Whatever angle you look at things from the prospects for future investment in the UK water sector don’t look good, for anyone. The travails of Thames Water especially (but other water companies are not exempt) have wrought such damage to the sector’s reputation that water, once a byword for the essence of life, is now more commonly aligned in headlines with words including risk, sewage and pollution.
Whether in infrastructure, through the Regulated Asset Base (RAB) compensation model, or the investment markets, attracting further injections of much needed cash are going to be difficult. This is not least because recent events raise the potential for aggressive haircuts to senior Class A debt. The market is already pricing in such an event, despite that debt amounting to less than 80% of the Regulated Asset Base (RAB) of the business. This has caused spreads to widen for all companies operating in the sector. And, on a comparison with other sectors, say UK Electricity or European/US utilities, spreads for bonds in the UK Water sector have widened significantly.
Severn Trent £ 2033s vs National Grid Electricity Transmission £ 2035s
Severn Trent underperforming by +45 basis points
Source: Bloomberg, 25 July 2024
Southern Water £ 2037s vs National Grid Electricity Transmission £ 2035s
Southern Water underperforming by +140 basis points
Source: Bloomberg, 25 July 2024
Draft Determinations (for 2025-2030)
Ofwat’s recent Draft Determinations (2025-2030 regulatory period) envisages allowing the UK Water Sector £91bn total expenditure and £35bn capital expenditure – an unprecedented level of investment, in order to replace aging infrastructure and address environmental challenges.
Applying the elevated debt costs – represented in the charts above – to this expenditure, would cost the industry hundreds of millions of pounds. A bad outcome for Thames Water debt would see these industry costs spiral higher still, further diminishing the attractiveness of the sector which needs to attract equity capital to help finance the necessary system upgrades identified by Ofwat.
The sector competes for equity capital internationally. If higher costs of borrowing became entrenched, Ofwat may have to ultimately revise its debt cost assumptions when it models future regulatory periods. In a vicious spiral, this could/would result in higher bills, for any given allowed equity return. For this reason alone, rising debt spreads should alarm everyone – from Ofwat, to the UK Government and UK taxpayer.
A simple fix?
There may, however, be a relatively simple fix to these issues. The UK Government could buy Thames Water and in fact do so by offering as little as £1 to existing equity holders, currently unwilling to commit new funds and already having written their investments down to zero. The UK Government could then invest £2.5bn equity over 5 years, which the Ofwat Draft Determination envisages for Thames Water.
Based on Ofwat’s assumed capital structure, the UK Government would earn a 4.8% real return on this investment. Over time, rather than paying out dividends to private shareholders the return achieved could be reinvested and lower bills, in the Thames region (the Welsh Water model) or alternatively, taken as a dividend or used to deleverage the capital structure.
If the UK Government didn’t want to fund this investment at Gilt yields, it could monetise a small proportion of other publicly held assets, such as it has with its stake in NatWest.
Scottish Water is already publicly owned. Welsh Water is owned by Glas Cymru, a private company limited by guarantee, with no shareholders. It operates under Ofwat’s regulatory regime for England & Wales. So such a move, by the UK government for Thames Water, would not be something particularly new for the sector.
Who takes the financial hit?
Alternatively, existing equity holders may attempt to sell their stakes to new private equity / infrastructure / pension investors. If the existing owners expect to get more than £1, i.e. they believe equity value remains in the business, it isn’t immediately obvious why the class A bonds should be trading at 70p (cash price).
One answer to that is that new private sector owners are likely to demand a very high return on equity to invest in Thames Water, and to get there they would attempt to force debt write-downs. That outcome would inflict losses on, among others, UK pension holders who typically own Investment Grade bonds in their pension portfolios.
If such write-downs were inflicted and Thames Water’s debt/RAB brought into line with the industry average (65%) the new owners could end up in the fortunate position of having acquired up to 35%, of a £20bn UK Utility Regulated Asset Base, for a fraction of the cost. For the UK taxpayer, this represents a poor outcome especially when, in our view, there is a relatively simple solution to the present predicament.
Returns for a modest outlay
If HM Government become an arms-length equity owner, as with NatWest, it could allow Thames Water to undertake the capex required to improve its aged systems and maybe even earn the Government / the UK taxpayer an attractive real equity return. In the process, bond spreads for the sector as a whole, could be narrowed/tightened back towards levels in line with utility companies in other countries – representing a further saving to UK taxpayers.
UK Government ownership, of Thames Water assets, could be the most suitable outcome – a trustworthy investor with the longest time horizon. The sector could then focus on financing investment to improve operational performance, which is the focus of the next review period. This is an outcome that would benefit the Government and UK taxpayers for what is a modest initial outlay.
Appendix: UK Water spread underperformance examples
While there are no UK Water only credit sub-indices we can look at bonds spreads at the issuer level to see this. For instance:
- At issuance in February 2022, Severn Trent £ 2033s (XS2445344570) priced with an approximately -15 basis points tighter spread to Gilts than National Grid £ 2035s (XS2241245203). Today the same Severn Trent bond trades +30 basis points wider than National Grid, representing a +45 basis points underperformance.
- Over the same period UK Water companies with lower credit ratings, such as Southern Water, have widened more significantly. The Southern Water £ 2037s (XS2180916871) have widened from +5 basis points wide of National Grid to +140 basis points back.
