The temptation, when in a hole, is to just keep digging. It’s especially tempting to politicians. It is path dependency and it is what the government and OFWAT are doing in their everlasting “negotiations” with Thames Water’s (Thames) distressed-debt specialists and other lead bondholders. Make an initial mistake, and then engage in a game of self-justification until the position becomes so unsustainable that it just can’t be sustained any longer. Having “no reverse gear” is the origin of many of the worst policy decisions.
Thames is the stand-out example, but others abound. HS2 just keeps getting ever more expensive, and still government can’t quite let go. It is now almost £1 billion per mile. Strive for a private capital financing of Sizewell C nuclear power station to keep it out of public accounts, and end up with the government being dragged into ever more shouldering of the risks, and it all goes on the public balance sheet anyway. It still ends up costing £16 billion per GW. The net zero 2030 hole is already a chasm, with the highest industrial electricity prices in the developed world, and yet the government is still reaching for more sticky plasters.
Thames is a textbook case of how not to do public policy. It is now close to a scandal. Make the initial mistake – no Special Administration – and then sink further and further into the hole, aided and abetted by the deep vested interests in endless negotiations, resulting in concession after concession. In the Thames case, it may yet take a few more years for the situation to get so serious that a U-turn is forced, but only after the underlying performance and the environmental consequences have got even worse.
To try to justify the hole-digging, the “Anything-But-Special-Administration” case is advanced by trying to rubbish the obvious solution – Special Administration – claiming that it would be costly and involve uncertainty and delays. Sight of the objectives is quickly lost. For Thames, that objective should be a turnaround plan that delivers a massive step change in its appalling performance and its failure to maintain its assets. A serious turnaround has been repeatedly delayed in the years of “negotiations” by the process of haggling in the interests of parties.
It is like the Danegeld handed out to the Vikings, and every bit as unsuccessful. Distressed-debt specialists are not the obvious parties to run a large water company, and the current board is not blessed with the sort of engineering and environmental expertise so badly needed for Thames. But distressed-debt specialists are exactly the right ones to extract maximum concessions, and get the richest rewards for their investors. That is their USP and in the Thames case, they are very, very good at it.
To try to justify what is going on, the government resorted to the slogan of claiming that it is a “market-led process”. This reflects either a profound ignorance of what a market is, or a deliberate deception (or both). In a market, bidders are invited to the table, and alternatives compared. The Special Administration Regime (SAR) is a market-led process. Administration is integral as a failure regime to any market. Allowing Thames to rule out any bidder other than KKR, paying its bid costs and then refusing to engage with any others is what only monopolies protected by regulators and the state can do, but not what happens in a “market” process.
The scale of the Thames hole is truly awesome, and much deeper because of the lack of action by the government and OFWAT. Repeatedly, the government has tried to see off Special Administration, with the result that the driving force is the interests of the existing bondholders and especially those who want the option to get out with a profit in 2030.
Recall the context. Thames has failed to properly carry out its functions and is in breach of its licence, multiple times. The distressed-debt players bought in at a big discount, coming to the party when Thames was in trouble and because it is in trouble. That’s what these sorts of investors specialise in. Their business is to make a profit out of the sort of mess that Thames has got itself into. Their interests, and those of the other lead bondholders, combine to project a formidable negotiating stance. If Special Administration is effectively ruled out by the government, there is really little incentive to take this necessary step to put Thames on a sustainable long-term path.
The tactics have been straightforward. Make sure that other B-class bondholders take the write-offs. Offer loans to the board at distressed-debt rates (the £3 billion short-term loan) as a lifeline to keep the company going – instead of going into administration. Aim to limit the write-down of their debt from the top-line valuation at par. Grab a chunk of the equity value in due course as they get out.
Having bought in at a discount, the preferred strategy was to get out quickly with a profit. That is where KKR came in. The lead bondholders wanted a good price, and the worry about opening up the bidding was that others might offer a better deal for the environment and for customers, but at a lower price. An open-bidding process – which is what a Special Administrator would have conducted – would be risky for the lead incumbents, and might well have meant a significant hit for them as they lost control of the process.
