade
cycle when measured and the degree of capacity utilization. In retailing this
figure tends to be 40-50 per cent, whereas in a service sector such as hospitals
labours share may be as high as 86 per cent. These are averages and, while
characteristic in general, there will be variation between companies and
industries, and in the short run. When demand is high, if trade unions force up
wages, any increase in labours share can be passed on to the consumers via
higher prices, and labours share can thereby be restored to the average at the
expense of the consumer.
If, on the other hand, demand is declining or static and labour rises, then it
becomes very difficult for the company to generate the surplus for distribution
to the other groups. The company will try to reduce the amount paid out to
suppliers for bought-in goods and services. However, in the absence of
monopsonistic power, such as the giant retailers, or without access to
alternative low-wage suppliers overseas, this will not be an option. In order to
protect its share, the capitalist firm will generally attempt to reduce labours
share by seeking aid from the State to reduce some aspect of the conversion
costs via changes in social legislation or regulations, fiscal policies, interest
rates, etc. Otherwise, the capitalist enterprise must reduce labours share by
some combination of sacking workers, increasing work output and cutting
wages and conditions. Thus the logic of the relations of production requires that
when revenues are not set to rise the share going to wages must be driven down.
Furthermore, the logic of the relations of distribution means that all the rival
claims on the surplus (for tax, interest, investment and dividends) cannot be
met to the satisfaction of all the parties all of the time. If, for example, capital
expenditure increases through competition, technical change, obsolescence or
statutory requirements, this restricts the surplus that can be distributed while
simultaneously increasing the absolute amount required by the owners to

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maintain the rate of return on capital employed (ROCE) in the future. In the
absence of an increase in demand or state assistance, it will usually be followed
by attempts to reduce labours share in order for the company to stay in the
business sector.
The value-added approach has the advantage that it is a measure of cash
earned by the enterprise as a result of its labour conversion process. The
surplus or net value added (after paying external costs and for labour) equates
largely (to within two or three percentage points) with the amount designated
as cash flow from operating activities in the cash flow statement contained in
the annual report and accounts. It therefore avoids some of the problems of
creative accounting which arose in the main out of reconfiguring the balance
sheet (capital) and releasing funds for distribution rather than from the
activities associated with the labour conversion process (Griffiths, 1986; Smith,
1992). An analysis based on this methodology can be made of any organization
which publishes its accounts in the form required by the various Companies
Acts. Increasingly these Acts include public sector organizations which are now
required to produce accruals-based accounts (HMSO, 1994, 1995).
Cash flow analysis
While the concept of value added shows how the firm has created the surplus,
a cash flow analysis based on the cash flow statement produced as part of the
statutory accounts shows the distribution of the surplus. It demonstrates
whether the business is:

increasing net cash inflow from operating activities;

able to fund comfortably its level of dividend payments and service its
debt;

maintaining its expenditure on fixed assets;

making acquisitions and generating funds by buying and selling

businesses; and

raising new share capital and/or debt.

Finally the cash flow statement shows what level of funding is needed and how
the businesss cash position has changed (Ellis and Williams, 1993).
The demands for cash flow statements began to appear in the late 1960s,
when the subjective nature of accounting profit became more apparent. The
demands were postponed until 1991 when the regime set up in 1970 to reduce
the variation in accounting standards itself collapsed. In the interim period,
companies were required to produce funds flow statements from which a cash
flow statement could be constructed. Surprisingly little attention has been paid
to the use of cash flow statements by academic researchers, despite their
concerns about the variability in the quality of accounting reports and the
relative merits of historic or current cost accounting conventions.

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Implications of the model for the scope of analysis

