JP’s Journal: Thames Water

This week’s journal is different, with a particular focus on Thames Water.

However, it would be remiss not to touch on the higher than expected US CPI (consumer price index) reading, which has further pushed backed the timing of the first Federal Reserve rate cut. Global bond yields rose, with 10-year US yields closing above 4.5%. The UK followed, although a Friday rally meant that 10-year rates ended below 4.2%, a rise of 7bps on the week.

It is not too controversial to say that the UK’s infrastructure is seen as inadequate and a drag on our long-term economic growth. This not only affects customer satisfaction but also reduces tax revenues that fund the services we all depend on.

The water sector is a good case in point. Since privatisation, the water utilities have increased capital expenditure but the public perception is negative, reflecting concern about water quality in rivers and sea but, more particularly, a view that private equity investors have taken advantage of the customer through financial manipulation and high pay-outs.

From my perspective we are at an incredibly important time when it comes to infrastructure investment. There needs to be significant investment in the water infrastructure – estimated to be £100bn over a five-year period. And even this figure is somewhat dwarfed when we consider broader infrastructure requirements, particularly the capital expenditure needed to transition to a low carbon society, to meet our net zero commitments.

The model that has been adopted in the water sector has its flaws but there is logic to the approach. Equity investors put in money; this is risk capital. Debt is then issued, to the extent appropriate to maintain an investment grade rating, as determined by a regulated return on the asset base of the utility. Debt investors are looking for a steady but modest return, based upon the fixed interest rate set at time of issuance; there is no participation in profit growth. A risk premium is offered on this debt, over the cost of government finance, which reflects the risk of failure.

Wholesale water sector nationalisation, which is increasingly popular, would lower the cost of debt by doing away with the risk premium. However, the pre-privatisation period showed that governments, perhaps understandably, have favoured spending on health, welfare, and education rather than fixing Victorian pipes to further improve river and sea quality. There is always competition as to where limited resources are allocated.

Indeed, the required risk premium for debt, for the water sector, has been low. This reflects confidence in the UK’s regulatory regime. In the case of the water sector, the size of the companies’ operating assets is determined by the regulator, Ofwat, and customer bills are set to reflect an economic return on this asset base. There is an incentive for the equity owner to take on more debt, when debt costs are low, but there is oversight provided by the regulator to ensure that this is not excessive. Debt investors have placed confidence in both the regulation of the sector and in Ofwat’s determination of a fair return on the regulated asset base.

A large part of the investment undertaken in infrastructure debt is held by current and future pensioners. The UK has an exceptionally large pool of pension assets which government hopes can be mobilised to improve our infrastructure and transition to a lower carbon society. As stewards of our clients’ money, we welcome opportunities to invest in the UK’s infrastructure when appropriate returns are available. As debt investors we target a small yield premium over government debt when we assess the risks are low; the regulatory regime has given us confidence that a small yield premium is sufficient for many UK utilities.

In the water sector we have a specific case where the outlined capital expenditure plans and accompanying request for higher water bills have been rejected by Ofwat – to the extent that the current equity owners have indicated that no further equity is available. And without that equity, further debt issuance will not be forthcoming to finance the spending plans. We await Ofwat’s draft determination, due in a few months’ time.

Thames Water is a significant component of the sterling credit market. Our credit strategies have a higher exposure to the issuer than our relevant benchmarks, and this has reduced outperformance over the last year. However, our positioning has always been as part of a diversified portfolio approach, which has been central to our investment philosophy. As an active investor we take positions that differ from benchmarks, and this has resulted in a strong long-term record. Even with the challenges posed by the underperformance of Thames bonds, our sterling credit funds, measured against their nominated sterling credit benchmark, have outperformed in the year to March 2024. And against our peers we score very well. This is no mean achievement given the range of our strategies.

Whatever happens, it seems inevitable that Thames customers face higher water bills, which will seem unpalatable given other cost pressures. However, to deliver the infrastructure investment on the scale envisaged requires money from long-term savers. It is a delicate balancing act for Ofwat. But an erosion of confidence in a regulatory regime will increase the cost of debt, not just in the water sector but more generally. Future investment will be available to support  infrastructure  spending, but the return required by pension funds will be higher if that confidence is lost. Striking that right balance between the interests of customers and savers will not be easy.