There are two stand-out cases of failure in the privatised companies. The first is Railtrack and the second is Thames Water (Thames). In the Railtrack case, the Office of Rail and Road (ORR) stood ready to help Railtrack, whereas in the Thames case, the Water Services Regulation Authority (OFWAT) looks to be unhelpful. There are good reasons in both cases: both Tom Winsor and David Black, the regulators of the rail and water sector, are trying to play by the rules – or at least the rules they prefer – and not to make ad hoc exceptions to these two companies.
Railtrack ended up in a chaotic and time-consuming administration, eventually to emerge as Network Rail, which was then nationalised when the Office for National Statistics (ONS) classified its debt as on the public balance sheet. The final resting place for Thames is yet to be determined. In the case of the railway industry, eventually much of the industry has ended up nationalised too; in the case of Thames, the government is trying hard to avoid nationalisation, and trying to do so by heading off calls for a Special Administrator. OFWAT seems to fear special administration too, perhaps for reputational reasons.
This will probably turn out to be a big mistake, and it might happen anyway. By dragging out the agony of Thames, something much more dangerous lurks beneath the surface – contagion across the rest of the water industry (and maybe beyond to regulated electricity markets too). Applying endless sticky plasters to Thames is neither going to fix Thames’s problems nor do any favours to the prospects of survival for the rest of the industry.
Thames will probably get sold at a very steep discount in a process controlled by its A-class bondholders, and will probably get broken up. Yet even if this turns out to be a potentially very profitable opportunity to purchase the business for a deeply discounted value, it does not bode well for Thames’s future. The private interests of the sellers in the short term should not be confused with the public interest that a Special Administrator would pursue.
To see how contagion may play out, and therefore how the endgame may eventuate, the starting point is to recognise what has gone wrong with Thames and why it is in the mess that it undoubtedly is in. Some of the reasons are specific to Thames, but, from the contagion perspective, what matters is which of its failures are shared with some, or all, of the rest of the water sector. The former can in theory (eventually) get solved, but Thames does not control the latter. Next, it is important to understand why Thames is not a self-righting ship; why it is unlikely to emerge as an efficient water and sewerage company over the next decade; and why the sticky plasters may serve to gradually undermine it further. This is the context within which to think about contagion and the wider implications: the possibility that the privatisation model may not survive and the possible ownership and regulatory models that might emerge, perhaps sooner than the next general election and the next periodic review in the water sector, due in 2029 (PR29).
Why Thames Water has failed and which failures are generic
Thames has failed for a conflagration of reasons, some of its own making, some caused by bad regulation, and some the fault of successive government over the past 25 years. These three have reinforced each other. Even the former is only partly unique to Thames (others have serious managerial failures too), whilst the other two are generic. All have an impact on the contagion risk.
Like all the water companies, Thames was privatised with zero debt (indeed a small cash injection was provided upon privatisation). It (and the other water companies) were privatised in order to run their networks and infrastructures better (bringing private sector cost disciplines) and to raise finance to pay for capital investments on the basis of borrowing so that current customers (and current voters) would not have to pay. The Thames model, like that of the other companies, was pay-when-delivered, not pay-as-you-go.
This gave two tasks to the management of all the companies: run the business more efficiently; and raise finance for capital investment. Thames has turned out not to have done the former very well; and it has used the balance sheet to securitise the business, rather than for the objective at privatisation, which was to borrow solely to invest. In both, it has been at the outer edge of water company performance and gearing.
This is not the place to give a detailed assessment of the efficiency of the business. But it is worth examining what the incentives have been and why cost-cutting has had priority over capital maintenance. RPI-X as a regulatory rule had the advantage of simplicity at the outset. The regulator would set the (fixed) prices ex ante every five years (originally it was supposed to be every ten), and the companies would maximise profits by minimising costs.
As was witnessed across the privatised utilities, this deceptively simple rule required regulators to be very clear about the outputs that had to be delivered as part of the fixed-price contract, and to make sure that they were actually delivered. In practice, this meant approving the business plan for the period, and having clear, measurable and enforceable environmental and social outcomes.
Thames (and others) ran rings around the regulators, and provoked a process of regulatory creep with ever-more complex and detailed interventions by the regulators, which even ended up regulating Thames’s dividends. As a rough rule of thumb, regulators added at least two new mechanisms at each periodic review. The added complexity did not result in greater performance improvements. Whilst it is true that if serious consideration is given to the counterfactuals, Thames did improve quite a lot on the environmental front, it is a remarkable feature of the last 35 years that Thames did not have a good grip of what assets it had, where they were, and their condition. It still does not. That, sadly, is also true of much of the sector.