The model can be used in several important ways:
to examine how the surplus in the organization is generated, the scope
for management action and the implications for outsourcing, the
workforce, consumers, etc.
to distinguish between different companies and sectors, in different time
periods, and to show how and why they differ;
to show the relations between companies and sectors; and finally
to make a social analysis of the particular form that the stakeholder
conflict takes in an industry, as the revenues, costs and the size of the
capital base change.
The accounting data in the annual report and accounts used in conjunction
with this model therefore permits not only a financial analysis but also an
economic, political and social analysis of a company or business sector since the
focus is on how the value created by the company is distributed to different
social groups, all of whom have claims on it. Because the size of these claims is
determined largely by exogenous considerations, the model recognizes that
there is conflict inherent in the relations of both production and distribution in
capitalist firms.
Background to the privatized water industry
It is necessary to make a few brief points about some of the accounting and
financial issues surrounding the privatization of the water industry in order to
understand the operation of the industry. Privatization presented the
Government with three issues to resolve: the forms of regulation; the funding of
the large EC-determined investment programme; and the form of capitalization.
Each of these will be considered in turn.
The regulatory functions were split three ways: environmental; drinkingwater quality; and economic. Economic regulation was to be carried out by the
newly established Office of Water Services (OFWAT) which would control the
prices via price capping based on statutory capital expenditure and average
industry costs or yardstick competition (Littlechild, 1986). But if any of the
quality regulators change their standards, this imposes expenditure on the
companies which may then apply to OFWAT for an adjustment to their price
cap. Thus OFWAT operates within a wider regulatory regime. Price capping is
applied only to the core activities of the companies despite the fact that the
parent company typically has a number of other subsidiaries, some of which
sell the bulk of their output to the core business.
The price cap was set at about 5 per cent above the rate of inflation, as
measured by the Retail Price Index (RPI) although it varied between
companies depending on their investment programme by the Government in
its capacity as the regulator of a publicly owned utility in 1989 before
privatization. The price cap, once fixed, was to stand for five or ten years and

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was intended to give incentives to the businesses to improve efficiency and earn
extra profits over and beyond the profit level implied by the price-capping
formula. Such profits would not be clawed back during the five-year period. But
the long-term benefits of improved efficiency would be passed on to the
consumer at the end of the period, when any excess profits could be clawed back
via the price-capping formula for the next period (OFWAT, 1992a).
The provision for rising real prices contrasted with the other privatized and
regulated utilities, which had been required to reduce prices in real terms. The
justification for this difference was that while privatization was being
considered in the 1980s, the financial implications of EC legislation on improved
water quality and waste-water treatment became apparent. It was estimated
that more than 28 billion of capital expenditure would be required to
compensate for years of neglect and underinvestment resulting from successive
governments macro-economic policies, and to restore service provision to that
required by public health and environmental standards. This estimate was later
revised upwards (OFWAT, 1990) and additional investment programmes have
been required (OFWAT, 1993b, 1994a). The European obligations, unless they
could be recouped by price rises, would have made the privatization
unattractive in the City.
The Government wrote off the industrys debts of 4.95 billion before
privatization and gave a further 1.25 billion cash injection, known as the
green dowry, towards the cost of the investment programme. The
Government sold the assets off cheaply at 5.25 billion which was much less
than the 8.87 billion net book value of the assets (historic cost), or the 34
billion (current replacement cost). It was even less than the debt write-off plus
the green dowry, not to mention the costs of the privatization itself. The
significance of a low capitalization was that it ensured that the companies could
generate an adequate rate of return, while allowing prices to rise to a politically
acceptable level to fund the investment programme.
Thus to summarize, the Government chose a method of economic regulation
based on long-term price capping with little further financial control of the
operations, expenditure or distribution of the water businesses proceeds.
Prices were set by the Government on the basis of an estimate of the businesses
investment plans, operating expenditure, capital maintenance and rate of
return on capital (Vass, 1993). The terms of the sale of the water industry were
designed specifically to ensure that the assets of the water industry, built up by
the contributions over more than a century of tax-payers and customers past
and present, would earn a return for its new owners and form the basis of
financially stable enterprises (NAO, 1992). Furthermore, the regulator would
pass on the benefits of efficiency gains to consumers via lower prices in the
future.
Data sources
The water industry consists of the ten privatized water authorities, which
operate as regional monopolies and supply water and sewerage services, and

