Investors Can Calm Troubled Waters

As climate-related risks worsen, including droughts and torrential rainfall, WTW’s Matt Huxham says investors can help improve the resiliency of the UK water industry.

To say it has been a difficult few years for the UK water sector is an understatement, with public anger over the quality of water and wastewater management services forcing the regulator to take a heavy hand with the industry.

According to the UK’s Environment Agency, raw sewage spills into England rivers and seas doubled in 2023 – 3.6 million hours of spills compared to 1.75 million hours in 2022. The report found the number of serious pollution incidents increased from 44 in 2022 to 47 in 2023, with over 90% caused by four companies: Anglian Water, Southern Water, Thames Water and Yorkshire Water.

The Water Services Regulation Authority (Ofwat) is meting out £168 million in fines to Northumbrian Water, Thames Water and Yorkshire Water for failing to manage their wastewater treatment works and networks. This follows actions against Southern Water and Thames Water in 2018-19, which resulted in £257 million (US$339 million) in penalties and rebates.

Thames Water, the country’s largest water and wastewater services company has made the headlines this year – not just for leaks and sewage spills, but also for its financial problems. Laden with £15.2bn of debt, it must raise new equity to keep insolvency at bay. On 24 July, the utility lost its investment grade status with two ratings agencies, Moody’s and S&P, and is now in breach of its licence.

Crises in the making

Matt Huxham, Director, Climate Practice at risk, insurance and advisory firm Willis Towers Watson (WTW), spoke to ESG Investor about the reasons why the UK water sector has ended up in this predicament.

“Too many of these companies have inflexible financing structures, which constrains their ability to address new regulations, changing business models and other developments, such as climate change, per- and polyfluorinated alkyl substances – the ‘forever chemicals’ – or the prospect of renationalisation,” said Huxham, who was previously an analyst for the UK water sector at Moody’s.

The rigid structure he refers to is the ‘whole-business securitisations’ financing model, first carried out by Welsh Water in 2001 and taken up by others since, including Thames Water. It is a highly structured form of corporate funding, which, in return for certain enhanced controls on operational and financial performance, allows a higher proportion of debt in a company’s capital structure than would otherwise be possible.

Back then, UK water companies were trying to use financial engineering to reduce financing costs, improve returns and ostensibly produce a better outcome for the consumer, Huxham explained.

While that was the original aim, the industry subsequently went through a period that saw the utilities taken over and financially restructured to create short-term gains for shareholders. The 2007-09 financial crisis prompted several emergency changes to the structures, which reduced some risks – but also created new ones in the process.

Many companies were banking on interest rates remaining low and stable inflation, as well as the nature of the business and regulatory environment remaining essentially the same.

But all that changed when the Bank of England began raising interest rates in late 2021. “It wasn’t just in the water sector where people made long-term bets around that time, not believing in the possibility of structural change,” Huxham said. “The consequences of those bets are now playing out.”

Pricing problems

In addition to a difficult macro and financing environment, UK water companies have had to deal with more than a decade of government pressure to keep consumer water bills down, as public scrutiny of the sector intensified.

“In the end, it seems like some water companies may have decided to cut back on some investment in order to stay afloat. This is clearly not sustainable and doesn’t bode well for the future,” said Huxham.

However, not much is expected to change on that front. Ofwat is in the process of its 2024 price review (PR24), with final decisions to be published on 13 December. In its proposals, companies are expected to triple investment in new infrastructure and resources to improve the environment, resilience, and service – from £11 billion to £35 billion.

At the same time, Ofwat has suggested that the average bill should only rise by £19 per year between 2024-25 and 2029-30 – £44 per year lower than what the companies were asking for in the consultation.

“Water companies are going to be expected to invest in resilience, as well as deliver enhanced service for consumers because of what has gone on in the past few years,” said Huxham. “I’m sceptical that they can do this without raising prices significantly.”

Huxham also questioned whether the utilities have the capability to address new areas, such as climate change, which is part of PR24’s proposed long-term targets. “Unless we can solve the biggest underlying issue, which is consumers’ ability to afford higher bills, then anything that we might talk about around climate risk and so on remains constrained within that framework,” he added.

Thames Water has voiced its frustrations around Ofwat’s proposals, warning that the cap on water bill increases would put its recovery in jeopardy, according to the Financial Times.

Stewardship needed

In recent years, many UK water companies have curtailed dividends due to the ongoing difficult operating environment. The knock-on effect could be that shareholders won’t be willing to step in when a company gets into a crisis situation – as was the case for Thames Water when its shareholders refused to provide a £500m lifeline in March. Its parent company, Kemble, defaulted on its debt in April.

While not as close to the details as when he covered the UK water sector at Moody’s, Huxham believes that many of the water utilities have been working on making their financial structures more resilient in recent years, due to the pressure from the regulator.

“However, the situation with Thames Water would suggest that there remains some issues,” he added.

Understandably, asset owners have become more nervous when it comes to UK water company bonds over the past few years, mindful of looming problems due to pressure on credit ratings. This may present a problem when these companies will look to refinance – particularly through riskier tranches of debt.

“Ultimately, class A debt in the securitisations is still highly rated,” said Huxham. “Some of those long-dated notes that were issued a long time ago are very valuable to pension funds and insurers to match their liabilities, so I would be surprised if divestment begins creeping in for those.”

There may also be more problems in refinancing class B notes, which are a key component of many of the financing structures – let alone holding company debt.

“That will then beg the question of whether we are looking at more fundamental financing restructuring, and that secondary effect could start to create issues for class A bondholders,” Huxham explained.

When it comes to large asset owners, such as pension funds, there is an opportunity for bond investors to help water companies de-risk, or understand the new types of operational and financial risk emerging from climate change – as well as develop strategies before the regulator steps in and compels them to do so, Huxham said.

He advocated engagement as an important way to help ensure water companies are getting ahead of climate change issues through building internal capacity.

“This might mean challenging some of the models that utilities currently use around water availability, stressing those for different physical climate scenarios, and also factoring in other trends that were previously not thought to be foreseeable, such as the impact of the transition on energy and materials prices,” he added.

Investors could also potentially share some of those benefits through ESG-related or other lower cost of capital bonds to try to incentivise the companies, Huxham explained.

“The best way may be initially through engagement with the companies, trying to get them to do meaningful analysis of the risks using the latest data and encouraging them to engage proactively with the regulators on emerging issues,” he added. “There will be other rewards to gain from encouraging companies to take serious action on these issues and increase financial resilience.

“Such guidance could help a company to improve its credit rating, or more likely, help it be more secure with a current investment grade credit rating. The latter is often what is most important for buy-and-hold investors,” he added.

Risk of renationalisation?

While there appears to be public support for renationalising the UK water industry, the Labour government has indicated it will not go down this path. Instead, it has laid out plans to strengthen the powers of the water regulator with the Water (Special Measures) Bill, which will give new powers to ban the payment of bonuses if environmental standards are not met and increase accountability for water executives.

Huxham pointed to the many state-owned water companies with investment grade credit ratings worldwide.

“There’s no reason why that end state might not result in a viable position for the sector,” he said. “There are issues to solve around the willingness to put in equity in extremis, which Thames Water shareholders decided not to do. Perhaps we might not have reached such a point of crisis if the government had been the owner.”

Though it may be possible to transition to a state-owned situation without triggering significant downgrades, the difficulty would be during the transition period – particularly with regards to perceptions of the regulator’s independence.

“Problems could arise if a government significantly changed or did away with Ofwat, or gave the impression of politically-motivated interference in pricing,” said Huxham.

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