Utility Week

18 | MAY 2023 | UTILITY WEEK Water Analysis Tapping into debt With water companies facing harsher scrutiny for sewage discharges, questions are again being asked about the high debt levels of some fi rms and whether there are links to poorperformance. F or most of the 30-plus years since pri- vatisation, 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 bene• tted from being viewed by most people as incon- sequential to their everyday lives. Its activi- ties were largely hidden from sight and few showed much interest in • nding out more. But things have changed dramatically in recent years. The sector has taken a ham- mering 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 moni- toring 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 ampli- • ed by the perception that despite failing to ful• l 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 pro- viding a good service, but for implementing complex and opaque • nancial 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 o- for decades. Raising all of this capital from equity investors would be impractical and ine‚ cient. However, this does not mean the criticism of their • nancial arrangements is invalid. Ofwat has for many years now had concerns over the mounting debts of some companies, and for two main reasons. First, the regulator fears that high debt has le… the companies in question with little headroom to deal with shocks. It worries that companies getting into di‚ cult waters will cut back on necessary investments or even fail completely if they can't keep up with their interest payments. Given public out- rage over sewage discharges and the persis- tent 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 penal- ties and • nes. Second, 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 com- panies to generate returns through • nan- cial 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 • nancial resil- ience monitoring framework, with yearly reports, and a new Gearing Outperformance Sharing Mechanism (GOSM) to claw back some of the supposedly excess returns from high debt levels. These e- orts are set to continue for PR24 a… er Ofwat con• rmed in its • nal methodol- ogy 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 a… er the mechanism was overturned by the Competition & Markets Authority (CMA) for the four water compa- nies that appealed their PR19 • nal determi- nations. However, the regulator does seem convinced that companies are pro• ting from high gearing levels, with consumers bearing much of the risks, and that 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 o- 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 com- pany debt had ballooned to £57.6 billion, equating to 68.5% of the total regulatory cap- ital value (RCV) of the sector. There was signi• cant 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 Sta- s 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 indi- vidual ratios ranging from 57.7% and 80.6%. The average gearing for non-securitised companies was signi• cantly 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 debt at the end of March 2022 was up almost £1.5 billion when compared with the previous year's • gure of £56.2 bil- lion. Yet somewhat counterintuitively the weighted average gearing level was down by 4 percentage points from a peak of 72.8%.

• Cover