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also the former privately owned Statutory Water Only Companies (reduced in
number via takeovers and mergers from 29 to 19 by April 1996). This study
relates to the ten water and sewerage companies because they constitute the
greater part of the industry. The cost structure of the ten large companies is
very similar to that of the industry as a whole (OFWAT, 1995b). For the sake of
brevity, these ten water and sewerage companies are henceforth referred to as
the water companies.
Each of the water companies is organized as a group or parent company with
a number of subsidiaries, one of which is the core or regulated water and
sewerage business. Although these core subsidiaries are allowed also to carry
out non-regulated activities, in fact they carry out virtually no other activities.
The analysis presented here relates only to the core businesses.
These subsidiaries produce two sets of accounts: those required by the
Government, which use historic cost conventions and those required by the
regulator, which use a form of financial capital maintenance. This study makes
use of:
financial data from the statutory accounts based on historic cost
conventions to enable comparisons to be made between the core
businesses and their parent companies at a later stage;
cash flow data from the company accounts and summarized in the
regulators reports on company performance (OFWAT, 1991a, 1992b,
1993a, 1994d, 1995d); and
the regulators reports on the companies performance (OFWAT, 1991a,
1992b, 1993a, 1994d, 1995d).
The accounting information of the ten water subsidiaries was aggregated to
create an industry total. Privatization, for which there had been several years
preparation both prior to and after the Governments announcement of its
intention in 1985, took place at the end of 1989. A number of the water
authorities activities were transferred to the National Rivers Authority (NRA)
and other restructuring consequent on the reorganization of the industry for
privatization took place for some time after April 1989. Since the first accounts
of the newly constituted water businesses were presented for the period April
1989-March 1990, the first years accounts include both the old and the new
regime and are marked by the disruption due the privatization process.
Although this paper is concerned with the industry since privatization in 1989,
this of necessity entails a comparison with the years prior to privatization.
Using the accounts for the five years prior to privatization, in addition to the
post-privatization accounts, permits an analysis of the industry over an 11-year
period.
Post-privatization performance
Sales revenues increased steadily over the entire period, but more rapidly after
privatization (see Table I). It is important to note that:

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95 per cent of domestic sales (which, in turn, are about two-thirds of total
sales) are based on a form of property valuation and therefore are not
volume-related;
sales revenue may therefore arguably be considered as equivalent to a
form of tax rather than a voluntary sale; and
the charges are set for the year, and paid in advance.
Total weighted average volumes of both water delivered and sewage collected
have declined slightly since privatization (see Table II). A more detailed
analysis (Shaoul, 1995) has shown that this was due largely to the change in
industrial demand resulting from the recession in the early 1990s and the
changing composition of industry. This contrasts with rising volumes during
the 1980s.
The increase in revenue was therefore the result of the price formula set by
the Government in 1989 in its capacity as regulator rather than any increase in
the volume of business. This interpretation is confirmed by OFWATs analysis
of demand and estimates of future levels of demand (OFWAT, 1994b). It is in the
context of this declining or static volume of business that the companies
performance must now be considered. It is useful to remember that this model
points to what is likely to happen when demand is stagnant: costs must

Sales (m)

Table I.
Sales, purchases and
the value added fund

Purchases (m)

Value added (m)

1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995

2,249
2,467
2,742
2,932
3,172
3,326
3,698
4,196
4,539
4,859
5,155

728
712
771
692
833
1,082
1,156
1,254
1,302
1,301
1,428

0.32
0.29
0.28
0.24
0.26
0.33
0.31
0.30
0.29
0.27
0.28

1,521
1,755
1,971
2,240
2,339
2,244
2,542
2,942
3,237
3,558
3,727

Total

39,335

11,259

0.29

28,076

Source: Annual reports and accounts (various) of ten water and sewerage businesses (based on
historic cost accounts)

1991-92

Table II.
Volume of water
delivered and sewage
collected

Purchases/sales

1992-93

1993-94

Water (ml/d)
12,913
12,601
12,443
Sewage (ml/d)
N/Aa
10,067
9,896
Note: a Not reported prior to 1992-93
Source: OFWAT (1995b), based on current costs accounting conventions

1994-95
12,724
10,049

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somehow be reduced if prices cannot be increased, in the short term at least, as

a result of price capping by the regulator.
Table I shows that the cost of bought-in goods and services (external costs)
has doubled since 1985. The ratio of purchases to sales averaged 29 per cent for
the 11-year period as a whole. A 29 per cent purchase to sales ratio is unusually
low compared to 60-70 per cent in the manufacturing industry and 80 per cent
in retailing. This is because the water industry, being a primary industry, has
relatively little in the way of bought-in raw materials and services: its raw
materials are water and sewerage for which it does not pay; and many of its
activities are carried out in-house. The significance of a low purchase-to-sales
ratio is that it permits a high value-added fund and, potentially high profits.
It is therefore highly instructive to see how the value added fund is shared
out (see Table III). The most striking factor is that labour takes a very low share
of the value-added fund (29 per cent). This is lower than even the retail (40-45
per cent) or manufacturing (70 per cent) sector. It has declined fairly
continuously apart from the period around privatization. The reduction in
labours share was greater before privatization than after.
It is important to understand why labours share is so low and how this
reduction was achieved. Employment in 1985 was about 52,000, unusually low
for an industry generating this level of revenue. It was due to the fact that the
industry is highly capital intensive. Employment fell by 27 per cent over the
period 1985-1995. It had fallen by 17 per cent between 1981-1985 (WSA, 1993)
and by 11 per cent between 1985-1989, as some of the work was contracted out.
There was a policy commitment to use contractors where this proved to be the
most efficient method of working, and to do so even where there was no clear
evidence of a cost differential, in order to keep the numbers employed as low as

