The contagion merchants are out in force at Thames Water. If the country’s biggest water company goes under, runs the argument from assorted bondholders and City bankers, we will all pay a price. Other water companies will pay more for their capital, shoving the cost on to our bills eventually, and the burned bondholders will exact revenge when they’re asked to finance everything from electricity pylons to nuclear power stations. Should we be scared?
Before everybody works themselves into a panic, it would be better to wait until 12 June, the day when the water regulator, Ofwat, gives its first view on the business plans of English and Welsh companies for the next five-year period, and says what level of bill increases it will accept and what assumptions it has made about the cost of capital. That is the first point at which the “contagion” noise can be properly assessed.
This column’s bet is that Ofwat’s proposals, for the whole industry, will be soft. In other words, the companies will be given terms that are seen as generous (to them) by historical standards. Why? Well, every five-year price review involves a trade-off between competing objectives, notably the desire to keep consumers’ bills down and the need to ensure investment in infrastructure happens. This time, the priority is obviously to accelerate investment to clean up the polluted waterways. Bills are going up significantly, the question is the degree.
Since Ofwat does not live in a bubble (whatever Thames’s shareholders might believe), it is probably also fair to assume it has noticed that interest rates have risen and there is international competition for capital these days. That’s another reason to expect a soft-ish settlement.
If that is how things turn out on 12 June, don’t expect water company bosses to jump with glee – they always roll around in agony and claim the regulator has been uniquely harsh. But, when the numbers have been digested, a perfectly plausible scenario might see eight or nine of the 10 big firms declare they can live with Ofwat’s proposals and will be able access capital at reasonable rates on the back of it.
A likely outlier would be Thames, of course, since its shareholders have already said they think Ofwat has made the firm “uninvestable”. But if most of Thames’s peers are simultaneously saying the regulator’s numbers add up, where is the contagion risk meant to lie? Thames would be seen as an isolated case: a company that borrowed far too much, managed its operations badly, got caught out by the rise in interest rates and then couldn’t keep up with the rest of the industry.
Nobody pretends that recapitalising Thames would be straightforward, but the basic principles aren’t complicated. Shareholders get wiped out, and then bondholders take the pain until the debt is reduced to a point at which newly arriving lenders can see a credible proposition. It’s anybody’s guess today where that point lies until Ofwat speaks. But would an overall 20% haircut, say, for lenders who have advanced £15bn to the regulated entity really cause an earthquake in the rest of UK infrastructure-land? Probably not if the rest of the UK water sector was getting on with raising capital.
The picture, admittedly, would look different if Ofwat’s five-year terms in June are regarded as genuinely tough. In that case, the contagion crew may have a point. But it is not today’s position.
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The share prices of the publicly listed United Utilities and Severn Trent have drifted slightly during the Thames kerfuffle, but not by much. In the wings, the US hedge fund Elliott Management was reported by the FT to be buying Thames debt at a discount to face value on the expectation that losses for bondholders won’t be severe. That development sounds like a sign that, far from believing the end is nigh for all UK infrastructure, financial markets are treating Thames like a special case and assessing how a much-needed financial reconstruction would work.
Yes, it could all change again in June. In the meantime, government ministers need to hold their nerve. The market has had years to work out that Thames was a bad risk. If its bondholders were asleep, that’s on them.