Thames in trouble, financial resilience, and AMP8 prospects

The nation is understandably absorbed in the financial drama at Thames, what this indicates about financial resilience in the wider water sector, and how we should respond as regards ownership models, industry structure and regulation (summary points below). Views are, obviously, polarised on these points, but the developments of last week suggest the path the industry is currently on – with draft plans for the coming five years due in just a couple of months – is highly fraught, and perhaps in some quarters untenable.

Features of the industry's path

• A doubling to tripling of investment in 2025-30, to drive towards securing basic services (sufficient future clean water supply) and responding to heightened environmental demands (storm discharges, nutrient neutrality). The bulk of this is driven by statutory requirements.

• Hostility to bill increases to fund this investment – evidenced by widespread media coverage last week of the prospect of 40% price rises; arguments gaining traction that customers shouldn’t ‘pay twice’ for green improvements they believe they have already funded; and political nervousness about the cost of essential services during a cost of living crisis. This was signalled by chancellor Jeremy Hunt’s meeting with utility regulators a week ago, which was technically about passing on inflation reductions promptly, but also signalled a broader concern about the affordability of bills.

• Waning shareholder appetite in the face of tightening policy and regulation, public hostility, soaring costs, unwieldy expectations about AMP8 investments and preferable alternative homes for capital. The toxicity of lots of last week’s debate and the associated uncertainty it has brought will only make it harder and more expensive to attract finance.

• Lack of any Government appetite for taxpayer funding to deliver public interest outcomes such as river health.

This is a Catch 22. If investment is scaled back in line with affordability, financeability and deliverability constraints, it would attract further criticism and delay urgently needed infrastructure improvements. Alternatively and preferably, some kind of positive adjustment in the risk/reward balance could be made to investors, and higher bills socialised with customers – but both would be unpopular and difficult to pull off given the intense criticism the sector is under.

Cheaper and greener, nature, catchment and outcomes-based approaches could be deployed where feasible to alleviate financial and carbon costs – but greater freedom for companies and uncertain results fly in the face of a public discourse hungry for fast improvements and tougher regulation.

The challenge is crystallised in a letter sent on Saturday from the shadow environment secretary, Jim McMahon, to his government counterpart, Therese Coffey, advocating six tests to “form the basis of a government act and protect plan, preventing taxpayers and workers from paying the price for boardroom failures”. This amounted to: no taxpayer or customer funded bailouts; no backtracking on investment earmarked for sewage spills and leakage; and shareholders or parent companies to plug any investment gaps – while a moratorium is placed on dividends and asset disposals are paused. Meanwhile any UK pension funds’ exposure through investing in companies of concern should be reviewed; and water workers with pensions shouldn’t be left high and dry.

The drama may be alluring, but a reality check seems sorely needed.

The salient summary points from last week’s events

Thames’ finances

• There is a risk that Thames has insufficient funding to operate effectively and, crucially, to meet its debt obligations.

• The widely reported causes of Thames’ distress can be traced to £14bn of debt, half of which is RPI-linked and which has become a struggle to manage since interest rates have spiked and because bills are now tied to the lower CPI metric. And to long-running struggles with operational issues (traditionally leakage, and more recently, storm overflow discharges as well). This has led to ODI penalties which ratings agency DBRS Morningstar calculated to be £53m in 2020-21 and £51m in 2021-22. In a note, it pointed out: “TW has reported large losses in FYE22 and FYE21 of £973.3m and £198.5m, respectively. These losses have made raising the additional capital from its current investor base even more difficult.”

• A year ago, Thames’ shareholders committed to inject £1.5bn of new equity into the business, and to an extra £2bn of capital expenditure. Specifically, investors pledged an initial £500m of equity in the 2022-23 financial year, with plans for an additional £1bn to be approved before 2025, as long as Thames’ turnaround stays on track. £500m was put in in March, but the other £1bn has not been forthcoming – probably a result of deteriorating prospects for the company on fronts including an increasingly toxic public reputation, patchy turnaround progress, huge investment demands for AMP8 and beyond, tightening regulation and high costs, on top of the existing issues of debt liability (with refinancing need) and poor performance.

• Reports swirled all of last week that Thames was on the brink of financial collapse and may need to undergo emergency nationalisation via the Special Administration Regime – where public support would be provided in the absence of an alternative, amounting to temporary public ownership. This speculation is generally regarded as overblown within the industry, with the discussion of contingency plans seen as a sensible precaution rather than a likely outcome.

