The issue of debt levels has long been growing as a source of conflict between water companies and the regulator. But with the sector facing a public backlash over sewage discharges and pollution, questions are now being asked more widely about their financial arrangements too. In a special report, Utility Week examines the current debt levels of the sector, whether high gearing has enabled companies to generate excess profits, and if it’s possible to draw a link between ownership, gearing and operational performance.

For most of the 30 plus years since privatisation, water companies have, comparatively speaking, been able to slip by under the radar, escaping the intense public scrutiny experienced by many other industries of equal or lesser importance.

In this sense, the industry has benefitted from being viewed by most people as inconsequential to their everyday lives. Its activities were largely hidden from sight and few showed much interest in finding out more.

Water bills are relatively small when compared with households’ other monthly outgoings. Most customers have very little interaction with their water company and are more than happy to keep it that way. So long as water kept coming out of the taps and they weren’t being chased for money, they largely ignored the industry, save from the occasional grumble about hosepipes bans or local roadworks.

But things have changed dramatically in recent years. The sector has taken a hammering in the press and news stories about water companies dumping sewage into rivers and seas have become a daily occurrence. Investigations by regulators, journalists and politicians, as well as companies own monitoring and publication of sewage discharges, are bringing to light the scale of the problem. And people don’t like what they see.

Anger over the issue has been amplified by the perception that despite failing to fulfil what are seen as their basic duties, companies have racked up tens of billions of pounds of debt, much of which has been paid out as dividends to shareholders, as well as bonuses to executives. They seem to many to have been rewarded, not for providing a good service, but for implementing complex and opaque financial arrangements to take advantage of a lax regulatory regime.

The reality is it makes sense for water companies to be large borrowers. A lot of their spending is on extremely long-term investments that will not be paid off for decades. Raising all of this capital from equity investors would be impractical and inefficient.

However, this does not mean the criticism of their financial arrangements is invalid. Ofwat has for many years now had concerns over the mounting debts of some companies, and for two main reasons.

Firstly, the regulator fears that high debts have left the companies in question with little headroom to deal with shocks. It worries that companies getting into difficult waters will cut back on necessary investments or even fail completely if they can’t keep up with their interest payments. Given public outrage over sewage discharges and the persistent poor performance of some companies, Ofwat also worries that this fragility could undermine the regulatory regime and act as a deterrent to the imposition of large penalties and fines.

Secondly, Ofwat is concerned that the full risks of failure are not borne by investors themselves. This, it believes, has allowed equity investors to earn excessive returns by ramping up their debt levels. There is also the question of whether the ability of companies to generate returns through financial engineering has contributed to poor performance.

For PR19, Ofwat took several steps to address these concerns, most obviously by reducing gearing of the notional company used to set the price controls from 62.5% to 60%. It also introduced a new financial resilience monitoring framework, with yearly reports, and a new gearing outperformance sharing mechanism (GOSM) to clawback some of the supposedly excess returns from high debt levels.

These efforts are set to continue for PR24 after Ofwat confirmed in its final methodology last year that the notional gearing will again be reduced, this time to 55%. There is no word yet on whether it intends to retain the GOSM for PR24 after the mechanism was overturned by the Competition and Markets Authority (CMA) for the four water companies that appealed their PR19 final determinations. However, the regulator does seem convinced that companies are profiting from high gearing levels, consumers are bearing much of the risks, and something needs to be done about it.

A mountain of debt

When water companies were privatised more than three decades ago, all of their debts were written off and they were even handed a “green dowry” of £1.5 billion to set them on their way.

But by the end of March 2022, water company debts had ballooned to £57.6 billion, equating to 68.5% of the total regulatory capital value (RCV) of the sector.

There was significant variation between companies, with the most heavily indebted, Thames Water, having a gearing ratio of 80.6%. The lowest geared company was Hafren Dyfrdwy at 39.7%, although it was something of an outlier. The company with the second lowest gearing ratio was South Staffs at 54.1%.

The average gearing at the end of March 2022 for securitised companies, which are subject to restrictive covenants designed to ensure they can maintain cover for their interest payments, was 70.2%, with the individual ratios ranging from 57.7% and 80.6%.

The average gearing for non-securitised companies was significantly lower at 61.6%, putting them only slightly above the notional gearing of 62.5%. Individual ratios ranged from 39.7% to 72.4%.

