Business as Usual, Says Thames Water. Is That a Good Thing?

As Thames Water tries to reassure investors and customers (in that order), Morningstar analysts assess the likely impact of renationalisation

Ollie Smith 4 April, 2024 | 12:40AM
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Thames Water UK Main

It's a stark reminder of our dependence on good utility companies that, rather than learning of problems with the local water from the news, residents in the south of England found out first-hand – when they saw human detritus floating down the street.

This is certainly the case in Berkshire, but the problem is bigger than that. Buckinghamshire residents have also noted serious problems with drainage and disposal. There are multiple other such cases across the South of England. Unfortunately, the situation itself is just a snapshot: of a utility company on the brink, and public confidence in UK utilities draining. 

Thames Water is the company at the heart of the saga. It has drawn increasing fire over many months, not just over a mismanagement long documented by journalists and MPs, but as a case study in privatisation gone wrong.

35 years after it was taken out of public ownership by the Thatcher government, Thames Water's owners, Kemble Water Utilities, and its shareholders (among which is the University Superannuation Scheme, one of the UK's largest pension funds) should be celebrating.

Instead it is staring down the barrel of collapse, after a standoff with the regulator Ofwat, which refused to allow the cost of an improvement plan to be passed onto customers via huge price hikes. In a bid to reassure customers, chief executive Chris Weston claimed it was "business as usual" at the firm. But if it cannot find liquidity, the company could pass back into government hands via a Special Administration Regime.

In plain English: renationalisation.

Why Did Thames Water Get into so Much Debt?

Thames Water is the UK's largest water company, so could be perceived as something of a bellwether for the health of UK water provision.

At a time of serious environmental introspection and shareholder activism, water companies have been battered by negative headlines anyway, amid allegations of sewage dumping and the issuance of hefty fines.

As Thames Water's own balance sheet looks so unhealthy, analysts at Morningstar DBRS argue a default will turn investor confidence sour – and result in precisely what Ofwat is attempting to avoid.

"Thames Water's balance sheet has been stressed because of its significant debt load, with approximately £15.7 billion of debt at the utility and another £2.4 billion at intermediate and holding companies," say Tom Li, senior vice president and sector lead for corporate ratings, energy and natural resources, and Chloe Blais, assistant vice president for european corporate ratings, energy and natural resources

"We note the UK government has been preparing an emergency plan, codenamed 'Operation Timber' if it needs to temporarily take over the business under a SAR. In the event Kemble Water defaults on its £190 million debt obligation in April, investor sentiment in the UK water sector could turn negative and sector funding costs could rise.

"Furthermore, customer bills for other UK water utilities could increase materially as they have requested significant hikes to fund their proposed business plans too."

But investors could be forgiven for asking how this all happened in the first place. Among other factors was a complacency about low interest rates, says Lindsey Stewart, Morningstar's director of investment stewardship research.

"I think people just got too used to the idea of super-low interest rates and overlooked the risk that, you know, interest rates could normalise," he says.

"We're now in a position where they have high debt and it's so much more expensive. I think it's fair to say that risk was overlooked".

Nationalisation? Not Now...

It's unlikely nationalisation will hit the broader UK utilities sector, however – if it happens at all. A general election is due this year, and polling currently points to the Conservatives losing office when the country goes to the ballot box. 

"In the event Thames Water is placed under an SAR, we do not believe financial contagion will spread to the other UK water utilities," Morningstar DBRS says.

"Water utility shareholders have largely supported turnaround plans, and a number of them have injected additional equity over the past few years.

"While Kemble Water and Thames Water also received £500 million from their shareholders in March 2023, this was in the form of an 8.0% fixed-rate convertible loan note.

"Additionally, while there have been calls for the sector to go back to the government's control, we believe this is unlikely at this time with the upcoming election in the UK and the significant cost to do so."

Neville White agrees, albeit for different reasons. A consultant and former head of responsible investing policy and corporate governance at EdenTree Investment Management, he says the business model was unique, and in all the wrong ways.

"Water is local, so although it was privatised, it's a natural monopoly," he says.

"You know, I can't buy my water from Anglian when I live in the Thames region. So in a way privatisation was a little bit of a nonsense in terms of providing competition. I think it was always around investment. 

"What went wrong in my view is some of the ownership structures were not properly thought through. So privatisation didn't provide for the right kind of owner."

There are other examples of things going better, however. Investors should note the case of Wessex Water, whose footprint covers the south west. 

"It's owned by a single sovereign wealth fund. It's been a single long term patient capital investor for 25, 30 years," says White.

"That strikes me as a very robust model for taking a company in the water sector private. They put in equity when they've needed to. It's well financed, it's got some problems because the whole industry has. But essentially the model was not to just take money out, it was to run it as a long-term patient capital vehicle."

As for the election and renationalising, he isn't convinced.

"Personally, [I think] if Thames Water was nationalised tomorrow, say, by a Labour government, suddenly that government has got to find billions of investment to put in," he says.

"So I still think that a privatised model that delivers investment in the infrastructure, but providing a reasonable rate of return on capital for investors is the best model even though it's an actual monopoly."

Should I Be More Cautious About Dividends Now?

It's still rare to see the issue of dividend payments thrust so firmly into the public eye, but in several recent cases, the payment of dividends by large companies – to the alleged detriment of other projects – has prompted a more explicit conversation about corporate governance, corporate and social responsibility, and ethics.

Now an unlikely consumer champion, comedian Joe Lycett took on this issue in a 2024 documentary that urged UK water companies to stop paying dividends while infrastructural problems were so severe

In the case of Thames Water, former owner Macquarie has been accused of using its assets to pay dividends to shareholders, to the neglect of fixing long-standing leakage and infrastructure problems. White agrees with this. 

"I think [the business model] was pretty broken to start with in the sense that, when Macquarie owned it, [they] just leveraged up the debt and used the assets to pay dividends," he says.

"So basically they took out debt against the the security of the assets and then paid themselves a lot of dividends. So the investment wasn't there."

Should investors therefore be more cautious about companies paying dividends? The UK is home to some real dividend stalwarts, after all (see chart above), and, while Thames Water is a private company, there are still lessons for investors.

"It's certainly something people should think about if they're investing in a company," Stewart says.

"How are those dividends being financed? Are they being financed by the continuing operations, profits and cash flows of the business, or is the management just exchanging equity for debt and paying dividends out of that?

"A couple of years ago there were some questions asked as part of a wider consultation on the capital management regime, [including] how do you ensure the management of the company isn't tunnelling out underneath creditors and debitors and other stakeholders by paying inappropriate dividends?

"We didn't get too far resolving that."

With additional reporting by Christopher Johnson, data journalist, Morningstar

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Ollie Smith

Ollie Smith  is editor of Morningstar UK

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