1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
Average

Labour: value
added

Labour costs
(m)

Number
employed

Cost per
employee ()

0.34
0.30
0.28
0.28
0.29
0.30
0.28
0.27
0.26
0.25
0.25
0.28

523
522
553
635
667
667
712
798
842
887
919

51,780
50,180
50,119
49,295
47,810
40,638
37,676
39,669
39,690
38,217
37,555

10,000
10,400
11,060
12,959
13,896
16,220
18,737
19,950
20,725
23,342
24,471

Source: Annual report and accounts (various) of ten water and sewerage businesses based on
historic cost accounts

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Table III.
Costs: labour and
value-added fund

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possible (Ogden, 1995). This reduction in employment resulted in a decline in

labours share of value added, from 34 per cent in 1985 to 29 per cent in 1989.
A further 10 per cent fall in employment occurred at privatization. This was
due in part to the transfer of some business operations to the NRA and other
subsidiaries of the parent companies. Further efforts were made to reduce
employment costs after privatization by ending national wage negotiations,
withdrawing union recognition and introducing non-standard labour contracts
which affected jobs, wages and conditions (OConnell Davidson, 1993). Labours
share of value added rose briefly at privatization, but then declined from 28 per
cent in 1991 to 25 per cent in 1995, less sharply than in the earlier period.
However, average employment costs per employee increased significantly after
privatization, suggesting that privatization was accompanied by some
combination of:
an increase in the percentage of highly paid staff;
a wage increase for some sections of the workforce; and/or
the loss of the less-highly paid.
Job losses in the 1990s have been fewer than in the 1980s, and in the other
privatized utilities. This suggests that, in the absence of a change in technology
or activities, there is relatively little room now for reducing employment levels
without affecting service delivery, as most of the improvements in labour
utilization were made in the run up to privatization. This and the already low
level of labour costs mean that shedding labour in the future will have relatively
little impact on the surplus (see Table IV).
The really extraordinary feature of the industry is that the largest share of
value added is the surplus available for investment in the industry and
distribution to the remaining stakeholders. It averaged 72 per cent for the 11year period. Such a high ratio of surplus to value added, although probably
unique to the water industry, occurred also under public ownership. It is a result

1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
Table IV.
Surplus created by the
water industry

Surplus: value added

Surplus: sales

0.66
0.70
0.72
0.72
0.71
0.70
0.72
0.73
0.74
0.75
0.75

0.44
0.50
0.52
0.55
0.53
0.47
0.49
0.51
0.53
0.55
0.54

Source: Annual reports and accounts (various) of ten water and sewerage businesses based on
historic cost accounts

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of the very unusual cost structure referred to earlier. However, the surplus as a
percentage of revenues dropped to 47 per cent after privatization because of the
increase in purchases and the average cost per employee as the number of
highly paid staff increased. It has since risen to the levels achieved under public
ownership.
However, several points need to be considered to explain this:
This increase in the surplus reflects an increase in sales revenue which
was set by the regulatory authority.
There was no increase in the volume of outputs.
There has been no marked change in the proportion of either external
labour costs or of labour utilization; despite a static or declining level of
output, merely the continuation of a trend, at a slower rate, begun under
public ownership.
The surplus is reaching the level obtained before privatization.
These factors taken together mean that the industry has not as yet been
radically transformed by the change in ownership.
While the analysis thus far relates to financial performance, the postprivatization performance of the industry should also be considered against
non-financial or physical measures, where these exist. Performance indicators,
known as levels of service, agreed by the industry and regulatory authorities,
are examined next.
Level of service provision refers to the availability of the water supply and
sewerage services. The measures include only five measures of physical
performance three indices of risk as assessed by the companies and two of
actual outcomes and several measures relating to customer service. They
have only limited use therefore, as output measures. A more detailed study
(Schofield and Shaoul, 1997) has examined all the publicly available data about
levels of service and output measures. It found that the quality of the
information was such that it was difficult to draw firm conclusions about
improvement in performance or the percentage of properties at risk from poor
services. This indeed was recognized by OFWAT (OFWAT, 1995c). Since the
overall physical level of service provision (as opposed to environmental and
quality standards) as reflected in these measures had achieved a relatively high
standard before 1989, (98 per cent and above), major improvements could not be
expected. The chief exception was the adequacy of the domestic water supply,
which was problematic in certain areas for reasons which will be developed
later. Furthermore, it was unclear whether the extent to which some of the
observed changes reflected improved performance or the varying weather
conditions. But the important point from the perspective of this study is that the
inability to radically transform the cost structure of the industry was not
countervailed by an improvement in other areas of performance.
Other studies of the utilities privatized in the first wave (i.e. British
Telecom and British Gas) have concluded generally that privatization without

