(Bloomberg) — If recent bond sales are a guide, Thames Water’s troubles are going to cost the UK water industry dearly.
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Yorkshire Water, Anglian Water and Welsh Water have sold new debt over the past month, and they all borrowed at rates higher than industry regulator Ofwat has currently factored in. The sector will still need to raise an estimated £40 billion ($53 billion) of debt to meet Ofwat’s requirement for infrastructure investment over the next five years, according to people with knowledge of the plans.
Applying Yorkshire’s costs to this amount of debt, then water utilities could face an additional £390 million in annual interest that the regulator hasn’t accounted for, calculations by Bloomberg show. Yorkshire paid the highest rates among recent deals, though even using the lowest from Welsh Water implies £140 million a year more.
It’s a sign that contagion risks after the default of Thames’s parent company have already started to materialize, though the figures don’t account for changes in future borrowing costs or the cash not being raised all at once. Still, the resolution of Thames’ finances looks pivotal for the sector’s debt burden, as it seeks to fix leaky pipes and curb sewage spills.
“The market and to a certain extent the rating agencies are questioning the regulatory regime,” said Jamie Irvine, an investment manager at abrdn plc. “You can see there is a lot more caution around the sector.”
Ofwat declined to comment specifically on the calculations. A spokesperson said it will take a final decision on its plan for the next five-year regulatory period in December, which will include the allowed cost of new debt, and it’s considering market data among the factors.
The regulator, which controls companies’ price of water bills and return on equity, can fine them for failing to meet targets. Total borrowing in the sector increased to £68.3 billion as of March 2023, up from £60.6 billion a year earlier, according to an Ofwat report.
While it can make changes to its estimated cost of debt to reflect moves in the market, a company with high costs won’t be able to fully recover the difference, according Paul Vickars, senior credit analyst at Bloomberg Intelligence.
“A company that’s debt is above the allowed level will have to absorb the extra costs, reducing profit and lowering margins, then making the companies less investible assets,” said Vickars.
Risk Premium
Following the default by Thames’ parent in April, the premium investors demand to hold water firms’ bonds over UK government bonds has been surging. Thames is now working with a group of its creditors to try to avoid running out of money.
“Thames Water: we can point to financial engineering, dividends, excess debt but then also the regulator just hasn’t played ball on necessary price increases,” said Gordon Shannon, portfolio manager at London-based TwentyFour Asset Management. “I do think you have to differentiate between sectors and even within water. But it feels like there should be more of a premium overall.”
The outlook is bleak for the industry. Investors warned the government at a recent meeting that without more attractive returns they are unlikely to inject more money into the sector. In Ofwat’s plans the sector will need to spend a total of £88 billion over the next five-year period.
While the sector is largely funded by debt, it needs to be attractive enough so that shareholders will stump up the equity needed to stop companies becoming too indebted and at risk of financial collapse. Yet further increases to water bills are likely be deeply unpopular, after what is being seen as years of profiteering by shareholders.
“Customers have already paid a price for Ofwat’s historic over-generosity on water companies’ financing costs, so we think it’s right the regulator is now challenging the industry hard on this issue,” said Mike Keil, chief executive of the Consumer Council for Water, an advisory group for consumers.
–With assistance from Jessica Shankleman.
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