Ailing UK water sector gets a risky lifeline
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
By Neil Unmack
LONDON, Dec 19 (Reuters Breakingviews) -The UK’s ailing water sector is getting a lifeline. Regulator Ofwat divulged on Thursday how it would help companies finance 104 billion pounds of critical investment to protect crumbling infrastructure from challenges like climate change, which causes more pollution and leaks. By being accommodative, the risk is that British billpayers see it as a de facto bailout of shaky Thames Water at their expense.
UK water plc is facing its biggest crisis since privatisation in 1989. Customers lament sewage leaks and paying bills to corporate fatcats, but investors moan about poor returns. Meanwhile Thames Water is on the verge of collapse, potentially causing bond and equity investors to shun the sector. In the middle sits regulator Ofwat, which sets prices every five years.
On the face of it, companies can breathe a sigh of relief. Compared with an initial draft in August, Ofwat has increased the amount it allows companies to charge, and the returns they deliver to shareholders and debtholders. The average allowed return on capital is now just under 4%, net of inflation, up some 30 basis points since the draft review, largely in line with analysts’ expectations. The real return on equity, now just over 5%, is up by nearly a quarter from the 2020-2025 period.
It may not be enough to save Thames. The group formerly owned by Macquarie needs to attract 3 billion pounds of equity, and cut its debt from over 80% of regulatory capital value (RCV), a metric used to model utility valuations. An investor contemplating writing that cheque may be encouraged by less stretching targets used to determine penalties for leakage, for example. But they may also be spooked by Ofwat’s description of Thames’ business plan as “inadequate”. The watchdog has lined up a “delivery mechanism” that will claw back investment allowances if Thames can’t justify expenditure.
Nationalisation therefore remains a possibility. But the price review should stop that cratering other firms. Barclays analysts reckon that listed groups like Pennon PNN.L or United Utilities UU.L could now be valued at a premium to their RCVs, a sign the returns are more than enough to draw investor capital. And the regulator has eased fears that the Thames fallout would hike borrowing costs: its assumed cost of debt has jumped partly to compensate for the fact that bond markets now demand a premium to lend to water companies, whereas they used to view them as less risky than other corporates.
Critics may see that as a reward for the sector’s excessive borrowing. For consumers, the extra investment and higher returns will mean bills five years hence will rise on average by 36%, even before factoring in inflation. If companies are deemed to have wasted the windfall, a political backlash will become more likely.
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CONTEXT NEWS
UK water regulator Ofwat on Dec. 19 published its final price determination, which will set bills and companies’ allowed returns between 2025 and 2030. The price review will allow companies to make a higher return on capital than in the previous five-year period, and in the draft price determination from August 2024.
Customer bills are expected to rise by an average of 36% before factoring in inflation over the next five years versus the prior five, which will help fund a 104 billion pound investment programme designed to lower leakage and tackle the effects of climate change.
The allowed return on capital for the sector will be 3.97%, above inflation, up from 3.66% in the draft determination, and less than 3% in the previous five years. The inflation-adjusted return on equity will be 5.1%, up from 4.80% in the draft determination, and 4.19% in the previous five years.
Shares of Pennon Group rose 2.2% as of 0937 GMT on Dec. 19, while United Utilities shares rose 0.9%.
Graphic: UK consumers faces a water bill shock https://reut.rs/400aXGZ
Editing by George Hay and Oliver Taslic
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