(Bloomberg) -- Britain’s water industry is bracing for the biggest overhaul since privatization in the 1980s amid a scandal over systematic sewage spills and chronic pipe leaks. The crisis follows decades of poor regulatory oversight that allowed company owners to pay themselves billions of pounds in dividends instead of using the money to maintain the infrastructure. Things have got so bad that Thames Water Ltd., which serves about a quarter of the UK population, is being taken into special measures and could eventually be broken up or nationalized. The industry’s finances are too weak to cover the heavy investments needed to fix the problems, so customers will be forced to shoulder the cost through higher bills.
1. What’s gone wrong?
UK water utilities have enjoyed a rock-steady stream of income from bill-paying households and businesses, but many of them are laboring under heavy debts racked up by the international investment funds that own them.
The owners of Thames Water, for example, used a structured financial product called a whole-business securitization model that allowed them to pile debt on the company and pay themselves more in dividends. This practice was encouraged by a flawed framework of incentives known as the “managed price system” devised by regulators.
2. Why is Thames Water being put into special measures?
Thames Water now likely has the highest ratio of debt to equity of any UK water company, and fines imposed by regulator Ofwat over poor performance have worsened its predicament.
What’s more, over half of Thames Water’s debt and derivative-linked liabilities were inflation-linked as of September 2023, according to credit rating firm Moody’s. As a result, its debt servicing costs soared when UK inflation jumped following the pandemic.
A public outcry over the widespread and systematic pumping of raw sewage into Britain’s waterways has jolted Ofwat into trying to tackle the root cause — decades of underinvestment.
Thames Water alone says it needs to spend £19.8 billion ($24.4 billion) through 2030 to fix leaks, boost sewage treatment capacity and make the country’s water network more resilient to the weather extremes caused by global warming, paid for through higher bills for consumers. The UK’s largest water and sewage company has the worst record in England and Wales for chronic leaks, and faces one of the biggest cleanup bills.
The scandal led its chief executive to quit in 2023, and its owners have spent the intervening months trying to thrash out an investment plan that’s acceptable to both industry regulator Ofwat and its own shareholders — most of them overseas pension funds and sovereign wealth funds.
3. What tipped Thames Water over the edge?
Matters came to a head in late March, when those investors refused to inject £500 million of cash into the business, saying the conditions required by Ofwat made the plan “uninvestible.” A week later, Thames Water’s holding company defaulted on about £1.4 billion of debt after failing to make an interest payment. In May, Thames’s biggest shareholder wrote off the entire value of its stake and one of its managing directors quit Thames’s board.
Dividends have also been a major problem. In April 2023, Ofwat changed the rules so that poorly performing companies aren’t allowed to pay dividends. Thames has said it doesn’t pay external dividends, but it does make payments to its parent company Kemble Group to service its debt. Those have now been cut off, meaning Kemble no longer has a source of income. Ofwat has said it’s considering taking action against Thames for paying dividends in October and March, which could lead to more fines. It says it doesn’t distinguish between external and internal dividends, and doesn’t want customer money used to service parent company debt.
4. What does it mean for water bills?
To dig itself out of trouble, Thames has proposed to raise bills. Under a plan set out by Ofwat on July 11, the company will be allowed to hike average annual customer bills by 23% to £535 per household, well below the £627 proposed by Thames. The increases are unlikely to go down well with consumers amid a cost-of-living crisis, and with trust in water utilities at a low.
5. How much debt did Thames Water take on?
When Thames Water was privatized in 1989, its slate of debt was wiped clean. Its indebtedness remained below the industry average until it was acquired in 2006 by Kemble, a consortium led by funds managed by Australia’s Macquarie Group. Macquarie’s use of the securitization model pushed the company’s debt above that of peers, and in following years the gap widened further.
Parts of Thames Water’s substantial debt pile now face the possibility of a downgrade to “junk” territory, which may trigger a default event. That would restrict the company’s ability to borrow more and increase the likelihood of a financial restructuring.
6. How did the “securitization model” work?
Thames Water’s owners monetized its valuable infrastructure and steady income stream by creating shell companies that then issued debt to be serviced using money siphoned from the core business. The operating company also issued debt regularly over the years, partly to finance investments in the network.
Critics of privatization say the system allowed companies to make billions of pounds in profits while allowing the nation’s water infrastructure to lapse into disrepair. They say successive governments failed to act as Thames Water dragged its feet on infrastructure spending and debt ballooned.
7. Are other water companies in trouble?
Ofwat uses a metric known as capital gearing to measure how much debt different water companies have as a proportion of their regulated capital base, and to judge whether a business is on a firm financial footing.
As of March 2023, Thames Water was the most exposed, but others weren’t far behind. In July 2023, Southern Water Ltd. was forced to suspend dividend payments as Fitch downgraded its debt and borrowing costs surged. The industry’s debt problem could get worse given the pressure it’s under to boost spending. Water companies are proposing to spend at least £96 billion between 2025 and 2030, an 88% increase from the previous five years, on what they’ve called the biggest modernization of sewers since the Victorian era.
8. Will Thames Water be nationalized?
It remains to be seen whether the bill increases will put Thames on a strong enough financial footing to convince new shareholders to stump up the £2.5 billion it needs as a bare minimum to fix the network.
Another option for Ofwat is to split Thames into two or more smaller water companies, or pursue a potential stock market listing to secure additional funding.
There’s little appetite in Keir Starmer’s new Labour government to take Thames Water back into full state ownership, as this could suck up taxpayer money that might be used to fund other priorities. The government is preparing plans of its own to fix the water crisis by generating more investment and pushing for tighter monitoring of how customer money is invested.
--With assistance from Priscila Azevedo Rocha and Tasos Vossos.
©2024 Bloomberg L.P.