It’s time to pull the plug at Thames Water

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Tim Short was an investment banker at Credit Suisse First Boston where he specialised in whole business securitisations. He has PhDs in physics and philosophy and has published several books.

The epic of the UK’s largest water company has rivalled Moby Dick for water, difficult situations and a desperate hunt for successful outcomes.  It no longer looks possible for the company to remain under the current ownership, or fully in the private sector.  The reason is simple: it hasn’t delivered on its promised investment.

The regulator recently announced its draft determination of the returns that water companies will be allowed to earn on their assets (https://www.ft.com/content/6087dea0-6ec0-40bd-831e-6a0f9ca91cd0).  There was plenty of bad news there for Thames Water.  But there has, or had, always been a narrow path to survival.

It never looked easy.  Success would depend on significant infrastructure investment and, moreover, on that investment being conducted under conditions of radical transparency.  One would then have to face MPs and the public, and commit to putting the entire investment programme on the internet in real time.  Sector specialists could comment and journalists could write pieces discussing problems as they arose.  The public would see progress as it happened and understand why and where there were delays.

As it occurs, the levels of investment approved by the regulator, although substantial, are much less than the companies requested. In ordinary circumstances, this would raise a question: why is the regulator allowed to reduce investment requests at all? I would change the regulatory framework such that the regulator can only do that if it can show a) the investment is not needed (no chance of that) or b) the investment does not represent good value for money (no reason to suspect that).

But these aren’t ordinary circumstances. As the Guardian reports, 108 of the projects agreed in the previous five year by Thames Water as part of its Asset Management Programme (AMP) have not been delivered. Many of the previous public objections have been spurious: but this is a serious problem, of a different level to the other known issues.

Until now, the allegation that excessive dividends have been paid has damaged Thames Water’s reputation, but never represented an existential threat. After all, the regulator sets the allowed return to equity and debt — and the level of equity is not munificent at something like 4 per cent real.  

Now, there are ways that the outturn returns to equity can exceed that level.  These are roughly as follows:

1. Have more debt than assumed by the regulator (gearing/financial engineering).

2. Get the debt away cheaper (not very easy).

3. Perform more efficiently than the regulator assumed (e.g. build infrastructure at a lower price).

4. Boost your asset value (hard work but legitimate).

5. Tax games (lots of debt is again good here).

6. Cheat

How would a water company cheat? One way is to deliver upgrades for less than was assumed. If that happens, it can keep the leftover money (or allow it to flow through to shareholders as a reward).

Previously, when cheating of that type was suspected to have occurred, it was not on a level that could be shown rigorously — ie, to legal standards — to have occurred.  There was lots of moaning about dividends, but that’s not the same thing. It may well be possible to show that the companies have failed in their legal duties on wastewater discharges, but that is complex: the companies can argue, for instance, that climate change has caused them problems. As a result, that process has not yet resulted in an outcome, negative or otherwise.

The upgrade failure is different. The company has admitted that it did not deliver. They spent the money but haven’t finished the work. In effect, they’ve been paid for work that they haven’t done.

This is qualitatively distinct to the other manifold failures of the company, because delivering the AMP upgrades is not optional. There is no question legally about whether it is optional. There is no defence. 

Sure, the company seeks to offer one when it says that the failure to deliver was “driven by macroeconomic conditions and a change in scope for many of the projects.” But this will not wash. Macro changes are a paradigm example of equity risk. The entire point of privatising something is to transfer risks like this to the private sector. Similarly on the change in scope, that’s something which was within the company’s control: if it chose to increase scope, it will have to pay.

The failure to deliver on the agreed infrastructure upgrades results in twin insoluble difficulties for the company.  Firstly, it can no longer argue that it has not cheated in how much it has returned to equity.  Secondly, it can no longer plausibly offer the public a major and transparent investment programme, because people can say “you didn’t do it last time.”

This can and should be a termination event for the entire current management.  The simplest way to achieve that would be through the appointment of Special Administrators, which is a step beyond the “special measures” regime the government seems to favour, but also short of full nationalisation and therefore much cheaper for the Treasury.  In any scenario, the whole board should go now.