“The water sector is relatively predictable, so much so that you can usually get a reasonable idea of what the next year will be like for a company by looking at the previous year,” says Colm Gibson, managing director and head of the economic regulation practice at consultancy Berkeley Research Group.
Gibson would know, having spent six years as head of economic regulation at Thames Water between 2012 and 2018. But this industry is fast losing that predictability, reliability and attractiveness.
It comes after a summer when investors wrote off one company, regulator Ofwat placed it in special measures to turn it around, and two ratings agencies downgraded its debt to junk status. That company was Thames Water, the country’s largest water utility, which, in addition to poor operational performance, has the highest gearing ratio in the industry at more than 80 percent.
Other water firms, though, have also faced a rising tide this summer, with record fines doled out for failures to manage wastewater treatment, compensation fees to customers doubled by the government and some continuing to suffer from heavy debt burdens.
It all comes against the backdrop of the draft determinations for the next five-year regulatory period beginning 1 April 2025 and ending 30 March 2030 (PR24) released in July. It saw Ofwat cut a proposed £16 billion ($20.4 billion; €18.7 billion) in collective investment suggested by the 17 water companies in England and Wales, with £88 billion to be invested instead. Bills will rise 21 percent on average, with companies having requested an average of 33 percent.
Of the £88 billion to be invested, £35 billion will be pumped into infrastructure upgrades aimed at reducing pollution, improving the water quality of rivers and beaches, and enhancing the – in places Victorian-age – network’s resilience to the effects of climate change, trebling the level of investment approved for the 2020-25 regulatory period.
Ofwat has raised the allowed return from 2.96 percent in the PR19 regulatory period to 3.72 percent for PR24.
This reflects “a cost of equity of 4.8 percent and debt at 2.84 percent, and underpinned by a gearing ratio of 55 percent”, Ofwat said in a statement. “At these levels, taking account of the overall balance of risk and return in these proposals, Ofwat is satisfied that an efficient company can finance its functions,” it added.
Still, “there are a lot of moving parts”, as Yeshvir Singh, head of UK utilities at Fitch Ratings, points out. “There will be several iterations of the business plans the water companies submitted in October.”
There will have to be if those companies whose plans were deemed either lacking ambition or inadequate want to avoid the penalties those assessments carry.
“Ofwat’s allowances can also change between now and when the final determinations are issued in December,” Singh notes. “So, there are many moving parts within this timeframe that can ultimately determine the capital structure.”
A catch-22
However, in an industry that has been populated by infrastructure investors since privatisation, existing and potential investors question Ofwat’s view of its risk and reward balance. Many existing investors are unwilling to put more equity in, while there is a short supply of new investors waiting in the wings.
“If you have a good understanding of the sector,” says Gibson, “I personally think it is quite investable, in most companies’ cases, but the companies need to step up their investor engagement to attract that investment. That’s true for both debt and equity investment.”
Under normal circumstances, Gibson’s advice makes sense. The problem, however, is that with many of the utilities’ leverage ratios significantly above the 55 percent notional average Ofwat is recommending, the situation is a bit of a “double whammy”, as Fitch Ratings’ Singh puts it.
“While some water companies are aiming for a reduction in net debt, there is also a need to support increasing levels of investment. For highly leveraged water companies, this indicates a greater reliance on equity.”
“[Some of the water utilities] will find it more challenging to maintain their existing ratings and reduce gearing. It’s a… challenging backdrop… given the… heightened regulatory and political oversight”
Yeshvir Singh
Fitch Ratings
According to Singh, utilities that Fitch scores ‘low’ in two out of three credit ratios – net debt/regulatory capital value (RCV), cash post maintenance interest coverage ratio (PMICR), and nominal PMICR “will find it more challenging to maintain their existing ratings and reduce gearing. It’s a particularly challenging backdrop for achieving such objectives, given the presence of additional risks, heightened regulatory and political oversight, and an increasing risk of penalties and fines, compounded by rising customer expectations.”
The utilities that fall into this “challenging” category are Northumbrian Water, Wessex Water and South West Water.
Will Price, head of utilities, EMEA, at Macquarie Asset Management – which between 2006 and 2017 was a major shareholder in Thames Water and now an investor in Southern Water – is cognisant of the sector-wide need for additional capital – and the risk that it heads elsewhere.
“There is a global market for capital,” says Price. “Even within utilities, there is significant demand for capital to upgrade energy networks for electrification and decarbonisation – National Grid’s recent £7 billion equity raise, for example. On the draft determination, it would be very challenging to attract the scale of equity and debt required.