To be fair, the old, nationalised, model of the Area Water Boards did not prioritise the impact of badly maintained pipes and sewers. On the contrary, leakage and river pollution were often tacitly taken as givens. But over 35 years, to remain so deeply analogue, to have so little grasp of sewage spills, and to allow the assets to continue to be poorly maintained and in some cases actually deteriorating, is an extraordinary outcome that would not have been acceptable at privatisation, and would not have been expected to be the outcome.
The extraordinary complacency is well-illustrated in the remarkable work of Professor Peter Hammond, in revealing what was actually going on at Thames’s sewerage works. A retired academic mathematician, Professor Hammond was able, on his own, to demonstrate how many sewage spills were taking place in the Thames catchment (and the other water companies’ areas too).
At a House of Commons Environmental Select Committee hearing,[1] several water company chief executives were grilled. At one point, Sarah Bentley, the then chief executive of Thames, was asked for her response to Professor Hammond’s findings. She replied to the effect that Thames’s management were keen to understand his analysis and how he did it. The very idea that a single retired professor working alone could do this, whilst Thames did not, speaks volumes about what was going on inside the company. Professor Hammond subsequently interrogated data for other water companies, showing that sewage leakage was generic. It is also worth noting that the Environment Agency (EA) similarly failed to monitor sewage spills properly.
Thames did have some very special problems in maintaining its assets because it covers the capital city. The complexities of running such a large urban infrastructure cause special difficulties, and the labour and access costs tend to be higher in London too. But this does not explain why the Thames infrastructure has been so badly maintained.
Perhaps it is not Thames’s poor management and inefficiency that is to blame, but rather successive regulators, egged on by government, focusing on holding down bills rather than providing sufficient revenues to fund the needed improvements? It is a good question, and the lack of appropriate price increases has played a part. OFWAT in the 1990s was known to be concerned about affordability and about getting the companies off the price escalator, and to be openly sceptical about the benefits of environmental improvements, referring to examples of pollution being like aspirins in a swimming pool. The relationship between the National Rivers Authority (NRA) (the forerunner of the EA) and OFWAT was not good.
Yet this regulatory and political backdrop does not let Thames off the hook. Water privatisation explicitly allowed for appeals against OFWAT’s price determinations. Thames could, at every periodic review, have appealed to the Competition and Markets Authority (CMA) (and its forerunner the Competition Commission). If Thames’s board considered it did not have enough revenue to finance its functions, it should have appealed.
It was not just Thames: mostly, the water companies did not appeal. Why not? Part of the reason is that the governments, OFWAT, the NRA/EA and the companies all implicitly worked on the basis of an approach that started with what they thought customers could afford and then agreed what could be done for these amounts, rather than starting with the environmental and other outcomes required, and then setting charges at whatever it costs to achieve them efficiently. This is the origin of a context in which a blind eye was turned to environmental failures, and the fines were so low as to be part of the cost of doing business. This affordability criterion has undoubtedly curtailed environmental improvements. All this went under the guise of the quadripartite process in the early periodic reviews.
What has happened over the past couple of years is that the public has noticed. As ever, there is a mismatch between, on the one hand, the demands for higher river and water quality, and, on the other hand, the opposition to bills being raised to pay for these. The belated and relatively sudden imposition of large fines reflects this change of tone. Thames and others could have reasonably assumed that the “implicit deal” around affordability would let them off the hook. What their successive boards failed to realise is that the licence gave them the obligations, and relying on politicians and regulators being objective, rather than following public opinion and media coverage, was always a dangerous strategy to pursue.
The other reason why performance on capital maintenance has been poor is that Thames has not invested in developing proper and complete asset mapping and fully embracing the opportunities that digitalisation of networks brings. It remains too analogue and as a consequence suffers the information deficiencies about the state of its assets. It remains astonishing how little Thames (and other water companies too) know about their assets. (Interestingly, this was also a problem for Railtrack at its privatisation – there was no comprehensive register of the railway networks and their supporting assets).
