OFU0003 Written Evidence from Thames Water


1 Introduction


1.1           Thank you for the opportunity to provide written evidence to your follow up inquiry into Ofwat, the water industry and the role of Government.


1.2           Thames Water is the UK's largest water and wastewater services provider, employing 7,000 people across London and the Thames Valley. Every day we supply around 2.6 billion litres of the highest quality drinking water to nine million customers across London and the Thames Valley. We recycle around 4.6 billion litres of wastewater safely back to the environment for 15 million customers.


2      Q1: What is the reason and justification for Thames Water’s high levels of gearing and complex company structure? Does Thames accept that these features raise questions about the motivations of its investors?


2.1           As with all utility companies in the UK, we keep customer bills low by borrowing debt on the most favourable terms possible and spreading the repayment costs over a longer period. Our debt is long dated, with varying lengths of repayment up to c.40 years, with an average tenor of 13 years. This means that the generations who will benefit from investment in our network are the ones that will help pay for them, making our bills fairer, lower and more sustainable.


2.2           Regulatory gearing at the end of March 2023 was 77.4%, its lowest in a decade. It is important to set this debt in context against the value of our asset base (the Regulatory Capital Value (“RCV”) which grows in line with investment and inflation), which is approximately £19 billion.


2.3           Importantly, the cash impact of rising interest rates was more than mitigated by our prudent treasury management policies, with 97% of our debt fixed in real or nominal terms (note net debt cash interest was £235 million in FY23, an equivalent cash cost of interest of 2.3% compared to the current Bank of England base rate of 5.0%).


2.4           Equity raised will support continued record levels of investment in our network and improvement in our operating performance for the benefit of our customers, communities, and environment.  Improvements in asset resilience and operational performance will in turn support the overall financial resilience of the business. By injecting more equity into the business, we are able to continue to raise debt to fund our approved PR19 business plan and future price control periods.


2.5           As is the case with many other water companies, Thames Water has a high covenanted debt structure, known as Whole Business Securitisation (“WBS”). This strengthens further the existing regulatory ring fence protections for the benefit of debt investors, which has benefits for customers. For example, the WBS contains historical and forward-looking financial covenants, restrictions on dividends and requirements to maintain substantial liquidity. This credit-enhancing protection is designed as an early warning signal and compels management to improve performance and financial resilience before the company becomes financially distressed.


2.6           These protections, and a stable regulatory framework, allow us to sustain gearing levels around 80%. The structure increases the available pool of capital with a set of common terms and allows us to diversify our debt sources, rather than relying solely on the Sterling market, which can be more costly and is unable to fully fund our capital programmes. This in turn provides us efficient access to the debt markets which we otherwise would not have, which ultimately brings long term benefits to customers through lower bills.


2.7           We fully recognise Ofwat’s focus on reducing gearing and have taken steps to do this.  Since the start of the current AMP7 price control period, shareholders injected £880 million into Thames Water, sourced from raising HoldCo debt and shareholder equity. This has reduced gearing to the lowest level in a decade, although gearing will naturally go up and down during a regulatory cycle, reflecting the amount of investment being made.  In addition, shareholders have this month (July 2023) agreed to provide £750 million of equity funding in the remainder of the AMP7 period subject to certain conditions, as well as acknowledging that delivery of Thames Water’s turnaround plan is likely to require the provision of further equity support in AMP8 (2025-30), indicatively expected to be in the region of £2.5 billion. This represents the largest ever equity support package provided to a water company since privatisation.


3      Q2: To what extent has taking on debt been necessary to finance investment to put right Thames’ historic performance? To what extent has debt been used to finance dividends paid by Thames Water, including internal dividends?


3.1           As indicated earlier, we take on debt on the most favourable terms possible and spread the repayment costs over a long period. Doing this allows us to keep customer bills low alongside making the necessary investments in our network. In accepting the Final Determination (“FD”) for the 2020 to 2025 regulatory period we said that we would not be able to operate within the cost and service thresholds set out in the FD and that additional costs and performance penalties would be required.


