Thames Water Returns Set Below Level Needed to Finance Plan

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(Bloomberg) — Thames Water equity investors will get a return of 5.1% over the next five years, which may not be enough for the heavily indebted company as it scrambles to avoid running out of cash.

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It’s at the lower end of the range requested by Thames, and investors will now need to decide if it’s enough to attract the billions of pounds Britain’s largest water utility says it needs to tackle chronic leaks and sewage spills — and avoid being plunged into temporary nationalization.

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Water regulator Ofwat on Thursday set rates of return for the entire industry, seeking to end months of speculation over how utilities will fund their biggest investment plans since privatization. Across the country, water companies are struggling to fix crumbling networks and quell public anger over poor performance.

“I don’t see how any equity investor will tip money in for that return – they would demand roughly 11%,” said Tim Whittaker, a research director at the EDHEC Infrastructure Institute. 

The return on equity is one of three rates of return Ofwat sets for each five-year regulatory period. There’s also one for debt, and then it combines the two for a weighted average cost of capital, or the WACC. That number was set at 4.03%, but Thames had said it needed to be 4.6% for its plan to be financeable.

In August, Thames said equity investors would need to see returns in the range of 4.97% to 6.28%. Investors want it to be at least around 6% to match what they would get in UK energy grids. 

The rate set by Ofwat on Thursday is only marginally higher than the 4.8% the regulator proposed in its draft ruling in July.

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Chris Walters, senior director for the price review, said Ofwat chose a “fair market rate of return” similar to those offered by energy regulator Ofgem. The two regulators use slightly different assumptions, such as a company’s gearing — the ratio of debt to equity.

“We think our rate of return and Ofgem’s rate of return are actually comparable given the slightly differing risk profiles of energy and water,” he said in a press briefing. “We believe we’ve got a rate of return that is sufficient to maintain the investibility of this sector.”

Thames is in the early stages of an equity raise, after its existing shareholders walked away from the business in March, declaring the company “uninvestible.” The new process attracted a handful of non-binding bids from Castle Water Ltd and Covalis Capital. The latest ruling will be critical to whether those bidders proceed, or if the company can get more bids in the new year.

Dividend Fines

Thames was separately fined £18.2 million on Thursday for paying two dividend payments to its shareholders over the last year. The ruling will send a strong signal to future investors that Ofwat won’t allow dividend payments to companies with poor performance.

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For Thames — which serves a quarter of England, including London — the ruling is critical. Without the returns set high enough from Ofwat, the company may not be able to get the £10 billion in debt and equity it says is needed for investment by the end of the decade. At least £3.3 billion of this amount needs to come from new equity. 

The utility only has enough money to last until March 24 and is in the process of seeking court approval for an emergency loan that would allow it to continue operating over the months while it seeks a longer-term fix.

Thames, like all water suppliers, now has two months to decide whether to appeal Ofwat’s ruling to the Competition and Markets Authority to seek a better outcome. But the timing is tight. Thames won’t even know if it has enough money to appeal the ruling until early February. That’s when a judge is due to rule on whether Thames can access as much as £3 billion in emergency funding from its creditors, which is separate to the equity.

The decision today leaves Thames’ “hopes of attracting fresh equity in the balance and increasing the likelihood of a drawn-out appeal to the CMA,” said Paul Vickars, senior credit analyst for Bloomberg Intelligence.

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Thames is among water companies that had a large gap between what they asked for and the final result. Others include Southern Water, Wessex Water and Hafren Dyfrdwy.

Bill Hikes

Thames will be allowed to raise bills by 35%, over the next five years, also falling short of the 52% increase the company said it needs to fix creaking infrastructure. Any investment costs will ultimately borne by customers. 

The hikes will fund a £20.5 billion investment program to 2030 for its service area. But Thames said it needs to spend more than £24 billion in order to turn around its poor performance on leaks and pollution, while also dealing with the effects of climate change and a growing population.

Ofwat has been criticized in the past for putting too much focus on keeping bills low, leading to decades of underinvestment in assets.

Thames’ investors, including Macquarie Asset Management have also been blamed for its financial mess, because they took advantage of industry rules to load up the company with debt and extract dividends. Thames’ gearing rose to 84.2% at the end of September. 

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Also See: Macquarie Borrowed Big. Thames Water Users Are Paying the Bill

Ofwat’s ruling was seen as more positive for better performing and listed companies, such as Severn Trent Plc, Pennon Group Plc and United Utilities Group Plc. 

“At first sight, we see a decent package,” said Jenny Ping, an analyst for Citigroup Global Market Ltd.

Companies and their investors will now need time to read through the hundreds of pages produced by Ofwat today to understand the balance of risk and return. That means working out if the allowed returns will be enough to secure the £104 billion investment that Ofwat signed off on. 

“Ofwat has at last recognised the need for bills to rise to meet unprecedented levels of investment. But it also has a duty to make the industry investible,” said Jon Phillips, chief executive of the Global Infrastructure Investor Association. “Investors will be looking very hard at whether the regulator has done enough to restore confidence.”

(Updates with response from Ofwat in eighth paragraph and details on CMA in 16th.)

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