UK Water — A Perfect Storm

The regulated UK water and wastewater (water utility) sector is facing increasing scrutiny in the media, and amongst consumer groups and politicians. Public expectations have become increasingly politicised in terms of performance and delivery, investment, capital structures, and shareholder returns. This situation is occurring against the back drop of climate change, recurrent use of storm overflows resulting in regular sewage discharges into our rivers, concerns regarding levels of leakage,It is worth noting that levels of leakage today are far lower than at the time of privatisation and in recent years. Up until about 10 years ago, there was an “efficient” level of leakage (i.e., accepted where it would cost more to fix than put more water into the supply). A lack of allowed investment in asset health in historic price reviews means that the replacement rate is c.1 in 800 years). the use of hosepipe bans in the summer months, and the perception (though not necessarily the reality) that executives and shareholders are handsomely rewarded regardless of performance and customer experience.

Ofwat’s Expectations for More Ambitious Business Plans and Greater Financial Resilience

The scrutiny and politicisation comes also at a time when UK water utility companies are required by the terms of their licences to deliver their annual certificate to Ofwat, the regulator for the UK water utility sector. The certificate (to be reviewed by the company’s auditors) must confirm that it has sufficient financial resources for at least the next 12 months. Ahead of Ofwat publishing draft price determinations in May/June 2024 and final price determinations in December 2024, water utility companies will also be submitting to Ofwat in early October of this year their business plans for the next five-year regulatory cycle starting in April 2025 (AMP 8).

Ofwat published its final methodology for assessing business plans and making its final price determination back in December 2022, in which it set out its ambition to transform performance in the sector by looking to companies to accelerate investment ahead of AMP 8 to reduce the use of storm overflows and per capita consumption of water, deliver more resilient and environmentally sustainable services, enhance transparency regarding the link between dividends and performance (to be supported by changes to company licences), and, more generally, encourage much greater financial resilience. Ultimately, as things stand, less financially resilient companies will likely struggle to meet or outperform delivery incentives set by Ofwat, resulting in potential reductions in allowed returns on equity.

Historic Approach to Water Regulation

Inevitably, Ofwat’s ambition for much greater financial resilience has put the spotlight on those water utility companies that have more significant levels of gearing (i.e., materially in excess of the 55% notional level of gearing assumed for the hypothetical notional company which uses this level in its PR24 pricing methodology. (The 55% level signifies a notable reduction in the notional gearing of 60% assumed by Ofwat in its PR19 pricing methodology). The more highly geared water utility companies have funded themselves through structures commonly (although somewhat misleadingly) referred to as “whole business securitisations”. Thames Water, Yorkshire Water, and Southern Water are probably the most well-known companies that have funded themselves on this basis. Much has been written or spoken about in the media and even in Parliament about these companies and their financing structures, much of which is incorrect or which, through the use of soundbites, speaks to an intended political audience. It is, however, worth looking at these structures in a little more detail, at least to understand the basis for their design and how resilient they are to external factors, and to assess what the risks may be for creditors and shareholders as we approach PR24 and AMP 8.

It may seem hard to believe in the current environment, but the UK experienced a sustained period of time, following the privatisation of UK water, when investing in a regulated water utility company was seen as a “gold standard”, stable investment that yielded steady and predictable regulated returns, with a supportive regulatory framework that protected the interests of consumers, shareholders, and creditors alike. Regulated UK water utility companies are granted licences by Ofwat which amount to local monopolies in the territories in which they operate and, absent material default or insolvency, are only terminable on 25 years’ notice (and then only on stringent conditions).

The noughties saw a spate of M&A activity, resulting in consortia of one or more infrastructure funds, asset managers, insurers, and sovereign wealth funds becoming owners of a number of the regulated companies in the sector, with acquisitions invariably concluded at significant premia to the regulatory capital values. The switch to private ownership in 1989 also came at a time when substantial financial investment was needed to fund upgrades to core infrastructure (Thames Water’s Victorian mains replacement programme being an obvious example).

The significant reduction in allowed revenues in Ofwat’s price determination of 1999 also led to the “flight of equity” and companies gearing up with cheaper debt. The debt markets were the obvious and most efficient means of funding the required investment, as well as refinancing debt incurred, to fund the acquisition of the relevant regulated company. The public bond markets were particularly attractive sources of capital, given the ability of water utility companies to raise fixed or inflation-linked debt with long-dated maturities. Furthermore, utilising securitisation technology to provide additional structural enhancements, whilst respecting regulatory and licence requirements, increased the amount of investment grade debt that could be raised. Additionally, issuing investment grade senior and junior tranches enabled a notching up of the senior debt above the “vanilla” corporate rating of the regulated entity.

Traditionally, Ofwat did not see itself as the arbiter of how licensees should fund themselves. Ofwat envisioned a “diverse ecosystem of funding structures”, leaving such matters for the regulated entity and its shareholders and noting the strict ring-fencing protections that licences impose on water utility companies, including a requirement to maintain an investment grade rating. Indeed, water utility companies were able to finance and term out their required capital expenditure investment in the benign interest rate environment that followed the financial crisis, and before the financial impacts of Brexit, the COVID-19 pandemic, and the war in Ukraine were first realised. This ability allowed Ofwat to maintain its focus on keeping customer bills as low as possible, and flat or declining in real terms for the last 10 years or so.