Net sector debts at the end of March 2022 were up almost £1.5 billion when compared to the previous year’s figure of £56.2 billion. Yet somewhat counterintuitively the weighted average gearing level was down by 4 percentage point from a peak of 72.8%.

This was partly due to the effects of higher inflation. While companies’ RCVs are linked to inflation, according to a recent report from ratings agency Moody’s just over a half of their debts (54%) were indexed as of the end of March 2022. This means a substantial share of their debt is falling in value relative to their RCV.

With high inflation set to persist throughout 2023 and into 2024, there will continue to be downward momentum on gearing levels for the next several years.

Moody’s nevertheless gave a negative outlook for the sector, warning that the benefits of inflation linked RCV growth will be offset by the accompanying cost pressures, with the effects on both sides of the scale varying significantly between companies.

The proportion of companies’ debt which was indexed to inflation ranged from roughly 25% for South West to around 90% for Hafren.

Meanwhile, the proportion of their debt which needed to be refinanced over the following four years, exposing them to increased interest rates, ranged from a few per cent for Affinity to almost 30% for Portsmouth.

Companies’ exposure to floating rate debt was generally limited but also varied significantly. The companies with the greatest exposure were Bristol and SES at over 20%. South Staffs, Affinity and Southern all had no exposure, while Yorkshire was slightly overhedged against rising interest rates.

Although the macroeconomic environment is generally putting downward pressure on gearing levels, Ofwat remains concerned that the companies with the greatest debts lack financial resilience. Its most recent financial resilience monitoring report in December, singled out five companies as requiring special attention: Thames, Southern, Yorkshire, Portsmouth and SES.

Ofwat worries that a lack of financial headroom has left these companies susceptible to shocks. If they get into trouble, the regulator fears they could cut back on investment, reduce service levels to customers and even go bust.

The regulator says they also need more equity to maintain the efficacy of the incentive regime and ensure fines are not constrained by concerns over their solvency. The latter is likely to be of particular concern for the regulator given its massive ongoing investigation into sewage treatment works and the government’s recent announcement that the sector should face unlimited fines for pollution.

These issues are best exemplified by the case of Southern Water, which has incurred hundreds of millions of pounds in fines and penalties in recent years. Speaking at a Utility Week event in November, former Ofwat chair Jonson Cox said the regulator came “very close” to taking Southern into special administration following a “material wipe-out of equity value for poor performance.”

Ofwat instead accepted an offer from Macquarie to acquire a majority stake in Southern’s parent company Greensands and inject £530 million of fresh equity into Southern itself as part of what Cox described as a “virtual special administration.”

Under sustained pressure from Ofwat, Anglian and Thames have also carried out or committed to large equity injections over the last several years.

Excess profits

“For as long as I can remember…. the stance of all the regulators – not just Ofwat but the Competition Commission and subsequently the CMA – has always been that the financial structure of regulated companies is not their concern”, Professor Robin Mason of the University of Birmingham tells Utility Week.

The economic foundation for this stance is the Modigliani-Miller theorem, which states that the cost of capital for a company is invariant to capital structure.

As financial losses by a company are initially borne by shareholders, they face greater risks than lenders and therefore expect higher compensation for investing their money. As a result, the cost of equity is higher than the cost of debt.

However, this does not mean companies are able to reduce their cost of capital by increasing their gearing. As they take on more debt, the risk per unit of remaining equity increases, raising the amount of compensation shareholders expect in return. Meanwhile, the cost of debt also rises as the risk of default grows. These effects completely offset the reduced weighting of equity in the capital structure.

Despite the regulator’s aspiration that it should comply with the theorem, the weighted average cost of capital (WACC) as determined by Ofwat is not in fact invariant to capital structure. Due to the specifics of the calculation, lowering the notional gearing, as the regulator has proposed to do for PR24, also reduces the WACC.

In its final methodology, Ofwat said its “early view” of the allowed return on equity for PR24 is 3.29% in real terms based on the CPIH measure of inflation and a notional gearing of 55%. It said this is 33 basis points higher than the allowed return of 2.96% set for PR19 based on a notional gearing of 60%. The regulator said the difference would grow to 46 basis points if the PR19 figure was restated for a gearing ratio of 55%.

But Mason says the Modigliani-Miller theorem “doesn’t hold in real life” either, meaning “the intellectual basis for not worrying about the financial structure of companies is removed immediately.”

