Thames Water fix is a stretch, but possible
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
By Neil Unmack
LONDON, Aug 6 (Reuters Breakingviews) -Fixing Thames Water is tricky, but possible. The indebted UK utility’s struggles to raise the 3.25 billion pounds it needs risk an imminent implosion, accompanied by nationalisation. But the right commitments from the government or a creditor haircut could yet tempt a new investor.
Thames has far too much debt. Leverage is equivalent to just over 80% of its 20 billion pound regulatory capital value (RCV), a metric used to value water companies based on their allowed returns. That’s roughly 20 percentage points above the target level used by regulator Ofwat. Thames’ own shareholders, including UK and Canadian pension funds, argue it is uninvestible. They have refused to stump up the 3.25 billion pound bill required over the next five years to cut debt and cope with climate change and sewage spills.
The current mess is not, however, unprecedented. In 2021, fellow UK utility Southern Water was rescued by Macquarie, the previous owner of Thames, which pumped money into the company when its existing shareholders stepped back. The rationale for a repeat in 2024 is that Thames’ travails mean it’s probably not worth its RCV level – meaning a new investor could buy in at a discount.
Right now, Thames’ equity – the difference between its RCV and its 16 billion pounds of net debt – is theoretically worth around 4 billion pounds. Imagine a new investor buys the utility for a nominal price of 1 pence, but on the condition that it ponies up the 3.25 billion pounds needed for investment split equally over the next five years. With that money on board, a recovering Thames could in 2030 be valued at its RCV once more, and probably a bit more given it would increase in line with inflation and customer bills. If the new investor put in 650 million pounds every year for five years, and then Thames’ equity hit 4.5 billion pounds by 2030, then it would get a 16% internal rate of return, according to Breakingviews’ calculations.
The snag is that ageing infrastructure means Thames has consistently failed to meet its targets and received hefty fines for poor service. If that continues, the new investor would see their return whittled away. It doesn’t help that Ofwat heavily criticised the company in its recent five-yearly price review, when it determined the sector’s investment needs and allowed returns.
Meanwhile, Thames’ debt headache may be worsening. Fears the utility could fail to raise money have raised the prospect of a government-led administration, and its debt has been successively cut by rating agencies. Thames’ highest ranking bond due 2028 yields over 12%, according to LSEG data. That makes the return even less predictable, as any new owner could face years of high interest costs.
New UK Prime Minister Keir Starmer and Ofwat could reduce these dual investment risks: they could allow Thames to hike bills more quickly, and suffer fewer penalties. Yet it would be a bad look for a still-ropey Thames to be handed a sweeter deal than other water companies. And any new investor would be worried that a future government or regulator might backtrack.
One other avenue is to get creditors to take a hit. Thames could get its bondholders to give up some of their claims, either as part of a government administration, or using the threat of one as a stick. Assume Thames restructured its debt to bring gearing down to 60% of RCV. At that point its equity would be worth nearly 8 billion pounds, assuming the group was valued in line with RCV. That would give the new investor a much bigger return for their 3.25 billion pounds, and incentivise them to take the plunge.
Yet a debt restructuring also brings huge risks. If bondholders lose money on one water company, they would probably demand a higher return on bonds issued by other ones. And they may lose faith in Ofwat, which has repeatedly squeezed water companies’ returns and imposed higher penalties. The fact a creditor would have lost money even though their debt was protected by a regulatory capital value that implied some equity cushion beneath them might undermine the entire framework for valuing water companies.
When Britain’s rail network Railtrack was placed in administration in 2001, the government led by Tony Blair chose not to burn bondholders for a similar reason. Yet saving creditors would reward poor lending and burden the taxpayer. And, if Thames’ creditors are hit, the government would find it easier to justify giving the sector some forbearance to ease the fallout, for example by further raising allowed returns. Either way the stakes for Starmer are high: get it wrong, and the taxpayer will have to fund all Thames’ 3.25 billion pound lifeline itself.
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CONTEXT NEWS
Thames Water on Aug. 6 received a 104 million pound fine from UK regulator Ofwat for not properly managing sewage spills, the highest penalty among three companies charged.
On July 24, Thames Water’s credit rating was lowered to Ba2 by Moody’s, below investment grade, due to concerns over the group’s ability to secure additional equity. The utility needs to raise 3.25 billion pounds in fresh equity over the next five years. Thames Water’s senior secured bonds due 2028 are yielding around 12.6%, up from around 6% in mid-March, according to LSEG data.
Editing by George Hay and Oliver Taslic
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