“Most of these companies are going to be cashflow negative in the next five years, even before interest. They all need lots more debt and lots more equity to fund these programmes, so it’s not just a case of wiping out the shareholder and moving on. You’ve got to find investors who are willing to put in incremental billions of money on the debt and equity side.”
After investing £1.1 billion in Southern Water in 2021, Macquarie invested a further £550 million in the utility in August 2023.
A maligned regulator
Assessments of Ofwat’s role in creating this situation varies. It has either facilitated a poorly performing sector, been taken advantage of by investors or ridden roughshod over the UK’s reputation for gold standard regulation, depending on opinions. Some stakeholders, like Price, whose Macquarie
is a sizeable investor in gas and electricity distribution through its ownership of National Gas, suggests a sideways look at its corresponding regulator, Ofgem.
“If you look overseas – or even at Ofgem in the UK – investors can earn a higher return with much less risk,” says Price. “Ofwat’s draft determination proposes targets for costs and performance that almost none of the 17 companies say they can meet, with huge associated penalties. This follows the current five-year regulatory period where latest forecasts show 16 of 17 companies will invest more than funded. That material skew to the downside is scaring investors and rating agencies.”
Not everyone agrees. The aforementioned allowed return increase overturns a trend of more than 15 years of Ofwat seeking to lower investor returns and customer bills at the same time. Oleg Shamovsky – a managing partner at Arjun Infrastructure Partners and former board member at portfolio company South Staffordshire Water, a position he held while at KKR, the utility’s previous owner from 2013 until 2018 – believes things are improving.
“I think the regulation has turned a corner [with PR24],” he says. “There was a time when the investor community felt that the regulator had an understandable desire to keep bills as low as possible. What became really apparent over the last few years is that we also had many failures of water companies, not able to cope with the necessary infrastructure upgrade required.
“I think the regulator realised that this is not just about one company, this is actually the system cracking and we need to make some changes. There was a material shift towards more attractive regulation to incentivise investment again.”
This turnaround also applies to the sector’s debt investors, says Gibson. “In simple terms, with respect to the cost of embedded debt, [for example] instead of looking at a rolling 15-year period like last time, Ofwat has extended the period it is looking at to 20 years, which retains years of high interest rates at the beginning of that block. If Ofwat did exactly what it did last time, then the high-priced debt from 2004-09 would have dropped off the back end of the calculation, resulting in a lower allowance.”
Once the new regulatory period begins, all the companies will have to maintain a credit rating of at least BBB, instead of BBB-, to avoid triggering a regulatory lock-up.
Has it done enough? Macquarie’s Price believes Ofwat has taken strides forward but has a more definitive answer to the question.
“Some of the bill increases are substantial,” Price says. “This is being driven by higher interest rates and costs – where investors have been taking pain for three years until this regulatory reset – as well as by another step-change in investment levels due to new legislation and customer feedback on priorities. [But] as the draft determination stands, it would not be possible to deliver this investment programme.”
Additional pressure is also being placed by the newly elected Labour government, which is planning to come down even harder on the sector, saying it will pass into law by year-end the Water (Special Measures) Bill, which would go as far as allowing Ofwat to block bonuses for executives of heavily polluting utilities and even bring criminal charges against the worst offenders.
While some of the measures in Ofwat’s draft determinations and the government’s proposed special measures may appease public opinion and address some of the “historical flashpoints, they don’t deal with the fact that there’s still a mountain of debt in many of these companies”, one lawyer tells Infrastructure Investor. “The rate of return that Ofwat is talking about – both on the equity and the debt side – is pretty low in terms of attracting new investments in an environment where interest rates are going up.”
Set up to fail?
Price’s suggestion that Ofwat could help investors manage the downside risk is prevalent. Ratings agency Moody’s last month suggested that, based on the draft determinations and assuming companies perform in line with their business plans, most companies are likely to incur net penalties over the next five years, amounting to around £2 billion across the sector.
Ofwat has added eight new environmental targets in the 24 common performance commitments, almost all of them subject to rewards for outperformance and penalties for underperformance.
One source suggests these targets are in fact setting the industry up for failure, with companies staring into the abyss on downside risk and penalties.
Shamovsky, though, is keen to stress the redeeming acts of Ofwat for PR24. “You have a changing reward penalty scheme, which rewards more for outperformance and incentivises water companies to really try to go for those rewards. I don’t think that was the case before.”