The theorem importantly assumes perfect market conditions, with companies facing the full costs and benefits of their decisions. And natural monopolies with prices set by a regulator are no economist’s idea of a perfect market.

For a number of years now, Ofwat has been concerned that some of the risks of gearing decisions are being borne by consumers and taxpayers rather than shareholders, allowing companies to generate excess returns by increasing their debt levels.

It was for this reason the regulator introduced a new gearing outperformance sharing mechanism (GOSM) for PR19 to clawback some of this benefit for consumers.

The GOSM initially applied to companies with a gearing ratio of 74% or more in 2020/21, with this threshold sliding down a glide path by 1% per year to 70% in 2024/25. It requires liable companies to return to consumers 50% of the difference between their notional cost of equity and nominal cost of debt for gearing in excess of 65%.

It’s fair to say the introduction of the mechanism has not gone smoothly after the CMA promptly overturned it for the four companies that successfully appealed their final determinations.

Explaining its decision in its final ruling, the CMA said although it recognised Ofwat’s “legitimate concerns” over high gearing, the GOSM is “ineffective as either a benefit-sharing mechanism or as a tool to improve financial resilience”.

The CMA said Ofwat had failed to provide evidence to “identify or quantify” gearing outperformance by companies or analysis of the risks of miscalibration. It said the mechanism effectively acted as a “tax on gearing.”

The GOSM has not had a smooth ride either in terms of its application to the water companies that did not appeal their final determinations.

The mechanism shares the difference between the notional cost of equity as set at the beginning of the price control and the actual cost of debt incurred by companies. But the cost of debt has risen significantly in recent years, so much so that this part of the calculation has become negative. Accordingly, several companies have seemingly sought to use the mechanism to claim additional money from bills.

In its annual financial report for 2020/21, Thames announced to its investors that it would see a £15.4 million benefit from the mechanism due to the rising cost of debt.

In a series of individual letters to water companies on the subject of their financial resilience, Ofwat recently instructed both Thames and Affinity Water to instead report a value of zero, stating: “This was an event we had not considered when developing the metric and the figure reported by the company was not meaningful”.

The regulator told Utility Week that Thames and Affinity were the only companies affected by the GOSM to be called out in the letters as they were the only ones to make this error.

‘One-sided bet’

Following the CMA’s decision, Ofwat commissioned Mason and fellow academic Steven Wright to produce a report on gearing and financial resilience, including potential alternatives to the GOSM.

Given their use of sophisticated financial instruments and complex corporate structures, Mason says it is “extraordinarily difficult” to even establish companies’ actual gearing levels as part of the regulatory process. “There’s a real opaqueness about it,” he remarks.

The gearing levels published by Ofwat do not include the debts of their parent companies and to what extent these debts would raise or reduce their gearing levels is unclear. Certainly, Ofwat was unable to provide any figures to Utility Week.

Mason says whilst there are growing public concerns over “high dividends, high levels of debt, not using equity to fund investment,” these are somewhat “barking up the wrong tree.”

“I think the greater problem is that there will no doubt be significant fallout if a water company failed,” he adds.

“Using economics language, the externalities from that I think are only partially addressed in the current regulatory regime and I think that’s the nub of it.”

He says there is a “moral hazard” if companies know they won’t bear the “full brunt of the downside” of their chosen capital structure.

The report from Mason and Wright said this gap between social and private costs can take a number of forms, from cuts to expenditure and reduced service levels to the more dramatic fallout from a firm going bankrupt.

It said there is also an externality in the form of “any explicit or implicit insurance offered by the regulator when there are concerns about financeability.”

“This leads to lower risk to equity and hence the WACC can be lowered through increased gearing. It is, of course, difficult to collect direct evidence that this behaviour occurs.”

It continued: “No regulator would be willing to state the insurance explicitly: the preference will be to assert that no adjustment to the terms of a regulatory contract will occur in the face of impending financial failure, and special administration procedures will sort it out.”

Investors also have little incentive to acknowledge this insurance in case there is an “adverse regulatory reaction”.

Mason says the issue of gearing outperformance is exacerbated by information asymmetry between the companies and the regulator. In general, this has led the latter to err on the side of overcompensation when setting price controls, “aiming up component by component” for fear of underinvestment.

“Of course, the regulated firms contest that very energetically and enthusiastically, but it’s undoubtedly the case,” he adds.

