(Bloomberg) -- The UK’s largest water and sewage supplier Thames Water is in trouble. A huge hole in its finances is threatening to drive the company to temporary nationalization, potentially creating a big problem for current or future governments. Here’s an explainer of how Thames Water came to be in this position, what could happen if the company collapses and what it all means for customers.

What is the Thames Water crisis?Thames Water is saddled with debt and desperately needs about £3 billion to repair its aging network. After months of deliberations with the regulator Ofwat, Thames Water’s shareholders announced in March that its business plan was “uninvestible,” and they refused to inject £500 million into the troubled supplier. A week later, those owners defaulted on about £1.4 billion of debt after failing to make an interest payment.

That leaves a yawning hole in Thames’s finances with big questions about how it will fix chronic leaks and sewage spills, which makes it the worst performing of all the water and sewage companies in England and Wales.

Public anger has focused on Thames’s proposal to raise bills by 40% by 2030 despite its poor performance. Thames’s owners have also been criticized for taking dividends out of the utility, with many arguing that money should have instead been spent on fixing infrastructure.

Why is Thames Water in so much debt?When Thames Water was privatized in 1989 by Margaret Thatcher, its slate was wiped clean. Now it has £16 billion of debt with £19 billion of capital, the highest gearing ratio in the water industry.

Over the last 35 years, Thames has had a series of owners, most notably Australian investment bank Macquarie, which took a 48% stake in 2006. Macquarie used a structured financial product called a whole-business securitization model that allowed it to increase debt at the company while paying itself dividends. More than half of Thames Water’s debt is linked to inflation, which means that its debt pile has grown quickly over the last couple of years as inflation has soared.

Macquarie says it has been unfairly criticized for how it acted during its time at Thames Water and says that it invested more than £1 billion a year between 2006 and 2017 to maintain, upgrade and expand the network. Macquarie also points out that the business model they used was allowed by the regulator at the time. 

Will Thames Water be nationalized?There’s no appetite in the current government to nationalize Thames Water. Prime Minister Rishi Sunak has made it clear to investors that they need to sort out their own financial mess, and Environment Secretary Steve Barclay rebuffed a plea from investors in Kemble Water Holdings Ltd., the parent company of Thames Water, to intervene in negotiations with Ofwat.

Thames Water’s chief executive Chris Weston has said temporary nationalization is on the horizon, but some way off. If Thames can’t find additional equity on the private market, the government may be forced to apply to the courts to trigger insolvency proceedings, bringing it into special administration.

Thames says it has £2.4 billion in cash, which is enough to last until July 2025. That means the nationalization question could be one for the next government as an election is due by January 2025. With polling currently showing a strong Labour lead, it could be a decision for Keir Starmer, who is also reluctant to nationalize Thames Water. 

Neither political party wants to choose this option as it would require billions of pounds of taxpayer money that they’d like to spend elsewhere. 

What would it mean for customers if Thames Water collapsed?Earlier this year, as the financial position of Kemble’s financing arm deteriorated, government officials created contingency plans that would see Thames Water put into special administration, investors wiped out and Kemble bondholders swallowing losses. 

If Thames Water runs out of money it doesn’t necessarily mean that it would stop supplying its millions of customers in and around London. In that scenario, it’s likely that contingency plans would be activated, and the special administrator would continue to operate the business and supply water with the backing of taxpayer money.

The water firm is viewed by the government as too big to fail, and it’s governed by the same regulations that protected UK utilities Wessex Water and Welsh Water when their parent companies collapsed in the early 2000s.

Who owns Thames Water?Thames has a byzantine ownership structure, which has been criticized for its opacity and complexity. The regulated utility of Thames is owned by a company called Kemble Water Holdings Ltd., which in turn has nine investors. They are a mixed bag, including a Canadian pension fund, the Universities Superannuation Scheme Ltd, one of the largest pension schemes in the UK, China Investment Corp. and a subsidiary of the Abu Dhabi sovereign wealth fund.

Kemble’s creditors include ING Groep NV, Bank of China and Macquarie.

Could water bills increase?Water bills for households in England are set to rise by 35% on average by the end of the decade as suppliers ramp up investment to expand and fix leaky networks and protect against future drought caused by worsening climate change. London is no exception, with Thames Water proposing to increase bills by 40% by 2030.

So far these are just proposals, and still need to be approved by the regulator Ofwat. The regulator will scrutinize the proposals to ensure they deliver value for money and are adequately funded. It has told the suppliers they won’t be allowed to use bill payers’ money to fix past mistakes. The final plan will be agreed in December 2024, with changes to bills taking effect from April the following year.

The Consumer Council for Water said Thames’s plan was “unacceptable” because it’s seeking to charge consumers more for future investments than the regulator’s baseline assumptions of the cost to finance its business. It also warned that Thames’s huge investment program may not be deliverable.

©2024 Bloomberg L.P.