(Bloomberg) -- Thames Water is set to be put in special measures by the regulator to try to get the beleaguered utility back on its feet before it runs out of money at the end of May.
Ofwat will get a bigger say in what Thames does next. The top priority is the quest to find investors willing to put in at least £2.5 billion of equity. But investors want decent returns. Ofwat proposed a rate of return on equity that’s below what Thames said it needs to look attractive. The regulator maintains that the level is fair.
A failure of Thames would be a massive problem for the new Labour government, for consumers and the UK as a destination for investors. Bills are set to rise and people are angry about sewage leaks into rivers and bathing spots. The new government will need to act decisively to avoid a messy failure blighting its start in power.
Here are some potential scenarios of what’s likely to come next:
Government Help
Thames has until the end of May to help shore up new investors. That’s when its cash runs out and it will no longer be able to operate. At that point the government may need to step in and temporarily nationalize the utility.
But Labour pushed back earlier this week on providing taxpayer help for failing companies. “There is no program of nationalization for the water industry. Why should bill payers pay twice?” Communities Minister Jim McMahon said.
When asked if privatization of the sector had been a mistake, Chancellor of the Exchequer Rachel Reeves said rising bills were a “bitter pill” for customers to swallow.
Investors bought some of Thames’s bonds on the assumption that losses would be around 10% in the event of special administration to try to reduce the company’s debt load.
New Equity
In the best case, the extra oversight by Ofwat could be enough to convince investors that Thames is investible again.
These need to be new investors after Thames’s current shareholders turned their back on the business in March and parent company Kemble Water Holdings defaulted on its debt. The largest shareholder has already written off its £1 billion stake.
Ofwat said it would be seeking engagement with investors. Any equity investor could become the new owner of Thames, wiping out existing shareholders. Last month, one of the UK’s largest pension funds said it may consider investing in Thames Water if it was up for sale.
The problem is that Ofwat proposed a return on equity rate of 4.8%. That’s below the 5.7% Thames says is key to attracting new investors. If that rate doesn’t improve before the final determination in December, Ofwat’s oversight may not make a difference.
Splitting Up
Thames could be split into two or more companies in the medium term, under Ofwat’s plans. This possibility has been mooted for years and most vocally by Dieter Helm, economics professor at the University of Oxford and a former government adviser. One option would be to hive off water supply from sewage into separate entities. Another would be to separate London from the rest of Thames.
Thames’s size — it’s serves a quarter of England — makes it harder to raise equity in private markets, according to David Black, chief executive at Ofwat.
“We think the company should be considering whether breaking itself up would make itself more attractive to investors and work better from a customer perspective,” he said.
But Helm argues it would be far easier to break up Thames if it was in special administration because there would be fewer stakeholders and competing interests.
Public Listing
Ofwat said on Thursday that a public listing to secure additional equity is an option. Listing Thames would require unraveling Thames’s current Whole Business Securitization structure and there’s no guarantee the company would perform any better.
But an IPO could be a better option in the long run. Industry observers have long maintained that publicly listed water companies, Severn Trent and United Utilities, perform better than their privately-held peers.
Thames’s chief executive on Tuesday said an IPO was a potential option but wasn’t something they were actively considering while they were focusing on seeking a new equity injection.
Junk Jitters
Thames could be downgraded by credit rating agencies to junk, a market term used to describe the riskier end of the credit spectrum. Dropping into junk territory typically also means the company drops out of many lucrative indexes and funds that only buy investment grade debt.
Already, S&P rates Thames at BBB-, the lowest investment grade rating, which means it can’t pay dividends. A junk rating, however, could spell the end for Thames, according to Bloomberg Intelligence senior analyst Paul Vickars.
“Ofwat’s draft determination doesn’t appear to boost allowed return on equity enough to attract new investors to Thames Water, leaving it facing a £3.25 billion funding gap through 2030, a forecast covenant trigger event by March that would restrict its ability to raise debt, less than 12 months of liquidity and higher risk of a downgrade that may be an event of default,” he said.
It would make a financial restructuring more likely and could speed a temporary nationalization.
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--With assistance from Abhinav Ramnarayan and Giulia Morpurgo.
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