Mason says the fact that the regulatory settlement offers excess returns to companies is demonstrated by recent acquisitions “where the market asset ratio is well above one.

“That’s really reflecting the kind of the one-sided bet that I think there is for utility companies that regulators really don’t want utility companies to fail, because although there’s a special admission administration regime, it’s really costly to bring in so they would prefer to ensure that there’s a little bit of uplift on the cost of capital to keep them well away from any finance stability concerns.”

When asked to quantify the size of the externalities from companies’ gearing decisions, Mason responds: “It’s really hard to answer in water, because we haven’t really had any incidents of failure, and therefore, we don’t have any empirical evidence as to the size of the externality.”

The special administration regime is intended to minimise the social costs of company failure, but the report said it is “questionable whether special administration procedures, on their own, or at least in their current form, are sufficient to address the externalities present.”

Remedies

Mason and Wright’s paper suggested several alternative options to address the issue of gearing, including a licence-based gearing cap, such as the one introduced by the Civil Aviation Authority for the company providing air traffic control.

Although the CMA also proposed this as a possible alternative to the GOSM in its final appeal ruling, Ofwat later dismissed the option on the grounds that fixed gearing caps would offer “imprecise protection” and would be “unlikely to capture the full range of risks to financial resilience”.

However, Ofwat has decided to press ahead with another of Mason and Wright’s suggestions – strengthening the existing cash lock-up condition in companies licences.

These conditions currently prevent water companies from paying out dividends without prior approval from the regulator if any of their credit ratings fall to the minimum investment grade of BBB-/Baa3 with a negative outlook.

From the beginning of the next asset management period on 1 April 2025, this trigger will be raised by one grade to BBB/Baa2 with a negative outlook, albeit with a three-month grace period in which companies can request a subsequent exemption.

The substantive potential impact of this move was demonstrated by Fitch’s subsequent decision to downgrade the credit rating of Kemble Water Finance Limited, a holding company of Thames Water, from B+ to B with a negative outlook.

Yet another suggestion of Mason and Wright was the creation of a new charge on highly geared companies that would be put into a fund and used to cover the costs of the special administration regime in the event that it is triggered. They said the charge could be levied on the basis of gearing levels or other measures of financial resilience such as credit ratings.

Alternatively, they said the conditions for triggering the special administration regime could be tightened such that “failure to meet service conditions by some margin, over some time period, is a sufficient condition to trigger special administration… irrespective of the degree of financial distress of the company concerned.”

As the cost of maintaining and restoring services levels would be treated as a “prior claim on the assets before both equity holders and all creditors,” the paper said this would provide a strong incentive for incumbent companies to avoid triggering the regime.

Someone who has been extremely critical of the current arrangements is University of Oxford professor Dieter Helm who in a series of papers has accused water companies of financial engineering – “exploiting the flaws in the regulatory controls, and especially in arbitraging between the cost of equity and the cost of debt”.

“The great financial engineering game was made worse by the regulators,” he added. “By setting a weighted average cost of capital, they positively encouraged the switch from equity to debt. The right answer should have been to set a split cost of capital, thereby capturing any benefits for customers.”

In a related paper addressing similar concerns over energy networks, Helm said if regulators want to be relaxed over companies finances then the special administration must be “beefed up” so it is a “credible threat”.

“Regulators have to be seen to be capable of implementing special administration in a practical and cost-contained way,” he stated.

In its report on water regulation in March, the House of Lords Industry and Regulators Committee also noted that a special administration regime that Ofwat is less scared to trigger could also be used to address poor operational performance.

The committee said the regime is a “powerful tool that has the potential to be used more widely where companies have been found not to have been meeting their obligations.

“Ofwat should consider whether to be more proactive in using these powers to change the management of continued poor performers in the sector.”

Links to performance

One question that has been raised is whether there has been any link between the ownership, gearing and operational performance of companies.

In terms of ownership and capital structures, there certainly seem to be a relationship. All three of the listed water companies (Severn Trent, United Utilities and Pennon Group’s South West Water) have gearing ratios below the sector average and close to the notional gearing. None of them are among the nine securitised companies, which as previously mentioned have an average gearing ratio 8.6 percentage points higher than the eight non-securitised companies.