3.2           Our Board recognises that we are now incurring significant performance penalties and costs beyond those anticipated when the FD was accepted including significant inflationary headwinds in core areas of largely uncontrollable expenditure (including power prices, chemical prices and business rates). We are also aware that our ageing asset base means that it costs us more than Ofwat’s benchmarking would suggest (and more therefore than we are permitted to recover from our customers) to provide services to a reasonable standard, especially in the face of climate change and population growth. We are spending approximately £2 billion in addition to what is recovered through customer bills. Our shareholders are investing an additional c.£2 billion in equity over the course of AMP7 to enable this additional expenditure to be financed.


3.3           In terms of dividends, any distributions are made in strict adherence to our licence conditions, and with our dividend policy. Dividend decisions are made independently, and shareholders have no vote.  Over the past 6 years, Thames Water Utilities Limited (TWUL) has paid a low internal dividend amounting to £47.7 million p.a. on average, equivalent to a dividend yield of 1.49% which is significantly lower than the Ofwat guidance of 4%. This internal dividend was paid to Thames Water Utilities Holdings Limited (“TWUHL”), our immediate parent company solely to service debt obligations and group related costs of other companies within the wider Kemble Water Group.


3.4           For the sixth year in a row, no income was paid to external shareholders of the group, who own shares in our ultimate parent company, Kemble Water Holdings Limited.


3.5           The level of dividend paid does not have a material impact on gearing and debt levels, especially when compared to an £18.9 billion RCV and £14.7 billion net debt as of end of March 2023 (covenant basis).


3.6           Facilitating shareholders’ ability to service such external debt also helps preserve our ready access to equity, thereby improving both operational and financial resilience at TWUL. Preventing the service of debt at HoldCo would mean equity being diverted away from TWUL, which we do not believe is in our customers’ best interest.


4      Q3: What is Thames Water’s view of Ofwat’s recent changes to company licences as they relate to financial resilience and the payment of dividends? Have they helped to contribute to Thames’ current situation by reducing its attractiveness to investors?


4.1           We understand Ofwat’s concerns about financial resilience in the sector. Water companies hold a privileged monopoly position to supply life’s essential service and with that privilege comes the responsibility of ensuring the financial resilience necessary to deliver for customers.


4.2           Our Board, Executive and shareholders take this responsibility very seriously. We recognise the underlying aim of Ofwat’s licence changes to ensure that money should not be taken out of a regulated company when it is needed to improve financial and operational resilience and performance for customers and the environment.


4.3           In their present form the licence changes may have unintended consequences which could cause poor outcomes for customers, communities, and the environment. The increased risk of regulatory intervention on dividends may materially reduce the attractiveness of the sector to equity investors, particularly those patient, long-term investors who seek their return on a year-on-year basis through dividend yield.


4.4           If such investors are deterred from investing in the UK water sector it may restrict the pool of investors at a time when Thames Water, and the sector more widely, is facing an unprecedented need for new investment, and when private finance has a critical role to play in enabling the cost of that investment to be spread over time. Without access to private finance, large investment cost would need to be recovered through customer bills when those costs fall. Pushing up the price of finance would also ultimately feed through to higher bills.


5      Q4: What would be the impact of any further moves to limit the debt that water companies could take on? Would this increase costs, reduce investor interest or affect companies’ ability to deliver operationally?


5.1           As noted in our response to the previous question, the recent changes to licence conditions raise concerns about unintended consequences for customers, communities, and the environment. Any moves to limit debt, such as capping absolute level of debt, would curtail investment into improving customer service, improving operational performance, and improving asset resilience. These would, in the long run, result in worse performance and less resilience


5.2           In addition, further capital structure interventions could lead to unintended consequences by deterring equity investment, which is critical to deliver the investment required. Capital markets are global and if equity investment in water in England becomes less attractive, the cost of equity would rise.  This would need to be reflected when setting the cost of capital at PR24 and beyond. This would in turn directly affect customers’ bills in the next control period and beyond.


5.3           The long-term challenges facing the sector are significant. Climate change and population growth are challenges that water companies must adapt to. Water companies are also expected to adhere to higher standards for environmental stewardship. To tackle these challenges and make the performance improvements in the short-term that are needed, water companies need to be able to attract patient and stable investors.


5.4           We recognise and understand the need for the regulatory framework to protect the financial resilience of water companies. The best way to do this, and to secure the investment needed to address the long-term challenges facing the sector, is for regulation to offer a compelling proposition for equity through a transparent, stable, and supportive regime that provides for reasonable, not egregious, returns.


