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The recent turmoil at Thames Water has prompted the UK government to consider contingency plans in case the heavily indebted utility collapses. Despite publishing a positive assessment of its long-term viability less than a year ago, the unexpected resignation of CEO Sarah Bentley has raised concerns about the company’s stability, causing the value of its bonds to plummet. How did a regulated company with a high debt burden suddenly become so uncertain, and what is putting pressure on Thames Water’s balance sheet?
One of the key assumptions behind the board of directors’ confidence in Thames Water’s finances was the belief that existing shareholders would inject £1.5bn of equity into the company to improve its financial resilience and address poor performance. However, rating agency Moody’s warned that the company’s credit rating was at risk of a downgrade if this additional investment did not materialize. So far, Thames Water has only received £500mn from its backers, leaving £1bn outstanding. The investors have declined to comment, suggesting that putting more money into the company may not be a wise decision given the growing regulatory scrutiny and recent policy changes that prevent shareholders from paying dividends if it harms the company’s financial health.
Thames Water’s high level of debt is a legacy of its leveraged buyout by Macquarie in 2006. With total gross borrowings of £15.9bn (£15.5bn net of cash), the company’s debt structure consists mainly of a whole-business securitization, a common technique for borrowing against regulated assets with predictable cash flows. Strict terms in the securitization bonds can restrict cash from being used to service the debt if the regulated utility faces pressure. This has led to a decline in the value of Kemble bonds, which shows that bondholders anticipate potential losses. The sustainability of Kemble’s debt poses a threat to shareholders’ investments, as equity is always subordinate to debt.
Surging inflation has created a mismatch between the measures of inflation used by Thames Water to hedge its debt and to price customers’ bills. Although the company can pass on costs to consumers, its debt, linked to the retail prices index (RPI), which is significantly higher than the consumer prices index adjusted for housing costs (CPIH), has caused strain on its balance sheet. Over half of the company’s debt is linked to inflation, resulting in higher interest payments. Its recent accounts reveal a significant increase in the weighted average interest on index-linked debt, indicating potential financial pain in the future. While Thames Water has implemented a hedge to manage inflation risk, it may not be sufficient.
In addition to its debt issues, Thames Water faces operational challenges. Increasing inflation and regulatory scrutiny have impacted the company’s earnings, resulting in a 6% decrease from March to September of last year. A cost of living crisis has made it difficult for households to pay their bills, posing financial risks for the company. Furthermore, Thames Water has been involved in high-profile sewage pollution incidents, leading to investigations by the Environment Agency and Ofwat. The company has also struggled to address leaks, which have reached a five-year high and will likely miss its target for leak reduction this year.
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