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substantive competition resulted in few, if any, efficiency gains (Bishop and Kay,
1988; Dunsire, Hartley and Parker, 1991; Vickers and Yarrow, 1988). Indeed
some research (Dunsire et al., 1991) suggested that even the advent of
competition did not guarantee improved performance. This analysis, by way of
contrast, showed that the pattern of demand, the history and activities of the
industry, their associated (low) labour content and the slow rate of technological
change have provided little further scope for major gains in efficiency,
irrespective of ownership change or competition. It refutes the Governments
1986 claim that a major improvement in performance would occur.
In summary, therefore, despite the fact that the water industry is a very cashgenerative business, the market constraints cited earlier mean that the ability of
the water businesses to expand by raising output or increasing their surplus is
severely limited. Most of the efficiency improvements had already been made in
the 1980s. If an industry cannot grow organically, it must diversify for there to
be any chance of future growth. This has implications for the distribution of the
surplus, which will be considered later. But if the expected improvement in
efficiency and standards have not materialized, then the winners or
beneficiaries of privatization depend, ultimately, on the way in which the
surplus has been distributed. It is this issue which the next section addresses.
Distribution
The significance of private ownership is that the surplus must henceforth be
sufficiently large to cover the requirements of the new owners as well as all the
existing claims. The industrys unusually high proportion (72 per cent) of value
added available for distribution, as well as its absolute size, makes it unique
and, in principle at least, more able than other industries to satisfy the
numerous and conflicting demands for tax, interest, investment, renewal of the
infrastructure; dividends and growth. Table V shows the cash-flow statement
for the years since the privatization and hence the distribution of the surplus.
Cash from operations is the surplus or the amount remaining after the costs of
purchases and labour have been deducted.
Tax and interest
Taking the period as a whole, the debt write-off in 1989 meant that little interest
was paid, although interest payments have been increasing. Little was paid in
the way of tax, despite a tax rate of 33 per cent, because of the investment
programme and the 7.7 billion capital allowances set at the time of
privatization (NAO, 1992). Thus the nation as tax-payers has lost a source of
revenue to fund the services of the State. Although under public ownership, the
industry did not pay tax, the surplus was used to fund state services instead of
capital maintenance and enhancement in the industry itself.
Investment programme
The largest single claim on the surplus was the capital expenditure programme
(expenditure on fixed assets) required by the EC for coastal water clean-up and

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the restoration of drinking-water quality. Total investment was 11.4 billion

after allowing for capital grants and transfers, but before disposals. This was
considerably less than expected (NEDC, 1992) because of a decline in real terms
in construction costs: it was 15% below the level assumed in 1989 (OFWAT,
1992c, p. 4). While OFWAT did not draw attention to this or compare actual and
expected expenditure for each year since privatization, it did recognize that this
had occurred (OFWAT, 1994a).
The water companies spent 5 per cent more than expected on water services,
7 per cent less than expected on sewerage services and 2 per cent less than
expected overall (OFWAT, 1995a). No explanation was offered for this
underspend nor indeed was any evidence provided as to whether any or all the
companies had actually implemented all the projects that they had specified in
their 1989 plans. But it was known that Yorkshire Water had hoped to be able to
achieve a saving of 50 million on sewage treatment works as a result of the
Department of the Environment redefining the coastal waters within three
miles of Hull; this would have enabled Yorkshire Water to dump untreated
sewage straight into the estuary/sea. In the event, the local authority obtained a
reversal of this via a Judicial Review. But the significance of this from the

(m)

