Ofwat is tightening up its guidance on dividend payments – the water sector regulator has told the water companies they should consider withholding or restricting dividends where there are significant service failures to be addressed or there is a risk of regulatory fines, penalties or a need to take remedial actions.

Introducing the updated guidance, Ofwat said equity investors have an essential role to play in providing the finance necessary for companies to deliver their investment programmes, to encourage companies to be efficient and to meet the levels of service expected by customers and wider stakeholders.

However, the regulator goes on to caution that as monopoly providers of essential public services with “inflation-linked revenues paid for by customers”, it was “critical” that companies can demonstrate that decisions on dividends reflect delivery of the company's wider obligations.

Ofwat expects dividends to take account of a range of issues, including:

• service delivery for customers and the environment
• current and future investment needs
• financial resilience over the longer term.
• dividends declared or paid reward efficiency and the effective management of risks to the business

In order to maintain public trust in the water sector, Ofwat says it is “imperative” that each company is transparent to customers and other stakeholders about its dividend policy.

As part of its review of companies' annual performance reports, Ofwat now intends to report on each company's compliance with the dividend policy licence condition. The regulator may also decide to write to companies individually where it has concerns with a company's dividend policy, the application of the policy, or disclosure in its annual performance report.

Ofwat said it will take action if it considers a company has not complied with the dividend licence condition.

The regulator requires “any and all dividends” to be justified, regardless of the purpose of the dividend or the position of the company, including preference dividends and dividends to service interest on intercompany loans and group debt.

Where Ofwat considers that a dividend paid or declared indicates a potential breach of the dividend policy licence condition, it may take enforcement action.

"In certain circumstances it may be appropriate for dividends to be “restricted or withheld”

Ofwat says in certain circumstances it may be appropriate for dividends to be “restricted or withheld.”  Examples include:

• where there is a need to support resilience
• where returns are low due to poor performance or poor historical financing choices
• where equity is needed to contribute to significant investment growth

The guidance states:

“If a company is significantly underperforming when compared with its determinations, has a serious performance issue in one or more areas or is encountering issues with financial resilience, the board may consider that funds would be better directed towards investing in improving services for customers or bolstering financial resilience. The board should also consider the external environment and if this poses additional risks that need to be taken into account.”

Ofwat says company boards should consider all areas of underperformance alongside outperformance in determining the level of dividend, including matters of public scrutiny.

Where a dividend is declared or paid, Ofwat would expect the company to be able to demonstrate that overall it has delivered against the majority of its performance commitments. “If a company that has underperformed seeks to pay a dividend, an additional explanation as to why this is appropriate is likely to be required,” the guidance says.

Investors should not be rewarded more than once for each year's performance

Ofwat goes on to suggest the water companies may also consider performance across a number of periods in determining the level of dividends. For example, if a company with performance in line with its determination withholds dividends for a specific year due to potential future liabilities or market disruption, “it may choose to reflect that performance in a future period where circumstances allow”.

Where a dividend is being paid in respect of previous years, Ofwat expects companies to explain the level of dividend in the context of performance during that period, along with any dividends that have already been paid in respect of the earlier years.

“Companies should provide sufficient explanation of how the board has ensured that performance in previous periods has not been reflected in previous dividends such that investors are not rewarded more than once for each year's performance,” the guidance states.

In addition, if a company “anticipates underperformance across a range of areas in future periods, the board should consider whether the funds would be better utilised in addressing that underperformance.”

Some companies need to attract new equity to improve financial resilience - may be may be an expectation of cash returns in the shorter term

Ofwat also acknowledges that some companies are in different positions to others in the sector, and that some need to attract new equity to improve financial resilience. The guidance states:

“While equity investors in such companies may expect to receive their return over a longer period, there may be an expectation of cash returns in the shorter term to help secure new investors who are prepared to invest to support a turnaround or to support additional investment by the regulated company.”

“Therefore, in some circumstances it may be appropriate to pay a level of dividend to recognise where significant improvement or progress along a recovery plan has been made.”

 Dividends should not be justified on basis of group obligations

The regulator goes on to warn that it is “not sufficient” for companies to justify or scale their dividend payments on the basis that a holding company in the group needs to meet specified interest costs or other holding company obligations.

Ofwat is emphasising that dividend decisions are the responsibility of the board of the regulated business and that such decisions should be made “independently of the group” and justified on the performance or financing needs of the regulated company.

“We do not consider it appropriate for dividends to be justified on the basis of group obligations,” the regulator says.

In addition, companies whose holding companies have inter-company loan or group loan obligations to fulfil should “reasonably expect” that the group structure builds in sufficient resilience and flexibility to manage holding company liabilities in periods when the regulated company is “unable to justify dividend payments or if dividend payments are insufficient to meet those obligations.”

Ofwat said it would not expect companies to make distributions based on decisions that “improve short term financial performance at the expense of longer term financial performance.” It expects companies to take account of the impact of paying out the dividend on the ability of the company to continue to finance its functions.

In terms of base dividend yield, in Ofwat’s view four percent is a reasonable yield for the period 2025-30 based on its early view of the allowed return for the 2024 Price Review.

However, Ofwat warns that this does not mean that investors are entitled to that level of dividend “if it is not supported by company performance.”

Click here to download the guidance in full.