Has Thames’ pipe dream burst? Kishan Paun in Premier Miton’s fixed income team shares his take on Ofwat’s review of water firms.
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Ofwat’s draft determination in a nutshell
One of the most exciting mornings in the diary of a utilities analyst in the UK is the day of an Ofwat determination.
It’s during this shower of regulatory documents where we find droplets of information as to Ofwat’s stance on water companies’ spending, consumer bills, and allowed returns.
Given the water industry’s provision of an essential service and its monopoly nature, the sector is regulated by Ofwat, the Environmental Agency (EA), and the Drinking Water Inspectorate (DWI). Ofwat’s responsibility as the economic regulator is in determining the “allowed revenue” each company can earn for a five-year period.
To calculate this return, Ofwat undergoes a two-year journey back and forth with the water companies. Ofwat proposes an “early view” allowed return and asks water companies to submit business plans with this new figure.
Ofwat reviews these business plans for nine months before returning with a draft determination.
After engaging with the water companies on the viability of business plans with the draft determination’s updated return figures, Ofwat publishes its final determination a few months later.
- Read more on fixedonbonds.com, Premier Miton’s bond blog: Lloyd Harris: Thames Water and the Temple of Doom
The regulator’s delicate dance of game theory
This five-yearly price review is a delicate dance of game theory. Water companies submit their initial business plans and inflate their spending needs (for which they can generate revenues on), contest Ofwat’s allowed return, and consequently look to increase customer bills, their primary source of revenue.
Ofwat, in turn, make some concessions on return levels, challenge the sector to spend more efficiently, and try to protect the public, as the consumer, from excessive bills. Eventually, they meet somewhere in the middle.
Whilst historically Ofwat have prioritised lower customer bills over company investment, the increase in media scrutiny and clearly overwhelmed infrastructure has led to a step change in the regulator’s approach.
UK water companies had, in aggregate, submitted plans for a c.£100bn spending programme to 2030, roughly double the spending proposed through to 2025. Ofwat have recognised that 90% of all proposed capital investment is a legal requirement, thereby water bill increases are inevitable.
What happened on 11 July?
Ofwat published its draft determination on 11 July and after consulting on decisions will publish its final determinations on 19 December.
As bond investors, we have focused on three key aspects:
- Allowed earnings: Ofwat raised the total allowed return to 3.72% from the 3.29% early view, with the return on equity portion rising to 4.8% from 4.14%. Consequently, average consumer bills will rise by 21% compared to the proposed 33%, adding about £94 over the period, with 1.4 million more customers expected to benefit from reduced social tariffs.
- Total spending Ofwat reduced total spending to approximately £90 billion, 15% below the companies’ initial proposals, driven by expected spending efficiencies. This is in line with previous drafts, which saw a 13% reduction.
- Funding: Ofwat imposed a 70% soft leverage limit for water companies. Companies will need to balance equity and debt funding to meet this new standard for financial resilience.
Whilst Ofwat have been pragmatic and listened to water company’s requirements of higher returns and spending, they’ve clearly made an error: Ofwat have miscalculated the risks involved in attracting equity investment into the water sector.
Ofgem, the UK’s gas and energy regulator, have issued an early view on the cost of equity at 5.43% for its sector. This is much higher than the 4.8% awarded by Ofwat, and for a sector that faces significantly less headline risk than water.
Will Thames Water struggle to stay afloat?
On Thames Water specifically, we see the draft determination as being particularly harsh to the group.
As Lloyd Harris, Head of Fixed Income, said in his recent post on our blog: “Being invested in Thames Water bonds must be just like being Indiana Jones getting chased by the torrent of water in the Temple of Doom – a rollercoaster.”
Whilst the allowed return has increased to levels that are closer to the company’s required 4.25%, its return on equity remains significantly below the company’s current cost of debt.
This implies that equity investors are being compensated less than bondholders, despite taking on more risk.
Secondly, Ofwat have placed Thames Water into a “Turnaround Oversight Regime”, which reflects the group’s financial and operational challenges. This requires greater regulatory scrutiny and surveillance of Thames Water, as well as a cap on borrowing, which would only be possible with an even greater equity investment.
Ofwat have confirmed that there will be no leniency on performance or fines whilst in the regime, despite some suggesting the opposite prior to the draft determination.
Although this move is meant to prevent nationalisation taking place, it could very well scare equity investors away, thereby forcing Thames Water into bankruptcy.
Lastly, Moody’s have downgraded Thames from investment grade to high-yield following the publication of their full-year results. The loss of their investment grade rating means they’re in breach of their licence conditions. Ofwat are now within their rights to force Thames into a nationalisation, though we believe they’re keen to avoid this.
With management stating the group only has liquidity available until May 2025, and that its leverage levels are likely to breach legal limits of 85% next March, the group are in a weak position.
Thames Water’s equity investors wanted to see bill rises of 44%, an adequate return on equity, and leniency in fines for the group to aid their turnaround. They’ve received none of these, and very little in concession from the regulator.
Does the draft determination change our credit view?
In short, no. The draft determination was broadly what we expected. We continue to remain sceptical on Thames Water’s ability to secure equity but view the draft determination as favourable for all but the distressed names.
On Thames Water, the outcome remains wildly uncertain, with an eventual bondholder haircut and/or risk of collapse increasing as time progresses. This view was confirmed by the market on Thursday 11 July as Thames Water’s subordinated bonds fell by 10 points following Ofwat’s publication.
With most companies financeable at the initial 3.29% weighted average cost of capital, the better-performing names should be able to attract their required equity and maintain gearing below Ofwat’s new 70% targets.
Severn Trent and Pennon were given “Outstanding” for their business plans and should continue to remain best-in-class demonstrated with the tightest levels of credit spreads.
Reduced total spending means we’re unlikely to see debt issuance in the sector reach the £50bn levels touted by Moody’s.
Total spending is still north of £90bn, a £40bn increase relative to the last regulatory period. Debt markets will be a key source of funding, and we expect technicals to remain weak for some time.
We remain happily on the sidelines and will be opportunistic in involvement in well-capitalised names and very happy to steer clear of those even close to being on the weaker side of the spectrum.