KKR in its wisdom did not ultimately play ball, and that left option B: to get the regulators to bend the rules for their benefit so that they would be able to hold onto value. Once KKR had bowed out, and having got the board of Thames to refrain from allowing anyone else a look-in, the incumbent lead bondholders effectively wanted to “buy” the company themselves on their own terms. This is what the government describes as a “market-led process”.
The next step is to get the regulators and the government to give Thames preferential treatment. This is the origin of the London and Valley Water (LVW) “bid”. No one can accuse LVW of a lack of ambition, and it read the feebleness of the government and OFWAT correctly. Each concession led to the next demand, and to further concessions. The government just kept digging a deeper hold.
The shopping list for the lead bondholders in the LVW is impressive. Delay the payment of fines incurred because of the manifest failures of the business. Gain concessions to have an open-ended option to appeal to the Competition and Markets Authority (CMA), and in the meantime get the benefit of the uplift to the weighted average cost of capital (WACC) that those water companies that did appeal were granted by the CMA. Relax the requirements to meet their obligations through an “aggregate sharing mechanism”. Price the debt to account for the rising cost of gilts plus a margin. Gain concessions in meeting the licence requirements and hence from new fines as it proposes to continue to fail to meet its licence requirements until possibly the end of the next decade. Get agreement that it can sell out in early 2030.
Are you already lost reading this? I am sure DEFRA is, and if OFWAT understands what the incumbent bondholders are up to, it should publish and explain all and every one of the concessions that they are after. Thames is a monopoly – therefore nothing should be confidential. We should see it all in its grisly detail.
The complexity is all part of how really good distressed-debt investors play their cards. The game is pretty obvious – play long, get the government deep into the hole and make it more and more politically difficult to get out, so that the investors win out. The less the government understands and the more in public it trots out the rubbish about a market-led process, the better for these investors. They are very smart people, and much smarter than the government or OFWAT at these sorts of “negotiations”.
It appears these investors are winning. The problem for the government – and possibly for them too – is that it does nothing to solve the underlying problems. Thames has yet to even start seriously on a “turnaround programme”. Being let off fines and having a relaxed timetable for improvements means that the company is going to inflict its poor levels of service on customers and on the environment for several years to come. The prime investors are not in it for the long term. It is not their style and they explicitly want to position to get out in less than 50 months’ time.
Maybe the government thinks that this market-led process will gradually wear down the public resistance. Maybe it hopes that it will just become accepted that this is the sort of performance to expect and perhaps the customers will just get used to the bills. Maybe it is like the potholes and the performance and costs of the railways.
In this game of ever-diminishing expectations, Thames is unlikely to get lucky. The public campaigns about water have not been a flash in the pan. They go on and on. They feed on one bad event after another. People care about the rivers, the pollution and the sewage discharges, and they care when relying on a constant supply of water out of the taps. There are very few people who think this market-led process is a good idea.
This public concern is fed by the developing science. It is now possible to see what is going on in ways that were previously hidden from the public view, and indeed apparently from some of the directors of the company too. Satellite data, sensors and sampling allow the state of our rivers and our sewers to be revealed. Angry people can use these resources and they can do their own sampling. All the while, we learn more and more about what is actually in our rivers, on the beaches and in our tap water.
Smart journalists work on these popular stories. They open up what has been going on in the market-led process to a broader audience. More people now know that the costs of the market-led process are now in the hundreds of millions – yes hundreds! Consultants and lawyers have done very well so far, and the longer the market-led process goes on, the more they make. If and when the lead bondholders get out in 2030, there will be yet another “market-led process” involving the sale of the equity and a rearrangement of the debts. More costs, more fees and more distractions. This market-led process just keeps on giving.
How does it end? Eventually, the hole gets so deep that politicians and regulators start to fall into it. It is when it dawns even on government that what is being milked for interest and fees and salaries and bonuses is a public infrastructure. It is when the supply of water, the treatment of sewage and the stewardship of our rivers and beaches are recognised as what matters.
It is not too late. Calling in the Special Administrator is the obvious thing to do – now.
