Thames Water

I spoke yesterday (Wednesday April 3rd) to Ruth Williams of Utility Week about the probable outcomes of the current debacle at Thames Water. I hypothesised that the financial challenges facing the company were so severe that it would inevitably end up in public ownership. The resulting article is here.

I’ll attempt to provide the detailed numbers in this note to justify this view. But first I’ll try to give some background.

The context.

Yesterday’s Utility Week conversation follows an interview last year when Ruth talked to me about the first attempt by private equity to gain control of a UK water company. This was in 2001/2 and involved Southern Water. I was then an independent member of the UK’s Competition Commission, now part of the Competition and Markets Authority. The Competition Commission was charged with examining water industry takeovers to ensure that Ofwat’s ability to regulate the industry was not impacted.

The Commission’s view was that the transaction should be permitted. I strongly disagreed. I was obliged by the Commission to focus my statement of dissent on technical matters that revolved around the loss of a separate water company as a result of the proposed deal.

If the transaction took place, Ofwat would then have a slightly reduced ability to compare the relative performances of the 22 water suppliers in the UK when setting prices. The regulatory framework obliged Ofwat to penalise relatively poorly performing companies by obliging them to reduce their prices in relation to those water businesses doing well on measures such as leakage rates, investment levels and water quality. This is the focus of the first pages of my dissent.

But my material on the loss of an independent competitor was a façade. My real concern, expressed forcefully but completely ineffectually within the Commission, was that the highly leveraged financial structure of the proposed takeover would make regulation impossible. I was allowed to mention this concern but only in an appendix to my dissent. Twenty years ago, the Commission had a view that the methods of financing of takeovers would have no impact on the acceptability of a merger.

This appendix was then redacted for 20 years before FOI requests obliged the Competition and Markets Authority to make the full version available here:

The Appendix can be found at page 11 to 18 of the full note.

It is not a particularly clear summary of my thinking but paragraph 6 makes the core point: regulators cannot regulate highly leveraged businesses if price controls would force them into bankruptcy.

Put simply, my question is this: how can the regulator use price reductions to force companies to generate efficiency gains if by so doing he makes these companies unable to finance the operation of their business? As I say below, a highly geared and sophisticated capital structure is likely to reward shareholders handsomely if the business does well. If it does badly, the most likely outcome is a renegotiation of the price regime. English and Welsh water businesses will need new capital for decades to come. If the regulator does not revise his price caps, capital investment programmes will suffer. In my opinion, he therefore has little choice but to give in to the demands of water businesses that need to deliver high levels of regular financial return to outside investors, banks and bond holders.

This is exactly what we are seeing today. Highly indebted Thames Water teeters on the edge and demands price rises of 40% in real terms (said to be 56% in nominal money) before 2030. Faced with this request, the options facing Ofwat are all deeply unattractive.

The current position

First of all, I need to say that I have rounded all the following numbers to aid comprehensibility. I don’t think there’s any detriment to the arguments. Most of these figures come from Thames’ latest half year report, multiplied to cover a full year. This report is available here.

1, Water companies, as with all ‘grid’ operators such as gas and electricity transmission companies and communications networks, have very high ratios of capital stock to yearly revenues.

o Thames Water has annual revenues of about £2.5bn a year. The capital employed in the business is around £19bn, or almost eight times as much.

2, Some water companies have financed their capital stock using money borrowed from outside lenders.

o Thames has borrowings of around £16.4bn. (It states it has a gearing ratio of under 80% (page 5) which is slightly inconsistent with this number and my assertion quoted in the previous paragraph that it has £19bn of capital employed).

3, Although water companies make good margins on sales, the free cash flow after paying interest on debt may be small compared to the continuing investment needs of the business.

o Thames Water is currently investing about £2.1bn a year. This compares to free cash flow of around £1.2bn a year. (page 5) So, even before considering the debt that is coming to maturity this year and for increasing capital investment needs, Thames has a requirement for nearly £1bn of extra outside money.

4, Water companies have large stocks of invested capital, now often financed with external debt. This debt all eventually comes due for repayment.

o Over the next four and a half years, about £5.4bn of Thames Water debt will come due. (page 10). This will average about £1.2bn a year. Maturing debt is therefore eats up approximately all free cash flow at current customer prices. And this is before any capital investment.

o Total fundraising needs will include both cover maturing debt (£1.2bn a year) as well as the £0.9bn difference between continuing capital investment (£2.1bn) and the free cash flow available to finance this investment (£1.2bn).

5, Under-investment in the past decades will imply a sharp rise in the capital spending over the next few years in many water company regions.

o Thames Water is proposing new investment at a much higher level than currently. It suggests a figure of around £18.7bn over the next five year regulatory period (2025-2030) to begin dealing with the enormous problems of waste water processing. This is equivalent to £3.7bn a year or nearly 50% more than total annual revenue. To repeat: Thames wants to invest 150% of its total income, before considering the costs of running its business.

o Add maturing debt and total fund raising will therefore need to be about £4.9bn a year, or about 4 times current annual free cash flow.

6, Interest payments on water company debt will rise from the low levels of a few years ago to reflect higher interest rates.

o Thames Water interest payments have been running at about £360m a year. (I have estimated this figure by doubling the half year number on p9). This seems to exclude what is called the ‘accretion’ of liabilities due on index-linked debt. This would substantially increase the £360m cost but I am unable to estimate by how much.

o New debt raised at fixed rates, rather than the index-linked instruments that provide about 60% of Thames’s current indebtedness, would cost substantially more. Government 10 year debt currently trades at a yield of around 4%, and I guess Thames would have to pay around 6.5% for a similar maturity. I estimate total fundraising needs will be £1.2bn (maturing debt in point 4) and new investment £3.7bn (point 5) less free cash flow of £1.2bn (point 4). £1.2bn plus £3.7bn less £1.2bn equals £3.7bn. At 6.5% this would cost extra £240m per year less the cost of perhaps £80m no longer payable on the matured debt. This yields a net figures of an extra £160m a year on top of the current £360m.

o The implication of this is that each year that passes will add £160m to Thames’ interest bill (or index linked equivalent). This alone would absorb about 60% of free cash flow by 2030.

7, We can assume Thames will be allowed to raise its prices, which will help produce more free cash flow to increase its investment. It is asking for 40% in real terms before 2030. In the highly unlikely event that this increase flowed directly into cash, it would increase the amount available for new investment by around a billion a year. This does not come close to covering the incremental cash needs specified in point 5.

8, The stream of numbers in this note can be compressed into two assertions:

o Without very substantial external fundraising Thames Water cannot meet its investment requirements, even if it is allowed to charge very much higher prices.

o The lack of any sign that Thames will be net cash positive in the next decade makes any form debt financing extremely difficult. Raising new shareholder equity is vanishingly unlikely. So there is virtually no chance of private money continuing to fund even the continuing operations of the company, much less its enhanced investment proposals.

This means that, possibly disguised in some form of ‘special administration’, Thames will inevitably end up in the hands of a state entity. This will cut the interest rates it will pay but it will still require large injections of new cash if it is to improve its dire record in river pollution.

Chris Goodall

chris@carboncommentary.com

+44 (0) 7767 386696

4th April 2024.

Please copy any part of this note if it would be helpful. I’d be grateful for attribution.