1990

1991

1992

1993

1994

1995

Total

1,626

1,907

2,084

2,310

2,655

2,923

13,507

344
2,651
7
3,003
1,377
0

126
615
0
490
1,417
1

6
793
0
787
1,298
4

79
1,253
24
1,356
954
10

184
786
1
971
1,191
7

199
762
11
951
1972
7

674
6,862
21
7,557
5,950
20

1,365
15
267
34
1,582
2,960

1,731
2
270
48
1,955
537

2,287
0
331
38
2,581
1,279

2,229
220
330
41
2,739
1,795

2,015
15
271
69
2,202
524

1,733
2
266
44
1957
9

11,360
195
1,736
274
13,016
7,088

Financing
Loans
Leases
Share issue
Total

217
2
4,203
3,987

1,027
0
90
1,117

978
0
0
978

800
57
600
1,457

574
8
0
566

11
21
0
11

3,172
30
4,892
8,095

Net cash

1,028

581

301

378

41

1,009

Cash from
activities
Returns
Net interest
Dividends to plcs
Interest leases
Total returns
Net cash
Tax
Investment activities
Fixed assets
Subsidiaries
Renewals
Disposals
Total
Net cash

Note: Fixed asset expenditure is shown net of Government grants

Sources: OFWAT reports on companies performance

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Table V.
Cash-flow statement for
ten water and sewerage
businesses

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398

perspective of the accounting model is that the company sought to reduce the
burden of investment by seeking a change in the regulations.
OFWAT did not however, claw back any of these savings via lower prices in
the next period. It is difficult to avoid the conclusion that the promised (but not
delivered) investment programmes provided the basis for higher prices. While
the companies can make an application to have their prices revised upwards if
investment increases, it seems that the consumers, via the regulator, have no
similar redress when investment turns out to be lower than was forecast.
Infrastructure renewals
Additional to the expenditure on improving the system is the expenditure on
maintaining the infrastructure: the renewal of the underground network.
Renewals cover repairs to burst mains, leaks, sewers, etc., both to the water and
to the sewerage systems. This is because the water industry has a vast and
ageing underground network of infrastructure assets mains, sewers,
impounding and pumped raw water storage reservoirs, dams and sea outfalls
which have a long life and must be maintained indefinitely.
By 1995, the companies had spent 1.7 billion on renewals. But the adequacy
of this expenditure for future service provision needs to be considered in
relation to the size of the system as a whole. The underground network
represents 75 per cent of the industrys assets and is worth about 110 billion at
current replacement cost (from annual reports and accounts for various years).
The assets have a life expectancy of about 60-100 years, implying an annual
renewals programme of about 1-2 per cent of their replacement value or 6-12 per
cent over the six-year period, or higher still if the infrastructure is in a poor
state.
Far from spending 10-12 per cent, the companies actually spent 1.5 per cent.
Irrespective of the age and condition of the network, this does not indicate an
extensive renewals programme. In the context of a decaying and ageing
network, this represents a very low spend. There was less spent on the
sewerage system (680 million) than on the water system (1,146 million) both
in absolute terms and in relation to the size of the two systems: 0.8 per cent of
the sewerage system and 3 per cent of the water system, (OFWAT, 1995a).
Furthermore, actual expenditure was lower than the provision for renewals
charge in the accounts in every year, indicating that the maintenance
programme has been delayed, and that the companies have built up a reserve of
about 285 million to be spent on renewals (see Table VI). Thus, not only was
expenditure low and declining, it was less than planned. Despite the fact that
the infrastructure constituted 75 per cent of the total assets of the industry, both
the provision and the actual expenditure on renewals was less than the
depreciation charge (on either a historic or a current cost basis) for the
remaining 25 per cent of the assets. From the perspective of the managers of the
water businesses, controlling the admittedly small expenditure on the
infrastructure, provides one of the few means of increasing the amount
available for distribution to other stakeholders.

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1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995

Historic cost
depreciation

Current cost
depreciation

Provision for
renewals

Actual cash
spent on renewals

209
230
264
232
257
243
272
324
381
442
507

N/A
N/A
N/A
N/A
N/A
N/A
589
674
713
785
882

N/A
N/A
N/A
217
224
329
367
364
338
340
283

N/A
N/A
N/A
N/A
N/A
267
270
331
330
271
266

Note: N/A = Not available

Source: Annual report and accounts (various) of ten water and sewerage businesses based on
historic cost accounts