• Despite the unattractive nature of the proposition, Thames’ shareholders are ultimately expected to put their hands in their pockets to avert the immediate crisis. Indeed the Universities Superannuation Scheme (USS), which has a 20% stake, has publicly committed to continue to support the turnaround. Other shareholders in the sector are doing likewise. Macquarie poured £1bn into Southern Water when it bought a majority stake in 2021 (there are reports of another £500m potentially going in now); Anglian has voluntarily deleveraged; and just last week Yorkshire Water raised £500m from its shareholders.

• Sarah Bentley resigned abruptly as chief executive last Tuesday, after just under three years in post (since September 2020) and still in the foothills of the eight-year turnaround she had been leading. Speaking to The Water Report in May 2021, Bentley said: “We’re not going to be turning around and going ‘ta-dah! look what we did!’ in 18 months.” But it seems the company became less patient. CFO Alastair Cochran and strategy director Cathryn Ross have assumed the role of joint interim CEO while a permanent successor to Bentley is recruited.

• Thames Water has appointed infrastructure and utilities specialist Sir Adrian Montague as chair, effective 10 July. Sir Adrian served as chair of Anglian Water in 2010-15 and is currently chair of Cadent Gas and Manchester Airports Group, though the latter will come to an end in September. His other previous chair roles have included Aviva, British Energy and 3i Group. Current chair Ian Marchant announced in April he would step down once a successor had been found. Sir Adrian's appointment has been widely welcomed as a highly experienced and steadying influence.

• Thames has issued statements to customers and suppliers that it is operating as normal and remains committed to its turnaround plan.

• Both Thames and Ofwat have emphasised the company’s strong liquidity position including £4.4bn of cash and committed funding, as at 31 March 2023, and shareholders’ March 2023 £500m equity injection.

• Whatever the outcome of the current financing situation, it seems likely that Thames will need to adopt an unwavering focus on fixing the basics going forward, which could come at the expense of its more progressive work – for instance on natural flood management and smarter catchments.

Implications for the wider industry

• Thames and other water companies have issues in common, including infrastructure challenges today, soaring expectations for tomorrow, inflationary and interest rate pressures, public hostility, and (to varying degrees) debt liability. More than half of the sector’s debt costs are linked to inflation. There has been a lot of focus in reports on the fact that companies were privatised with a clean balance sheet but how have £60bn of debt, most of it taken on when borrowing was cheap. Now inflation is high, companies face shocks but some lack a sizeable equity buffer to absorb it. Thames’ situation specifically is aggravated specifically by its size, high debt level, and long-term operational underperformance.

• Ofwat has signalled the sector remains financially resilient. In a statement, it said: "Overall, the sector is continuing to attract international capital and is especially attractive to long term investors such as pension funds. Indeed, there has been an additional equity injection of around £2bn since 2020, with companies acting to strengthen their financial position.” This position was supported by water minister Rebecca Pow in answering an Urgent Question in Parliament. She said: “The sector as a whole is financially resilient” and pointed to “Market confidence in the sector is demonstrated by new acquisitions, such as Pennon’s purchase of Bristol Water, and by shareholders being willing to inject new capital.” Moreover: “Debt to equity fell last year by 4% in the water industry, actually making it more resilient.”

• However, DBRS Morningstar said: “TW’s current unstable financial position and infrastructure problems will likely have a bearing on other sector participants, adding to sector credit risk and the ability for companies to raise capital at a reasonable cost.”

• Some have warned of a domino-effect, should Thames fall over.

Future ownership and structures

• It would be a strange twist if necessity rather than ideology triggered water’s (even temporary) return to state ownership under a Conservative government.

• Legitimate questions over the industry’s financial fragility have re-opened the debate about ownership that last surfaced under Jeremy Corbyn’s Labour manifesto ahead of the 2019 general election. Boris Johnson’s landslide victory put pay to that, and nationalisation is no longer Labour policy. But now more than then, public ownership of water has entered the national discourse, and seems to be gaining traction as an idea.

• Existing pro-public ownership groups have snapped up the opportunity to find an alternate route to their end goal. A WeOwnIt petition, for instance, called on business secretary Kemi Badenoch to permanently nationalise Thames Water, and to use legal powers to protect billpayers rather than bailing out shareholders and creditors. Director Cat Hobbs said: “Thames Water needs to go into special administration and then stay in public ownership. This kind of model has been used before, with Railtrack becoming publicly-owned Network Rail.

“The situation is precarious with Thames Water and the other private English water monopolies. The responsible thing for the government to do would be to get ready for more private companies to collapse by setting up shadow public sector bodies in every region to take over from failing water companies. These should involve councils and communities in developing a plan to sort out leaks and sewage.”

