Thames Water: a sensible outcome can help get UK infra investment flowing

The UK authorities face a tricky balancing act regarding the water sector.

Ofwat’s draft tariff proposals for 2025-2030 will be seen as tough by the industry and markets. The water and sewerage companies have been offered only around two-thirds of the bill increases they asked for to fund much-needed upgrades to networks.

Credit rating agency Moody’s commented in a note last week that “we may revise our view of the regulatory framework following Ofwat's final determination”.

The taps run dry

Thames Water is in the eye of the storm, with Moody’s downgrading its bonds to junk last week. The company’s overgeared finances triggered the present standoff between regulator and shareholders. But the problem at Thames Water is not purely one of excessive gearing; it is mainly about inadequate returns on capital.

In order to attract ongoing funding from the capital markets, the company needs to be put on a sustainable footing in terms of future returns, not just financial leverage.

There is no ‘free lunch’. If a regulated utility’s financial and operational health declines beyond the point where putting more equity in makes sense, then investors should expect to face losses.

Spillover effects

However, the size of any losses, and the way they are distributed across investors, would have wider ramifications for the UK water sector. It could even affect other UK sectors that use the ‘regulatory asset base’ model too, if losses were severe enough.

This is because the size of losses crystallised would imply a valuation discount to Thames Water’s asset base. If the implied discount were bigger than can be justified, then the rating agencies and markets might need to build similar discounts into other UK asset bases. This, in turn, could reduce the sector’s debt capacity and increase the cost to consumers of funding upgrades.

Thames Water reported Class A net gearing of 73.5% at March 2024, suggesting that senior lenders’ claims are well covered by the asset base. Therefore, we think any losses crystallised by senior lenders would imply a large valuation discount versus Thames Water’s asset base.

If the UK government would like to see ongoing competitive debt funding for UK water infrastructure from the private sector, it should ensure that any implied valuation discount for Thames Water is not larger than can be justified, and that future returns are adequate.

A satisfactory resolution could help make rebuilding Britain more achievable and affordable.