Thus, by any objective financial maintenance criteria, the renewals programme

set at privatization was low and raises questions about the ability to deliver
services in the future. This overall picture is confirmed by an examination of
the physical data. We can estimate the percentage of each system replaced and
renewed by using data about the size of the maintenance programme since 1989
(OFWAT, 1995a), and the length of the system (WSA 1993): 4 per cent and 4.6
per cent of the water mains were relined and renewed respectively. Less than 1
per cent of the critical sewers were renovated and replaced, while 5 per cent of
the communications pipes were replaced.
Based on these investment levels, it would take more than 100 years to reline
or replace the water mains, and several centuries to renew or replace the critical
sewers. Yet sewer collapses are not infrequent events. In 1980, about 20 per cent
of the sewers were more than 100 years old (WRC, 1986), and there is no reason
to believe that this figure has changed very much, given the low level of sewer
rehabilitation in the 1980s. This picture is confirmed by the increasing amount
of water, totalling more than 30 per cent lost through leakage in the decaying
infrastructure (OFWAT, 1996). The high rate of leakages was responsible for
the inadequacy of the water supply in some regions, referred to in the earlier
section on levels of service.
The programme of infrastructure renewals was determined by past patterns
of expenditure rather than by the objective physical or even the financial
requirements of the system. It means that the companies are actually running
down the asset base and jeopardizing the future delivery of services. But this in
turn means that such a short-term perspective threatens to create additional
costs in the future.

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Table VI.
Infrastructure renewals

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400

Dividends
Finally we consider the level of dividends paid to the parent companies.
Dividends by 1993, at 5.312 billion, constituted 67 per cent of the surplus,
more than the original purchase price of 5.25 billion. The parent companies
paid out 24 per cent to the shareholders. By March 1994, they had spent 1.247
billion on acquisitions to provide future earnings growth with dividends
generated by and loans raised on the strength of the core businesses (OFWAT,
1994c). Yet in 1994 the core businesses accounted for 85 per cent of the sales but
101 per cent of profits of the parent companies, and an even higher percentage
of the profits in the following year; that is the parent companies other
subsidiaries and acquisitions were not very successful and were, in effect, being
carried by the core businesses.
The regulator recognized that the price formula set by the Government had
front-loaded the revenue stream, and it warned the companies against paying
out too much in dividends (OFWAT, 1991b). By 1995, the average return on the
ten water companies and the FTSE 100 Index for the period since privatization
were 94 per cent and 35 per cent respectively: water shares had outperformed
the market. As the regulator stated :
those who bought the original shares and retained them up to March 1994 would have made
an annual return of between 25 and 34% in real terms after the payment of income tax at the
standard rate (OFWAT, 1994a, p. 38).

He thereby confirmed that the shareholders had earned an above average

return.
Cash from operating activities exceeded the expenditure on new capital
equipment and infrastructure renewals over the six-year period (see Table V). In
other words, the companies could have covered both the investment and the
renewals programme entirely from revenues and spent the remainder on
additional infrastructure renewals had they not been required to satisfy the
demands imposed by private ownership for dividends and future dividend
growth. As it was, the only way that the conflicting demands could be met was
by borrowing. It was clear from the accounts and from OFWATs (1994c)
analysis of the water industrys debt that some of the parent companies were
recycling the dividends back in the form of interest-bearing loans, thereby
earning interest from the core businesses. But these loans constitute a charge on
the surplus created by the industry which will intensify the conflict over the
distribution of the surplus in the future and, in turn, necessitate higher prices if
all these claims are to be met.
This stakeholder analysis relating to the distribution and use of the surplus
by the core businesses shows that there is more to distribution than
dividends: it encompasses tax, interest, investment, dividends to the parent
companies and ultimate shareholders, diversification and the circulation of the
funds produced by the water businesses. Even local monopolies which are as
profitable as water and, as yet, do not have to pay significant amounts to the
government or the banks can only satisfy the conflicting demands of the stock