Failures of capital maintenance made Thames a sitting duck when the public discovered the state of the rivers – especially when travel was restricted during the Covid lockdowns. Thames has 16 million customers, all in the affluent south and in a relatively densely populated catchment. The public could see with their own eyes the state of some parts of the Thames river catchment; they could suffer the consequences of swimming in rivers; and they were told by Professor Hammond and others about the sheer scale of the sewage discharges. These discharges did not occur just during storms when the sewerage works were designed to spill into rivers and the sea, but during dry periods and in some cases as a very regular event.
The public outcry prompted the EA and OFWAT to notice what had been going on, and to start to get into the fining business. The game had moved on, and now a much bigger capital maintenance programme would be required, as governments got into broad “plans for water”. (Capital maintenance is typically called investment, to hide the obviously painful politics of making customers pay for the ongoing maintenance out of current bills.) This did set the scene for a much greater spend at the periodic review in 2024, and for possible appeals by all and any companies (including Thames), whose boards consider the outcomes to be insufficient to meet the discharge of their functions, though if Thames is acquired at a very steep discount to the value of the regulated asset base (RAB), opportunist buyers may even forgo appealing to the CMA.
Poor management and poor capital maintenance should bring a company into difficulties, but what makes Thames more of a basket case than the others is that, in addition to failing on the capital maintenance, it was profit-maximising by gearing up its balance sheet at the outer limits of what was sustainable. This turned out to be the most profitable activity of the company. Whereas the balance sheet had been set up at privatisation to move from pay-as-you-go to pay-when-delivered, Thames (and others) used the balance sheet to mortgage the assets and pay out the proceeds in special dividends and other benefits to the shareholders. All the companies were doing this, but Thames pushed it further (though not as far as, for example, Heathrow Airport, at 95% gearing).
The reason that this model was so profitable was the combination of very poor regulation and extremely low interest rates. OFWAT is the stand-out case of the failure to protect the balance sheets for the purposes they were intended (although OFGEM has neglected balance sheets too). Indeed, OFWAT stressed the importance of leaving matters pertaining to the capital structure and the balance sheets to the companies.
OFWAT sets the cost of capital using the CAPM (capital asset pricing model) and then applies a WACC (weighted average cost of capital) to set the allowed returns. The WACC is an average of the costs of debt and the costs of equity. By definition, it will over-reward debt and under-reward equity – before any other consideration is applied to the tax and other impacts. Hence the simple opportunity: replace equity with debt by mortgaging the assets.
Thames took this to a whole new scale, engaging in whole-company securitisation and creating an offshore set of companies to facilitate this, going under the label of various Kemble entities. It was brilliantly executed, building on a strategy that had its origins back in the mid-1990s when OFWAT (and OFGEM’s predecessors: OFFER and OFGAS) decided not to act to protect the balance sheets. It was as if the owners were shown an open goal – not only had the goalkeeper been removed, but the referee was taken off the pitch too.
It is easy to blame the companies for taking advantage of these obvious, very profitable, opportunities. But this is wrong: they were simply exploiting the opportunities placed in front of them. OFWAT belatedly recognised the mistake of ignoring gearing and balance sheets, and went so far as to give indications about the sorts of gearing it might like, yet at no point did it run proper pro-forma balance sheets from privatisation setting the gearing against investments not paid for by current customers.
The upshot of this combination of failures – failure by Thames to run itself efficiently; failure by Thames to do the necessary capital maintenance; failure by Thames to understand its assets; failure by OFWAT to get a grip on the balance sheets and prevent the huge scale of financial engineering; failure by the NRA and then the EA to properly enforce environmental standards and performance; failure by governments, OFWAT and Thames to ensure that the periodic reviews provided sufficient revenues through customers’ bills; and failure by Thames to appeal against the OFWAT periodic review determinations – is the sorry mess that Thames now finds itself in.
Why the sticky plasters are unlikely to work
Is the result of this combination of failures redeemable? Can they be turned around? Though, in theory, there is no reason why not, there are some very practical reasons why a turnaround will probably be largely specific to Thames. These are: that the actions of the A-class bondholders, whilst very beneficial to themselves, are likely to result in a sale at a very much lower value compared to the RAB valuation; that the financial consequences of the current crisis will likely drive the company’s direction for the foreseeable future and distract from any turnaround to the shorter-term advantages of the new owners; and that any turnaround will probably make matters worse before they get better. A great deal of customer trust and support has been lost. Through its actions, the company has effectively lost what might be called its “social licence” to operate. Arguably, so has quite a lot of the industry too.
