Thames under the cosh

The unprecedented attack by Ofwat on Thames Water over leakage and transparency marks a sea change in the regulator’s attitude which Thames would be wise to respect, says Nigel Hawkins.

The political and regulatory knives are out for Thames Water, with Ofwat’s patience almost exhausted. Indeed, its Chairman, Johnson Cox, has waved the big stick by laying down an aggressive challenge in Utility Week (23 June) to Thames to “sort” five key issues.

It seems a far cry from privatisation in 1989 when Thames was the poster boy of the ten water companies for sale – with its bold ambition to become a global water player. Subsequently, it has undergone various changes – ownership and otherwise – but the issue of excessive water leakage persists.

Indeed, it is this issue that seems to have persuaded Ofwat to bare its teeth, with Cox criticising Thames’ failure to meet its water leakage target, which it missed by “a huge margin”, namely 47 million litres daily.

Most interestingly, within Cox’s five issues, there was a requirement to address Thames’ opaque financing structure. Cox demanded “transparency and clarity about the financial returns to the Company’s investors each year. This requires a clear comparison in the Annual Report between the financial flows under the complex highly-leveraged structure that the Company has chosen and what those returns would be under a more conservative structure we use for assessing all companies”.

Given this broadside, senior managers in Thames’ treasury department are unlikely to be taking lengthy holidays over the summer.

Cox’s concern about Thames’ highly complex corporate structure centres on the Kemble Water companies – and where the ultimate liability for its £10.7 billion net debt actually lies. Drilling down further into Thames’ finances requires a focus on the operating profit line, which is broadly a trade-off between the k-factor-driven revenues and the core cost base.

In Severn Trent’s case, Thames’ nearest comparator, the “clean” equivalent of this figure provides a pretty good guide of operational progress during a given year.

Under the private equity model, several water companies have been acquired by new owners who – due to the high quality of the revenue stream – have racked up debt financing, on the basis that (for the moment at least) it is cheaper. This phenomenon has been driven by the ultra-low interest rate environment since the financial crash of 2008/09. But it will not continue for ever.

No doubt Cox will study carefully how Thames calculates the annual financial benefits of heavy debt funding compared with the key financial ratio – debt/equity over regulatory capital value – template used by Ofwat. He will also note how these so-called benefits have been allocated between investors and customers over the past decade – a share-out that will be politically sensitive.

Despite a formidable 2016/17 capital expenditure outturn of more than £1.1 billion, Thames has been castigated for its investment levels. Most notably, the construction and financing of the pivotal £4.2 billion-plus Thames Tideway Tunnel (TTT), which would normally be part of Thames’ investment programme, has been outsourced to the independent Bazalgette Tunnel. Part of Thames’ sewerage revenues are recycled to help fund the TTT.

The TTT financing structure has been widely criticised, including by former Ofwat director general, Sir Ian Byatt, who noted that Thames’ very substantial dividend payments in recent years – £100 million for 2016/17 alone – could have been deployed to part-finance it.

Like some other private equity companies, Thames’ corporation tax payments have been minimal. In 2015/16 and 2016/17, its accounts showed combined corporation tax credits of £123 million. The combination of high capex and high interest payments are the key factors in minimising the tax take.

Although there is nothing illegal in such arrangements, there is a persuasive case for the Treasury to introduce a minimum corporation tax payment through prescribing annual offset limits.

Overall, Thames’s detailed response to the raft of issues raised by Cox will be very interesting, and may well impact other utility companies, who should be deeply concerned that Ofwat is “on manoeuvres”.

In effect, Thames is being asked to justify private equity ownership, aside from delivering bumper dividend payments. Has it created greater operational efficiency, say, compared with a Severn Trent or United Utilities structure?

Furthermore, it could be argued that privatised utilities should be required, as part of their licensing requirements, to maintain a UK stock exchange listing for sector comparative purposes.

From Thames’ responses, Cox should be better informed about the extent to which the 2019/20 periodic review can deliver deeper price cuts – commensurate with retaining the treasured sector investment grade credit rating; this will also provide a very relevant read-over to other water companies.

There are challenges galore, then, for Thames and its chief executive, Steve Robertson, and for its new owners, Canada’s Borealis and the Middle East-financed Wren House. Looking back, few expected the hyped-up Thames of 1989 to end up, almost 30 years on, with c£10.7 billion of net debt, a virtually unchanged core UK business and minimal activities overseas – notwithstanding the hiving off of its pivotal TTT scheme.