The resignation of Thames Water’s chief executive triggered speculation about nationalisation of the company. We explain why we don’t think that’s likely
Thames Water credit spreads have widened materially in recent weeks, following the surprise resignation of the company’s CEO and press speculation that the government is preparing contingency plans for a potential nationalisation.
Background on the UK water sector
The UK water sector has been subjected to criticism since its privatisation more than 30 years ago. Many water companies have fallen into the hands of pension and infrastructure investors attracted to the stable inflation-linked returns that the sector provides. But, while some companies have adopted prudent financial policies, others have employed more aggressive financial leverage – via complex financial structures – that serves the purpose of “juicing” shareholder returns. This has prompted criticism that shareholders have earned outsized returns while taking minimal risk, with the taxpayer ultimately “on-the-hook” in the event that mismanagement resulted in a (potential) corporate failure. Some water companies have also been criticised for the unauthorised discharge of raw sewage into rivers and seas and lack of investment to improve environmental resilience. Questions have also been asked about The Water Services Regulation Authority’s (Ofwat) role in allowing water companies to determine their own financial policies, as well as its role in the oversight of the sector’s environment failings.
Ofwat has more recently shown its teeth, taking a much tougher stance towards the companies it regulates. Highly leveraged water businesses have been required to improve financial resilience and reduce debt. Fines relating to environment failings have become more commonplace, and water companies are under increased pressure to improve operational performance and resiliency.
Thames Water has been front-and-centre regarding Ofwat’s tougher stance. But progress under the stewardship of CEO Sarah Bentley (appointed in 2020) was encouraging. A long-term turnaround plan was put in place and its operational performance showed signs of improvement, albeit from a low base. Shareholders injected £500mn of equity as recently as March 2023, with the promise of additional new equity to come. However, the recent CEO resignation and speculation that the government was preparing a nationalisation contingency plan has put to question Thames Water’s turnaround plan and the commitment of its shareholders.
The CEO resignation was a surprise to most and the reasons for Sarah Bentley’s departure are unclear. Was there a breakdown in the relationship between company management (representing shareholders) and Ofwat? Was there a disagreement about how additional necessary investment would be remunerated or how it would be spent? Were there differing views regarding the size of additional equity required? The relationship between management and regulator are vital in any regulated industry and, while (potential) friction is cause for concern, we view the move in credit spreads as an overreaction.
Shareholders and government – understanding the perspectives
In our view, it is unlikely that shareholders would just walk away from ownership of the asset. To demonstrate why, let’s run through some high-level numbers.
The starting point for valuing a water company is typically its Regulatory Capital Value (RCV) – the basis from which the companies return is earned. The RCV of Thames is £18.9bn (as at March 2023) and the company has net debt of approximately £15.9bn (this includes operating company and holding company debt). Equity stakes in UK-regulated utilities historically exchanged hands in the +20-30%* range and, while sale premiums are generally not made public, some reports suggest that more recent transactions in the sector have been made at between flat to a +5% premium to RCV. Using a range of flat to +20% premium to RCV implies equity valuations of between £3bn and £6.8bn. Somewhat complicating this analysis are inflation-linked swaps at the company, which are £1.5bn out-of-the-money (as at March 2023); however, even if we adjust debt numbers for these, implied equity remains meaningful. Even if there was limited appetite for current shareholders to provide additional equity, we think it likely that fresh equity via new investors – while dilutive – could be sought rather than current shareholders handing over the keys and walking away. Shareholders have shown signs of commitment to the business; last week, additional equity support of £750mn during the current regulatory period (which concludes in 2025) was announced, though this is conditional on Ofwat’s approval of its business plan. An additional £2.5bn has also been highlighted as required over the next regulatory period from 2025-2030.
We also think that Ofwat and the government would be reluctant to step in prematurely through a nationalisation of Thames Water. Such action could be perceived as heavy-handed, would likely increase future financing costs for the sector and could reduce the attractiveness of future investment in a sector that has significant future environmental-related investment needs.
What happens if the government takes control of Thames Water?
The process by which the government takes control of a water company is called Special Administration, which involves taking temporary ownership of the assets to ensure they are in the public interest, while new shareholders are found in a timely manner to take ownership of the business. Gearing at the operating company today stands at 77% of RCV (March 2023), implying reasonable equity headroom relative to Thames Water’s RCV value. In the short term, interest payments could be serviced from the business’s cash flow and debt repaid from its ample £4.4bn liquidity position, meaning investment-grade ratings at the operating company could be maintained. The outcome of holding company bonds – at an entity called Kemble – is more questionable. We estimate gearing at the Kemble level is at 84% of RCV, with interest serviced from dividends distributed from the Thames Water operating company, making it more at risk of not being able to service its debt. However, Kemble bonds trade at circa 70 pence in the pound today and, given shareholder commitments to provide additional equity, there is a strong case for upside for these bonds, too.
Conclusions
Many might cheer (and hope for) the return of assets providing a public good and serving the public interest moving back into government hands. But the UK does not have a history of expropriating assets, and such action would likely require substantial compensation and a commitment to publicly fund future significant investment requirements. Such action would suggest an ideological change from government, one that does not seem to be a priority of either major political party as it stands.
One might also question investor support for a sector that has faced environmental challenges such as UK water. However, we recognise that antiquated infrastructure, population growth and climate change have presented water companies with sizeable environmental challenges. While mistakes have likely been made in the past, we endeavour to support those companies that have credible plans to improve environmental resilience. We believe the provision of water is an essential social need and therefore are supportive of companies who can provide this social benefit.
Our base case for Thames Water is that existing shareholders inject additional equity and that a more normalised relationship between management, shareholders and Ofwat will ensue. Shareholders have substantial equity to lose should they walk away, and the asset should remain attractive given the inflation-linked returns it generates (albeit returns may be less generous than before). Equally, the investment needs of the sector – and other sectors that operate under similar regulatory frameworks in the UK – should incentivise Ofwat and the government to work towards a solution, maintaining UK infrastructure as an attractive place to invest. Assuming our base case is correct, there is a case for a relative retracement of Thames Water credit spreads in the future.
*It is common for regulated companies to be valued at premiums to RCV given the attractiveness of inflation-linked assets and returns. Publicly listed water companies UU and Severn Trent currently trade at modest premiums to RCV.