To these may be added a more profound obstacle: Thames is probably too big and diverse to be able to be managed efficiently. The necessary break-up will take time and, if conducted by the A-class bondholders, will reflect the bids they receive, rather than the longer-term structure that would better serve the public interest and one a Special Administrator could pursue.
Let’s start with the current financial machinations. The existing equity owners have said that Thames is uninvestable. They are right: the WACC deliberately underprovides for the return on equity, and, if set correctly, makes equity investment in principle loss-making. This is unfortunate in a context in which the company needs an equity injection just to stabilise the business, before considering more equity for new investments.
It does not, however, follow that the business is worthless. On the contrary, it has a RAB on which it is provided with a return. The RAB is supposed to represent investors’ sunk and fixed costs for past investments, and it is a given accounting number. If Thames is rewarded with a WACC on this number, the value of the business starts with the capital value of the RAB.
The business is not, however, worth the full value of the RAB to a new buyer, since there is much remedial capital maintenance to make up. When the A-class bondholders sell their equity (which they will assume in taking control of the company in return for their £3 billion loan), they will receive significantly less than the full value of the RAB. In the battle to extract revenues, the actions of the A-class bondholders, and the £3 billion loan in particular, may increase the discount on the sale versus the full value of the RAB. The A-class bondholders providing the £3 billion loan can force harsher write-downs of the B-class bonds, whilst receiving a return on the loan of 9.75%, plus fees and other costs, together estimated by some observers at 20% or more (though the details are not revealed and hence the 20% amounts to speculation).
There is quite a long road from the loan agreement to the eventual sale and exit of the A-class bondholders, as well as the writing-off of the existing equity holders (which has already de facto happened) and most of the value of the B-class bonds. The key question is whether this is a zero-sum game between the various investors, with no impact on the licensed Thames entity, or whether the way the game plays out has an impact on the main business, and hence ultimately on customers.
Superficially, it looks like it is indeed a zero-sum game, but in practice, it is much more complicated, bearing upon the very stability of the UK regulatory regime, and in particular the RABs that are the guarantees against time-inconsistency and expropriation risks. In addition to the impact on the future reliability of RAB valuations, the very conduct of the financial restructuring further undermines the social licence to operate. A £250 million bill so far for advisers, 9.75% interest, and debt specialists profiting from the mess, add to the problems and customer distaste for the whole model.
The next obstacle is the final determination (FD) of the prices for the period from 2025 up to 2030. Thames has asked for considerably more than OFWAT is so far allowing. Some have suggested that OFWAT should help out the company in distress, but this fails to recognise the huge obstacle in OFWAT’s way. OFWAT has a set-piece methodology for the review, and a set-piece methodology for calculating the costs of capital. Both are very deeply flawed, but the point at this stage is that they were set out early in the process and have been subject to consultation. It is very hard for any regulator to discriminate between companies, other than to fudge particular numbers. In this periodic review, OFWAT has been particularly prescriptive – for example, telling the companies what cost of capital to use in their business plans and even “fining” one company £30 million for daring to use the number that the company considered appropriate. This is yet another example of regulators exceeding the spirit of predictable regulation, and is a questionable application of the letter of the law.
Suppose that Thames does not get what it asks for. What then? It could appeal to the CMA, but the CMA is stuck in the same CAPM/WACC rut, and the history of past cases suggests that its changes to PR24 will be marginal. Again, like OFWAT, the CMA is set in its ways. Any significant changes to the methodology it uses will have implications not only for Thames, but for the other water companies too. (OFWAT would come under pressure to pass on any ameliorations that Thames wins, even if not obliged to do so.) Even more importantly, the ripples will go out throughout the utilities sector much more widely.
Would the A-class bondholders actually care what the outcome of the FD is? This might sound an odd question, but it has been suggested that neither the utility company nor the A-class bondholders care much about how expensive the £3 billion loan is, and a similar logic might prevail for the FD price increases allowed. The rationale is that the outcome is, as will the loan burden be, effectively a zero-sum game, and the implied losses will show up by reducing the value of the company relative to the RAB. Whilst it could be argued that the loan monies are a case of dog-eats-dog, this cannot be the case with the FD, because it further expropriates the reliance on the RAB. This is because, unless the company lied about its expected costs to meet its licence obligations, or simply did not understand that it could be as efficient as OFWAT assumes it can be, it will now not have enough money to cover its costs in the coming period. Hence it will have to write down the value of the company in a sale relative to the RAB.
How Thames Water might the first domino fall?