Allen Twyning from Pension Insurance Corporation, a regular lender to the sector, says it is only the private equity owners that have been able to adopt the securitisation model that has enabled extremely high gearing. He says they are more comfortable with “complicated debt structures” and are able to exercise much greater control over the management of the companies, adding: “It’s the private equity backed ones that are definitely more levered.”

According to Helm, although private equity owners have “tended to be aggressive on financial engineering,” the publicly listed companies “have not however been far behind. Look at the dividend policies and the share buybacks of the quoted companies. It is a matter of degree and not kind.”

But whether there is any correlation between financial structures and poor operational performance is less clear.

A 2018 report from Moody’s which looked at a number of performance metrics during the period 2015 to 2018 suggested there was no systematic relationship between high gearing and operational performance, stating: “While companies in highly covenanted structures have been accused of focusing on financial engineering rather than operational performance, some have been consistently among the strongest performers in the sector.”

Looking at leakage as an example, Moody’s said these highly covenanted companies included Anglian Water, which exhibited the lowest leakage levels across the sector by a number of measures. It said their collective performance was dragged down by Thames Water and if this outlier is removed from the picture, then highly covenanted water and sewage companies actually outperformed their peers on average.

However, the Mason and Wright’s report said that “more recent evidence gives a counterbalance to this view,” noting the “well known” difficulties of highly geared Southern Water.

Their own comparison of companies’ credit ratings with their categorisation in Ofwat’s annual service delivery reports from 2018 to 2021 found a small correlation in 2018/19, a medium-tending-to-large correlation in 2019/20 and a large correlation in 2020/21.

However, the paper also said the “fact of the matter” is there is “still relatively little data on which to base an assessment of whether there is a robust relationship between measures of financial resilience and operational performance.”

In its report on water regulation, the House of Lords Industry and Regulators Committee said it was told by witnesses that the introduction of private equity ownership has been a driver in companies focusing on financial performance at the expense of service levels and resilience.

It said Ofwat should require all water companies to “disclose information to the same standard as publicly listed companies” as this has the “the potential to improve their governance and increase scrutiny of their financial arrangements.”

Speaking to us shortly after appearing at a Utility Week event in November, former Ofwat chair Jonson Cox said it is “possibly difficult to prove a theoretical causality here. But I can make a strong empirical observation that, with only one exception – Anglian – those companies with the most aggressive financial structures sat low down in the performance league. And that set us really worrying.”

Cox said “across the infrastructure space globally, private capital has demonstrated it can run utilities well.

“But”, he added, “the model of the debt-led consortia of the 2006-2010 period has, with only one exception, failed to create resilient performing water businesses. As a regulator we wanted investors to make money from operating the business well, not merely from being more leveraged.”

Ofwat is certainly making moves to ensure this is the case. Alongside its decision to strengthen cash lock-up conditions, the regulator also confirmed plans in March to amend companies’ licences to require them to link dividend policies and payments to their operational performance, including service levels for customers and the environment, from 17 May 2023.

To ensure this incentive applies to managers as well as shareholders, the regulator also announced plans at the beginning of April to regularly review executive bonuses to ensure they are reflective of operational performance and introduce a mechanism to clawback revenues from companies at the end of the current regulatory period if they are not.

Utility Week contacted a number of water companies and the trade body for reaction to this and other points in this report but none of them have provided a response.

The way forward

Although it has yet to make a clear decision on the matter, the return of the GOSM or some variation for PR24 seems highly doubtful, particularly given that the CMA has concerns over the fundamental design of the mechanism, which are unlikely to be assuaged by tweaks to the way it works or more evidence to back up its parameters. Bringing it back would give clear grounds for any water company to appeal their final determinations.

But Ofwat is pulling every other lever at hand to prevent companies earning excess returns through financial engineering, either by pushing companies to reduce the gearing levels that enable them to achieve these returns or preventing them from being paid out to shareholders through dividends.

Water companies may dispute that they have generated excessive returns from higher debt, and insist that measures to limit their freedom will increase costs, but they have wholly failed to persuade Ofwat, which is pushing from multiple directions to make sure companies are left with no room for financial engineering.

Gearing levels are automatically falling and, amid growing public outrage over water companies’ seeming ability to profit from polluting Britain’s waters, Ofwat looks determined to ensure they do not return to their recent highs.

Appendix: Gearing and performance levels

Gearing levels

Outcome delivery incentive payments as percentage of regulated equity