The petition secured 10,000 signatures in less than 24 hours.

• While Labour no longer has full nationalisation in its sights, McMahon last week openly criticised the current organisational arrangements. He said: “The Conservative Party’s cycle of privatising profit, usually for multibillion-pound foreign sovereign wealth funds, and nationalising risk is not sustainable, and neither is it a fair deal for working people.” Labour’s six test letter (see above) seemed to suggest private entities should stand but profit be spent solely on investment. How that would attract the billions of pounds of new capital required was unclear.

• The Liberal Democrats have suggested reforming water companies into ‘public good’ companies, transforming their boards and priorities in the interests of the environment and consumers.

• Water Minister Rebecca Pow defended the current model, arguing among other things: “Since privatisation, total capital investment has outstripped dividends by 250%” and “Since privatisation, capital investment in the water industry has been 84% higher than it was pre-privatisation—we need to get that out there and on the table…Privatisation has enabled clean and plentiful water to come out of our taps. It has unlocked £190bn of funding to invest in the industry. That is the equivalent of £5bn annually, and is double what we had pre-privatisation.”

• However, reported moves by Severn Trent’s Liv Garfield to rally her fellow water industry chief executives and the Labour front bench to reform companies as privately-owned, profit-making “social purpose” companies that give greater weight to the needs of customers, staff and the environment suggest some in the sector at least see maintenance of status quo as unrealistic. Many online commentators have condemned the move as greenwashing.

Regulation in the dock

• Regulators are already out of favour for tolerating spills and leaks for too long. Labour has already signalled it plans to reform Ofwat and the Environment Agency.

• Some of the recent headlines have focused on why regulators have allowed companies to gear up, pay shareholders out and underdeliver for customers and the environment. The sentiment was articulated by Labour MP Angela Eagle, who said in Parliament: “When they were privatised, water companies had all the debt written off, so they started with zero. Since then, they have borrowed £53bn much of which has been used to help pay £72bn in dividends. The investment has been made by borrowing and putting it on to customers’ bills. Now, the ratings agency S&P has negative outlooks for two thirds of the UK water companies it rates, because they are over-leveraged and took out too much debt in an era of low interest, which they now have to pay back. This is not a triumph but a huge problem for the resilience of our water industry.”

• Some, even Conservative, politicians seem to be growing impatient with Ofwat. Robert Buckland, for example, said aspects of Ofwat’s operation do not seem to be in customer interests. Robert Fuller called for better oversight of the regulator. However Pow robustly defended Ofwat and insisted regulation was fit for purpose.

• There is a growing narrative, too, of regulatory capture. A piece in The Observer yesterday reported 27 former Ofwat directors, managers and consultants are now working in the industry they helped to regulate.

• Issues for those closer to the industry

– Long-term awareness of Thames’ vulnerability: Ofwat gave the "significant scrutiny" company the lowest ‘D' grade in its Initial Assessment of Plans (IAP) ahead of PR19 for “securing long-term resilience”.

– Squeezed cost efficiency at PR19: Thames’ original business plan at £11.7bn totex was over £2bn adrift of Ofwat’s IAP figure of £9.4bn. Sector totex then at £56bn was 13% above the level Ofwat considered necessary, with a 7.9% gap on wholesale base costs on average and a 30% gap on enhancement costs. By the Final Determination stage, the disparity had closed considerably but on base costs, Anglian and Yorkshire faced a significant challenge, while on enhancement costs, there are material gaps for five firms, including Thames.

– The pledge this time last year by Thames’ shareholders to inject £1.5bn of equity was a huge win for Ofwat. It boosted the PR19-agreed business plan from £9.6bn to nearer the £11bn originally sought by the firm, and came after considerable cajoling by former chair Jonson Cox. The message seemed clear: if price determinations are set too tight but companies choose not to appeal them, it is shareholders’ rather than customers’ problem. Last week’s events suggest this is less clear cut.

Further scrutiny

• The Environment, Food and Rural Affairs Committee has “invited” senior management from Ofwat and Thames Water and water minister Rebecca Pow to a public hearing on 12 July to scrutinise the causes of Thames Water’s issues and potential solutions; whether other water firms face similar difficulties; and the regulation and legal oversight of water utilities.

• Tomorrow, Ofwat’s chiefe executive officer, David Black, and its chair, Iain Coucher, will give evidence to the House of Lords Industry and Regulators Committee’s follow-up work to its inquiry into the work of Ofwat.