5.5           We would need to carefully consider any future proposals which would limit our ability to raise external debt, as the alternative could result in funds within Thames Water being redirected toward reducing existing debt which may, in turn, have an impact on the speed in which we are able to deliver improvement in performance for our customers and the environment.


6      Q5: Is Thames Water confident of receiving the £1bn of equity that it needs during the current Price Review period?


6.1           Our liquidity remains strong at £4.4 billion as of 31st March 2023 and we have the money available that we need to meet our financial obligations and invest in our business for at least the next 12 months.


6.2           Shareholders have already provided £500 million of new equity funding this year in March 2023 and have now agreed to provide a further £750 million of equity funding by 2025, subject to the satisfaction of certain conditions and appropriate regulatory arrangements. They have also acknowledged that delivery of a sustained and sustainable turnaround of the business is likely to require the provision of further equity support in the next price control period (2025-30), significantly in excess of their current commitment. Indicatively, the AMP8 equity support is expected to be in the region of £2.5 billion, but the nature and level of such medium-term support will depend on the finalisation of the business plan and the regulatory framework that will apply to the AMP8 period.


6.3           Any larger equity injection in the current period would offer no additional benefit at this point in time as we simply do not have the capacity to deliver any more, given constraints in the supply chains we rely on. The equity support from shareholders in this and the next price control period represents the largest equity support package provided to a water company since privatisation and significantly in excess of what had previously been announced.


7      Q6: Is Thames Water confident that it will continue to raise the equity it needs during future Price Review periods, and does it have a timeline for reaching Ofwat’s gearing targets? 


7.1           Significant investment is required in future price control periods to tackle issues such as water scarcity, pollution, and river health. The rate of investment, regulatory framework, decisions around pricing and our performance will determine the level of equity required. Given such variables, it would not be appropriate to speculate on the level of equity required and at which stage. What is certain is that our shareholders have a long-term investment horizon and are willing to invest in a stable regulatory framework. As publicly stated, our shareholders have acknowledged that we are likely to need significant further funding in AMP8, indicatively expected to be in the region of £2.5 billion, but the nature and level of such medium-term support will depend on the finalisation of the business plan and the regulatory framework that will apply to the AMP8 period.


8      Q7: How much investment does Thames Water expect to make to reach the Government’s targets on storm overflows? How much of this cost does the company expect to pass on to its customers, and how much may the company’s bills rise during the next Price Review, subject to regulatory approval?


8.1           We announced in March the doubling of investment in our sewage treatment works and sewer networks to £1.6bn in the two years to 2025. This includes £1.12 billion on sewage treatment works, including £650 million on enhancing and upgrading over 135 existing sites to improve resilience and provide additional capacity, with further investment in the wider sewer network. 


8.2           Price limits beyond the end of the current price control period in March 2025 will be determined by the outcome of the price review, known as PR24. Companies are yet to finalise their plans ahead of submission to Ofwat in October. However, the level of investment needed to meet the statutory requirements set out in the Water Industry National Environment Programme, alongside other statutory requirements and programmes such as those needed to protect the health of critical assets and secure drinking water quality, is set to lead to an increase in customers’ bills across the sector. In our view, it will be important to ensure that whatever the final requirements within the Water Industry National Environment Programme are, they are cost beneficial, will focus on those things that will deliver most environmental benefit and represent good use of customers’ money.


8.3           We are developing our plans for 2025 to 2030. This work includes customer engagement so that we reflect their priorities in our proposals, which will also be supported by research testing the extent to which they are prepared to pay higher bills. We explained to customers and stakeholders, when we discussed our emerging plans with them in May, that bills could rise from £417 per year (or £1.14 per day) in 2022-23 to about £518 per year (or £1.42 per day) by 2030.


8.4           To support customers during the cost-of-living crisis we are providing financial support for customers to a total value of £110 million in 2023-24.  Since April 2023, an additional 53,000 households are receiving financial help to pay their water bills, taking the total number of households we support to 384,000. This includes our “WaterHelp scheme which can cut bills by up to 50 per cent and is currently the largest of its kind in the UK.


15 August 2023