For its part, Ofwat believes such measures are “stretching but achievable” and indeed “more stretching than the industry median forecast but below the upper quartile benchmark”, it said in regulatory documents.
Fines and investigations
Perhaps July was the sector’s high-water mark in terms of fines and penalties. Ofwat announced that all 11 of the wastewater companies in England and Wales were under investigation into how they manage sewage treatment works and environmental pollution.
Last year, sewage was discharged into rivers and seas for 3.6 million hours, according to the Environment Agency, a 54 percent increase from 2022. The EA said this was in part due to heavy rain and better data collection, but stressed water companies have a legal responsibility to manage storm overflows. However, a BBC investigation last September found that Thames Water, Wessex Water and Southern Water, which shared data with the broadcaster, collectively released sewage for 3,500 hours in 2022 when it wasn’t raining. Known as dry spills, these discharges are potentially illegal.
In June, the BBC provided an update on the investigation, having received data from the Environment Agency for the six utilities that had refused to share data with the BBC: Anglian Water, Northumbrian Water, Severn Trent, South West Water, United Utilities and Yorkshire Water. The firms have pushed back against the BBC with criticism ranging from data being preliminary and unverified, to taking issue with the BBC’s definition of a “dry spill” and its methodology.
The Environment Agency for its part said it would be increasing its “inspections fourfold this year, with up to 500 additional staff, and making better use of data and intelligence to inform our work and hold water companies to account”. The next regulatory period has a target to reduce spills from storm overflows by 44 percent.
“On the draft determination, it would be very challenging to attract the scale of equity and debt required. Most of these companies are going to be cashflow negative in the next five years, even before interest”
Will Price
Macquarie Asset Management
Despite the investor criticism, Ofwat points the finger the other way. Explicitly, via a statement following the announcement of the 11 companies under investigation, where chief executive David Black said it “demonstrates how concerned we are about the sector’s environmental performance”. But also implicitly, through some of the changes for PR24. These include ring-fencing investment funding so that any money not spent on investment will be returned to customers; linking executive bonuses to performance; and forcing water companies to draw up their five-year business plans within the context of a 25-year strategy.
Another new requirement in this price review is that all water companies must amend their articles of association to reflect that protecting the environment and serving customers is their primary objective.
One reason why Shamovsky might be happier with the system than others is related to Arjun’s South Staffordshire Water being one of six water-only companies not responsible for the wastewater works that have tripped up so many others in the sector.
“The sewage businesses are much more complex operationally and much more prone to failures,” he says. “The fact that South Staffordshire is a water-only company has helped us a lot because it gave us a company that was less complex to run and operate.”
Portsmouth Water, bought by Ancala Partners in 2018, is another water-only company providing a relative safe haven to infrastructure investors, while also listed by Ofwat as one of the higher-performing companies.
“We took a lot of comfort from the company’s leading performance and customer service record, and the opportunity to construct the Havant Thicket reservoir,” says Ancala partner Lee Mellor.
“Being a water-only company, it is also not exposed to wastewater. These factors were important in our decision to invest in 2018 and to continue to provide the business with more capital.”
‘Massive reset opportunity’
The fortunes and performance of the sector won’t change overnight, regardless of the measures in the PR24 programme. Still, the troubles the sector is facing “present a massive opportunity for a reset; and there needs to be one”, another legal expert tells us.
An example of what that reset could look like would be adopting a different investment model, the expert says. “You’ve got the contractual model, which is concession agreements. That’s one mechanism that I personally like because it’s time limited, usually 25-30 years. Once the concession expires, the government, which retains ownership of the asset, can re-tender it.”
The regulator has already launched such an initiative that one of the lawyers describes as “a hybrid concession”. The initiative, which includes the direct procurement for customers (DPC) model and the Water Industry Specified Infrastructure Projects Regulations 2013 (SIPR) model, allows water utilities to establish privately financed, special purpose vehicles to deliver major infrastructure projects, such as reservoirs, water treatment plants and pipelines. The difference between the two is that the DPC is governed by a contract between the utility and the contractor, while the SIPR is regulated by Ofwat through a separate licence.
“You have a changing reward penalty scheme, which rewards more for outperformance and incentivises water companies to really try to go for those rewards. I don’t think that was the case before”
Oleg Shamovsky
Arjun Infrastructure Partners
Ofwat has identified 18 such projects to be delivered through these two models, which it estimates will attract around £26 billion of new investment to the sector in the next five to 15 years. “This builds on the experience from the £4.5 billion Thames Tideway super sewer… showing how the use of competitive models for delivery and innovation in finance arrangements helps deliver better outcomes for customers and the environment,” Ofwat said in a statement.