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market and capital replacement by means of high prices, job losses and loans. It
refutes the claim that private ownership would benefit the industry, the nation
and the customer. It demonstrates that the real beneficiaries of the change in
ownership are the new owners. Furthermore, the benefits of privatization have
had more to do with the terms of the privatization settlement, including
regulation, than with the efficiency initiatives introduced by the water
companies themselves.
Enabling accounting
The Government justified its privatization programme, of which the water
industry was part, on a number of grounds. In particular it claimed that
privatization would improve industrial performance by subjecting the
nationalized industries to the discipline of the market and so yield benefits, via
greater efficiency, to the industry, its customers and the nation.
This paper has used an accounting model and the financial numbers in the
annual reports and accounts to describe and explain the outcomes of the
privatization of the water industry. The evidence does not substantiate the
Governments claims. First, the study has found that greater efficiency, meaning
lower costs relative to output, did not occur. Significant increases in efficiency
had occurred prior to privatization, leaving little room to improve efficiency
without jeopardizing levels of service and future service provision. Second, the
distribution of the surplus, which publicly is seen as a conflict between
consumers and shareholders, is in fact much wider than this. It has not only
substantially benefited the shareholders at the expense of other stakeholders,
but it has also created the conditions whereby the other stakeholders will be
disadvantaged in the future. The real beneficiaries, it can be seen now were
largely invisible in the Governments case for privatization.
The value-added model, by distinguishing between internal and external
costs, is able to show the impact of the different ownership regimes on the
surplus of the industry. The cash-flow statements provided the means by which
the distribution of the surplus to the different stakeholders could be revealed.
The rival claims on the surplus have resulted in a conflict which was resolved
in favour of the shareholders at the expense of consumers, the industry itself
and future levels of service. Furthermore, the more recent public concern over
the adequacy of the water supply and the crumbling infrastructure means that
capital maintenance cannot be delayed indefinitely. Taken together, they
indicate the tendencies of development. Given that the regulators primary duty
is to ensure that the water businesses can continue to finance their activities,
which include dividends, then the regulator must allow prices to rise.
Such outcomes are far removed from the original claims that were made for
privatization. The analysis has shown that the expectations were always
unreasonable because it was impossible to increase revenues by increasing
output. Neither was it possible to improve in any significant way the
businesses operating characteristics, given labours unusually low share of

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value added. Indeed this analysis casts doubts on the Governments unstated
assumption that the industry was inefficient.
While an analysis such as this conceals many important aspects of social
reality, and while the data are in many respects inadequate, what has been seen
is that it is possible to use an accounting model with the publicly available
corporate data to make an objective social analysis and critique of economic life
and thereby challenge existing notions and problem definitions. Several major
points can be said to have emerged from this analysis which have important
implications for the debates not only about privatization but other aspects of
public policy:
The financial evidence refutes the assertions about the superiority of
private ownership in controlling costs.
It casts doubt on the tacit assumption of public sector inefficiency and
raises questions about the ability of management to endlessly increase
efficiency.
Furthermore it refutes the notion of the stakeholder economy from
which all can benefit (Hutton, 1995) by showing empirically that the
stakeholders are in conflict.
The constructive or enabling power of the accounting model lies in its ability to:
challenge existing problem definitions and the rhetoric accompanying
the introduction of reforms and policy changes; and
pose alternative questions and solutions.
Instead of or in addition to evaluating public policy in terms of efficiency, this
study has shown the importance of analysing and evaluating the distributional
impact of public policy on the different stakeholders. While not rejecting the
need for more corporate disclosure for the benefit of other stakeholders, this
work has shown that it is possible to use existing corporate data to assess the
effect of corporate behaviour on consumers, the workforce, the industry and the
public.
This study has shown that the source of the distributional conflict was the
inadequate surplus relative to the amount of capital investment which had been
funded by past generations of consumers and tax payers and which was now
required to provide a return to the new owners. The conflict can be resolved in
the wider public interest only by excluding the claims of one of the stakeholders
the new owners.
Finally, the issue, surely is not whether this or that industry or service
benefits from a particular policy but whether all economic life is to be run in the
interests of the privileged few, seeking ever-higher profits; or whether it should
be organized to meet social and public needs, not just of this but also of future
generations. After all, if even the most cash-generative industry in the country
cannot meet all the claims on the surplus, the stage is set for increasing social,
economic and political conflict. To ask the question is to answer it.

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To conclude: an accounting model working with publicly available corporate

data can be used to make an objective social analysis and critique of economic
life. It can, moreover, assume a constructive and emancipatory role by
challenging existing problem definitions and by posing alternative questions
and solutions. This is possible because the concepts and practices of
conventional accounting and finance are the reflections of the social relations of
capitalism (Bryer, 1994). They are thus the mirrors in which those relations are
revealed for the kind of analysis and critique which surely are the prime
functions of research scholarship. It signifies that we can use accounting to say
something about the social world we live in. However, whether or not it is
emancipatory depends on the stakeholder perspective and programme of those
who use it.
References
ASSC (1975), The Corporate Report, Accounting Standards Steering Committee, London.
Adcroft, A., Cutler, T., Haslam, C., Williams, J. and Williams, K. (1991), Hanson and ICI: the
consequences of financial engineering, Occasional Paper on Business, Economy and Society,
No. 2, University of East London, London.
Berry, A., Capps, T., Cooper, D., Hopper, T. and Lowe, E.A. (1985), NCB accounts a mine of
disinformation? Accountancy, January, pp. 10-12.
Bishop, M. and Kay, J. (1988), Does Privatization Work? Lessons From the UK, Centre for Business
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