Mike Birch, Independent Trustee at Vidett and former Director of Supervision at The Pensions Regulator (TPR), addresses the financial turbulence within the water sector, focusing on the increased regulatory demands and investment challenges they face, and the impact on pension schemes.
The water industry is currently subject to significant attention, with Ofwat’s July 2024 draft determination imposing increased expectations on companies at the same time as halving the price increases they sought in order to deliver improvements. The period between the draft and final determination in December will see intense negotiations between water companies and Ofwat to seek to influence the final outcome and between the companies and their finance providers – both debt and equity. There are other key stakeholders too – notably the trustees of the various water pension schemes, several of which will have critical issues to address.
In my previous role as Director of Supervision at The Pensions Regulator (TPR), I was struck by the strength of conviction among pension trustees that, as a regulated utility provider, water companies were effectively government risk. There was a general assumption they would not be allowed to fail and, even if they were, pension schemes would be looked after under the Special Administration Regime. Those assumptions now look likely to be tested for some water pension schemes.
The financial structure used to set the income for water companies is complex. It essentially comes down to a balance of what Ofwat expects them to deliver in terms of improved service through increased investment, what costs it considers reasonable for them to pass on to consumers and the return on capital allowed for the debt and equity used to do this. Pension deficits are one of the costs receiving particular attention, a point I’ll return to later.
As widely reported, Ofwat’s draft determination tipped the balance of this calculation significantly less favourably for the water companies and their investors. Some, most notably Thames Water (Thames), are now saying it makes their business “uninvestable”.
The accounts for Thames’ parent company, Kemble, make interesting reading (bear with me here!). They detail 18 risks to the business. Among them are two which, for me encapsulate the problems Thames and other water companies are facing:
- Regulatory, legislative and political developments – “…political and regulatory scrutiny across the sector on environmental impact remains high, with river health and leakage dominating the agenda. In addition, public stakeholders are requiring increased reassurance on the pace and progress of our turnaround plan…”
- Public value – “Our customers and stakeholders expect that we will provide public value (including customer value and environmental stewardship) in the way that we deliver our service and it is core to our strategy. If we fail to do this we will suffer reputational damage, negative stakeholder perception and it will undermine our ability to work in partnership. There is a potential for enforcement action with financial penalties, more investigations, adverse regulatory and public policy outcomes and an adverse PR24 settlement. The ultimate consequence would be loss of our Instrument of Appointment or being re-nationalised, possibly with little or no compensation.”
This is the situation Thames Water now finds itself in. The loss of public support and resulting political environment has meant a series of adverse developments.
Thames has been clear that, without new equity, its cash reserves will last only until May 2025. Its shareholders have been clear they will not provide the £750m equity included in the current business plan. Any new debt would require the consent of existing lenders as Thames Water has forecast a breach of its financial covenants.
In its July draft determination, Ofwat rated Thames’ plan as “inadequate”. Not only have they reduced the proposed recoverable costs from £22bn for the 2025-30 period to £16.9bn but they also ruled the plan does not meet minimum quality expectations. Unless that is rectified ahead of the final determination, Thames will be fined £141m. Additionally, Ofwat proposed Thames will be placed under a “turnaround oversight regime”, with enhanced monitoring of detailed delivery plans “given the deep operational and financial resilience challenges the company faces”.
In response, Moody’s and S&P downgraded the credit rating to sub-investment grade, meaning Thames no longer meets the ratings condition of its license. Ofwat appointed an Independent Monitor to report on the company’s progress, including against its transformation plan, along with new Non-Executive Directors.
Ofwat also fined Thames £104m on 6 August 2024 for failing to manage its sewage works, leading to effluent “routinely” flowing into rivers and seas. This was in addition to a £40m fine levied on 1 June for the £37.5m shareholder dividend paid in spite of poor performance which blocked such dividends.
Ofwat’s approach to the draft determination will also impact Thames’ pension schemes. The company has 3 defined benefit (DB) schemes, with the Thames Water Pension Scheme in the most difficult position with a deficit as at 31/3/22 of £152m and no agreed recovery plan. Ofwat ruled Thames’ proposal to charge customers £156.6m through bills to plug the pension shortfall was submitted “without providing sufficient and convincing evidence that it is appropriate for customers to pay these costs”.
In its 2009 price review, Ofwat said deficit repair contributions should be shared 50:50 between customers and shareholders with deficits cleared in a minimum of 10 or 15 years. However, Thames has been blocked from funding pension deficits with customer money since 2023, so the responsibility has fallen “wholly to management and shareholders to deal with”. With a sponsor whose profitability and shareholder returns are far tighter than proposed, and existing shareholders publicly saying they will not invest the new equity the company needs, pension trustees will be working hard to find a way through.
Ofwat’s states, “our draft decision will enable Thames Water to attract the borrowing and equity it needs to deliver a step up in performance, but we will make sure that investors can only earn high returns from great performance in delivering for customers and the environment”. However, Thames’ shareholders believe the business is uninvestable.
Negotiations between now and December will reveal whether this gap can be bridged. If it can’t, Thames faces the risk of Special Administration which would ensure vital services are maintained whilst its balance sheet is reset through debt write-downs and it is passed to a new owner willing to invest sufficient new equity. The government’s public position is nationalising Thames would not be consistent with Labour’s fiscal rules. However, this wouldn’t prevent the business being passed to a not-for-profit public interest company, following the example of Welsh Water.
The Special Administration process, which would be overseen by the UK Government Investments (UKGI) team, is untested. UKGI, part of HM Treasury, are brought in to commercially complex and difficult situations of interest to government. Responsibility for ensuring a business plan is agreed which delivers appropriate quality services at a reasonable cost sits with Ofwat. UKGI would ensure a politically and commercially acceptable solution is reached if Special Administration is necessary.
The key question for pension trustees would be whether retaining the scheme as part of the business passed to a new owner would be considered important enough for Ofwat and UKGI to make this part of the Special Administration approach. Ofwat has said Thames may be split into more than one company, adding further complexity to the trustees’ position.
Thames is the most extreme example of the issues in the industry and its financial position is the most stressed. However, the broader issues are faced by other companies in the sector. Trustees of water company DB schemes will be working hard to ensure they understand how their sponsoring employers’ ability to support them has been affected by the changing regulatory environment and Ofwat’s draft determination.