But will this new model allow the utilities to load up on even more debt? Ofwat declined to comment, but one source familiar with the regulator’s thinking told us that the DPC is not a model to facilitate off-balance sheet finance, “as it is expected to be accounted for as a lease liability in a water company’s accounts pursuant to IFRS-16”.
Dieter Helm, professor of Economic Policy at the University of Oxford, remains unconvinced. While acknowledging some of the merits of the DPC model, he told the Financial Times that their use is in part a result of “Ofwat’s failure to stop the balance sheets of the utilities being misused for financial engineering”.
‘More accountable’
One increasingly popular view suggests publicly listed entities are better placed to prevent financial engineering. In addition to making companies’ operations, practices and finances more transparent, listed entities “also have somewhat easier access to the equity markets, which also hold them more accountable”, says Johnathan Owen, a portfolio manager within the investment grade team at TwentyFour Asset Management, a London-based boutique firm specialising in fixed income.
“You can see that in share prices, which incentivise management to perform well and maintain a healthy share price,” he points out.
Our source, who is close to the regulator, confirmed that Ofwat, “having observed challenges arising with the ability of some consortium-owned companies to raise new equity where investors have competing interests [and acknowledging that] there are benefits associated with the greater levels of transparency and commentary on the performance of companies with an equity listing”, is considering an option to provide funding for the net efficient costs related to this transition.
With Thames Water now the poster child for the failure of the private investor-led model, its relaunch could herald a new dawn for the industry.
‘In no man’s land’
In the meantime, however, the fate of Thames Water – in the direst of straits with its existing shareholders refusing to inject much-needed equity, its debt downgraded to junk by Moody’s and S&P Global Ratings, which in turn triggered a regulatory lock-up – continues to be uncertain
Its handling by the regulator is also what has evoked the sharpest criticism from multiple sources we spoke to.
“Where Thames Water is left now, is really in limbo,” one source tells us. “It’s not a great position for the sector to be in, having a company that is in no man’s land. The bonds move on every single headline. And we’re now starting to see more contagion across the broader sector. The bottom line is the company needs equity, but it can’t get equity in its current state. It needs to be placed under special administration and debt holders, bond holders, will need to take a haircut because the company needs to get leverage down so that it’s investable for new equity.”
It’s an astounding conclusion for a company seemingly protected by a regulatory system and whose shareholders since privatisation have seemed like a who’s who of the utility, infrastructure and sovereign wealth world.
“If you asked me three years ago ‘could any water company get into that position?’, I’d have said no,” says Colm Gibson, managing director and head of the economic regulation practice at consultancy Berkeley Research Group.
Dieter Helm, professor of Economic Policy at the University of Oxford, agrees that Thames Water should be put into special administration rather than the Turnaround Oversight Regime that Ofwat opted for.
“What is going on here is that Ofwat implicitly takes over the functions of the board of the company,” Helm wrote in a paper commenting on the PR24 draft determinations and the turnaround oversight regime. “Ofwat will in effect have directors reporting to it [via the Independent Monitor that will be appointed] and it will have the power to adjudicate on their actions. It becomes the de facto decision-maker.”
But that’s what the special administrator would do, he points out. The difference, however, is that under special administration, the objective is to place the company under new ownership, and it provides a clear exit, unlike the turnaround oversight regime, Helm notes. Another reason special administration is preferable, says Helm, is that “foreign investors like clear rules. The special administration rules could not be clearer,” he writes. “Other investors would like Thames to be dealt with, for fear of infecting them too.”
A foreign investor in the UK water sector confirmed Helm’s assessment.
“The regulator has removed all value in the equity of Thames for existing investors and has made any future investment highly unlikely and probably put a high degree of uncertainty around our appetite to invest into the UK in the regulated spheres of opportunity,” this person, who asked to remain anonymous, says.
“It’s not all over,” he adds, noting things can change between now and the final determination. But, from our point of view, there are better places for us to deploy capital; where we have more comfort, more security in terms of respect for long-term capital, respect for procedural justice and an understanding how businesses, which are essential, but which also face many challenges, would be afforded the opportunity to contribute into the respective economy.
“With respect to the UK, that’s not something we can be confident about at the moment, until we get the final determination and understand what the government of the day is willing to do.”
