Water sector’s future rests on precarious debt plans

It’s no secret that England’s water companies need to spend big to upgrade their leaky infrastructure. The interim reports of the country’s three listed water companies, Pennon Group (PNN), United Utilities (UU.) and Severn Trent (SVT), suggest they have every intention of doing so. 

The latter group said it’s planning to invest £5bn in enhancement projects across AMP8, the price control period from 2025 to 2030. Meanwhile, Pennon Group, the owner of Bristol Water and South West Water, has £4.5bn earmarked for the same window. United Utilities has been more tight-lipped, but tender plans suggest its investment programme will far exceed the £1.5bn it committed to invest in the five years to 2025. 

But the question of how to fund these improvements has become increasingly complicated in an era of high borrowing costs. Trade association Water UK, which counts all of the country’s water companies as its members, has promised the industry will invest £96bn in its network between 2025 and 2030. Customers will pay for this through higher bills. 

However, recent events at Thames Water – the UK’s largest water company in revenue terms – show that the sector remains heavily dependent on debt. The privately held utility told MPs in July that its shareholders had provided it with an additional £500mn in equity following a well-publicised period of financial difficulty.

Last week it was revealed that the funding was actually offered to the company in the form of a loan at 8 per cent interest, with payments to be made each March. The convoluted structure means that at the Thames Water level it is an equity investment, but it was a loan from shareholders to Kemba Water, which controls the utility. 

While there’s no indication that the trio of listed water companies is in equally dire straits, the required capital outlays look daunting. 

Gearing up

Fitch Ratings, a provider of corporate credit ratings, has predicted that UK water companies’ total expenditure will almost double to £95bn in AMP8. Business plans analysed by the ratings agency also assumed total equity injections of £6.5bn across the sector in the last five years of this decade. Of course, this depends on shareholders’ willingness to support an increasingly embattled industry. “The risk and return balance will be a key consideration for [company] investment committees,” Fitch said. Shareholder injections will be "crucial to strengthen the capital structures given the steep increase in [total expenditure]", the ratings agency added. 

Higher spending needs should also be a key consideration for private investors with shares in the three London-listed water groups.

In the near term, Severn Trent doesn’t appear to have a great deal to worry about given it raised £1bn in equity back in September. Exactly half of the total came in the form of an investment by Qatar’s sovereign wealth fund, with the remainder accounted for through a share placing and retail offer. 

With a gearing ratio – defined as net debt divided by regulatory capital value (RCV) – of just under 62 per cent, Severn Trent is also one of the least indebted groups in its industry. United Utilities’ gearing figure for the last financial year was almost 65 per cent, while Thames Water’s was over 80 per cent. “The reason a lot of these companies are highly levered isn’t because they’ve grown over a long period of time,” said Severn Trent chief executive Liv Garfield on an interim earnings call last month. “It’s that they failed to deliver their costs to budget.”

Ofwat, the sector regulator, has proposed a reduction in the notional gearing assumption from 60 per cent to 55 per cent for the period 2025-30. This figure is essentially the regulator’s view on what constitutes a manageable level of debt in the water sector. Only three of the 17 English and Welsh utilities under Ofwat’s purview had a gearing ratio below 60 per cent last year. 

Returns at risk?

Investors in United Utilities, which operates in north-west England, may be growing concerned that the company’s level of debt will eat into their returns. The group has set out £13.7bn in total spending on its assets across the five years to 2030, but to do this it will need to raise over £5bn. It wants to achieve this through borrowing, as opposed to issuing new shares that would dilute existing investors. 

Consequently, its gearing level will move up to 65 per cent – well beyond the regulator’s recommended level. Analysts at Hargreaves Lansdown have predicted this could “put pressure” on the dividend policy, which targets growth in line with inflation.

Then there’s also the matter of increasing bills during a protracted cost of living crisis. Pennon said that it will keep costs to consumers “as low as possible”, with below-inflation increases to 2025. Whether this is sustainable beyond that date remains to be seen. The group upped its total capital investment by 87 per cent (to £266mn) across the six months to the end of September as its infrastructure overhaul ramps up. 

All of this is underpinned by a growing feeling of resentment towards the water suppliers among politicians and the public. It has long been alleged that the sector’s high level of gearing enabled it to pay shareholders while it neglected its critical assets. The sewage scandal is never far from the headlines, either. Just this week a BBC Panorama documentary claimed that United Utilities had been covering up serious sewage discharges in protected natural areas. The company told the broadcaster it followed Environmental Authority rules around reporting discharges. 

After a volatile year, shares in the listed water groups saw modest gains after Thames Water announced a three-year turnaround plan. This should not, however, be taken as a sign of the sector’s inherent stability. It can only dodge a crisis so many times.