The “Whole Business Securitisation” Model

The paradigm “whole business securitisation” financing model for a UK regulated water utility can be summarised at a high level as follows:

• The regulated utility establishes a wholly owned special purpose subsidiary (Finco).
• Finco raises debt typically comprising public bonds, private placement notes, and bank debt, the proceeds of which it lends to the regulated entity at the corresponding economic terms. All debt is, however, subject to common terms in terms of representations, warranties, covenants, trigger, or lock-up events and events of default.
• In a number of cases, the common terms debt is tranched into senior and junior classes of debt, with the subordination of, and credit enhancement provided by, the junior tranche providing a notching up of the rating of the senior tranche above the corporate family rating of the regulated entity. Originally this tranching resulted from investor preference for a rated debt instrument of A-/A3 or above.
• Refinancing risk for the common terms debt is mitigated by a restriction on the amount of debt that is permitted to mature in any consecutive period of 24 months and over the course of each regulatory cycle.
• The common terms debt is guaranteed by the holding company of the regulated entity (typically the newly established special purpose holding company for the acquisition) (Holdco).
• The common terms debt is secured principally by a fixed charge from Holdco over its shareholding in the regulated entity.Although security is purported to be taken over assets of the UK water utility company, law and regulation do not permit effective security to be taken over the core infrastructure assets. Any security granted at the level of the regulated entity is therefore purely defensive in nature.
• The occurrence of a “trigger event” (e.g., failure to meet target financial ratios (leverage and interest cover) or to maintain adequate liquidity for capital expenditure, working capital, and scheduled debt service) leads to an immediate lock-up of dividends and distributions to shareholders until such time as it is remedied.
• The occurrence of an event of default automatically results in an immediate 18-month mandatory standstill among secured creditors, during which time:
  • no secured creditor can take any enforcement against the regulated entity or Finco, including acceleration of indebtedness or the early termination of any interest rate, inflation, or cross-currency hedging;
  • through the appointment of a standstill cash manager, the application of cash is tightly controlled to ensure operating expenses can be met in full ahead of scheduled debt service to allow for the regulated entity to continue to trade as a going concern;
  • secured creditors have recourse to a debt service liquidity facility sized to cover 18 months’ projected debt service, enabling them to continue to receive timely payments of scheduled amounts falling due, notwithstanding the occurrence of an event of default and any interruptions to cashflow;
  • secured creditors can step in and secure a private exit outside of a court-administered process by appointing a receiver under the share charge from Holdco and selling the regulated utility as a going concern; and
  • the proceeds of disposal from the sale of the shares in the regulated entity are applied in prepayment of the common terms debt in the order of priority set out in the relevant post-enforcement waterfall.

Special Administration

A key objective of the structuring in the so-called “securitised” financings is to reduce the risk that the UK government would have grounds for appointing a special administrator to the regulated entity on the basis of its insolvency (with financial covenant default ratios and liquidity maintenance requirements set at levels with a significant headroom to balance sheet and cashflow insolvency). Special administration is the mechanism by which the government can, as a last resort, take temporary control of key UK regulated infrastructure assets pending the transfer of the licence of the regulated entity to a new appointee together with all, some, or none of the liabilities of the incumbent (as the special administrator shall determine).

Special administration is not the same as nationalisation, for which Parliament would need to pass specific legislation to take the regulated entity into public ownership. There is no precedent for the appointment of a special administrator in the UK water sector. However, creditors and shareholders perceive such an appointment as a negative, since consumer interests (and the need to ensure the continuous safe supply of water and (if applicable) wastewater services) rank above the interests of creditors and shareholders. Although the special administrator still has to obtain the best price reasonably obtainable in the context of any transfer of the licence and have regard for the interests of creditors and shareholders in that order, the primacy of the interests of consumers is not something that would otherwise apply in any ordinary administration or receivership exposing creditors and shareholders to the risk of a greater haircut in recoveries.

Whilst much has been made in recent weeks of the prospect of the UK government putting Thames Water into special administration, it is worth noting that Thames Water has over £4 billion of available liquidity and its leverage has about an additional 15% of headroom (measured as net debt to its regulatory capital value) before a leverage default would occur. Discussion at recent select committees involving Ofwat have clarified that special administration is a particularly high bar and, while considered prudently as a contingency by government, it is not currently considered likely for Thames Water or any other water utility company. Accordingly, there is nothing yet to suggest that the so-called “whole business securitisations” are not robust and fail to provide the protections intended for debt investors.

Conclusion

The debate around the UK water utility companies therefore remains much more about the ability of the more leveraged companies to deliver business plans which match Ofwat’s ambition and the need to demonstrate greater financial resilience, whilst at the same time being perceived as attractive investment opportunities by international infrastructure investors.

The announcement that Thames Water’s shareholders have agreed to inject a further £750 million of equity (in addition to the £500 million of equity injected in March 2023) means that Thames Water has access to funding for the additional required investment in line with its turnaround plan over the remainder of AMP 7. However, the additional equity remains conditional on the preparation of a business plan that delivers targeted performance improvements for customers, the environment, and other stakeholders over the next three years and is supported by appropriate regulatory arrangements. A lot therefore hinges on what is “appropriate”, noting that Thames Water’s shareholders have not taken a dividend in the last six years. It’s a similar story for the shareholders of Yorkshire Water, Southern Water, and Anglian Water.

Whilst we expect to see the UK water sector remain an area of continuing focus and debate, we see the existing political and regulatory risks and uncertainties remaining with investors whose equity or debt returns depend on dividend distributions from the regulated water company and not with creditors whose claims benefit from, and are within, the regulatory ringfence.