There are several routes to collapse for Thames. The slow death comes from continued failures to do the capital maintenance and run the business efficiently. The debris left as the existing investors in bonds and equity exit will leave a financially stretched shell business, or businesses if broken up. The A-class bondholders will most likely sell out, and lots of opportunist buyers are eyeing up a bargain – Thames at a heavy discount to its RAB. New investors may not be long-term. They may include private equity and vulture funds. The board of the company will need to jump to their interests, and these will have a heavy cash pressure to fund the interest and dividend payments on their finance. The new investors will want to portray themselves as long-term, which would be a novelty for Thames. None has stayed long-term over the past 35 years. But new investors will need to beware – OFWAT controls the company’s dividends. The investors will have seen the difficulties that Macquarie has encountered in coming into a distressed Southern Water. New investors are going to want a very heavily discounted price.
All this points to the struggle that the Thames board may have in addressing the day job – turning around the business. When the last chief executive left abruptly, the new one was brought in to deliver a turnaround plan. That has been near impossible, given the overwhelming preoccupations in the company to keep itself afloat. Why would this be easier in the future? The turnaround is going to have to be deep and profound, and long-term. There are no quick fixes.
Let’s suppose that new owners and new management actually try to “do the right thing”. They will face a very real immediate problem. If the turnaround is deep and serious, then things usually get worse before they get better. The workforce has to be restructured, managers fired, new people brought in, and the organisational structure of the depots, the supply chain and much else assessed and reorganised. No doubt some more consultants will be brought in and there may be strikes and labour reactions. All this is familiar to those who bear the scars of turnaround plans.
There is no knowing how long the agony lasts. It depends on the combination of public and customer anger, environmental fines and penalties since the sewers cannot be fixed overnight and the leaks will go on for a long time to come, and the politics. The government could take a left turn if and when the economic growth fails to materialise and if and when taxes have to go up again. Nationalisation is overwhelmingly popular amongst Labour MPs in private, and is popular too with the electorate. As time marches on, PR29 approaches, and in the run-up to an election, there may be little appetite to offer a further round of high price increases.
How might the other dominoes start to fall?
RABs matter. The Thames investors’ apparent zero-sum game is an ex post one between existing investors in debt and equity. It is a cat fight in the sack, which A-class bondholders appear to be winning. Not so for new investors and those in other companies that might be vulnerable. They will look at their RABs and recognise that these can no longer be relied upon. Tobin’s Q[2] is no longer a sensible basis for valuation. The value of the company can vary from a RAB premium for outperformance to a value close to zero for the RAB.
As with Thames, the game starts when companies try to roll over existing debt, and then when they try to raise new equity. Even the quoted companies have been in the business of discounted equity injections, as in the case of Severn Trent Water.
Given that quite a lot of Thames’ problems are generic (if more extreme), there are several other companies close to the edge that Thames has fallen over. Anglian Water is struggling to roll over its debt, some of Southern Water’s debt is close to junk, and Yorkshire Water and Northumbrian Water have significant debt challenges too. Drip by drip, the proximity to the cliff edges is being revealed as they go to market for debt and hope to raise more equity, and when they do the latter, the scale of the discounts is being revealed.
The key point is that the marginal cost of finance is now increasingly the marginal cost of equity, plus the marginal interest on rolled-over debt. These are all creeping up. New investors will look at what is happening to the RABs and how these are being gradually expropriated, and will wonder whether the UK water sector is the stable and reliable investable proposition it once was. It is hard to overestimate the importance of the RABs as the fundamental foundations of UK regulation. Once this becomes vulnerable, investors see the core brick knocked out of the foundations of their investments. This is the most dangerous dimension of the current view about the “uninvestability” of the water sector in England and Wales.
Losing confidence has its own momentum, and as it has seeped away, so the actual cost of capital has gone up. That higher cost opens up a wider and wider gap with the WACC allowed by OFWAT. The companies can go on in theory until all the RAB values have been fully expropriated, as long as they cover their operating costs (that is the essence of the time-inconsistency problem). But as the process unfolds, the incentive to invest more gets less and less. It can easily become a vicious circle, triggering perhaps a faster collapse than many now expect. And all the while, the boards focus on preventing the administrator stepping in rather than fixing the day job.
How to get a better outcome?
The answer the government gives to the above is that it is all going to be sorted out by the Cunliffe Commission, which it believes will come up with reform proposals that re-set the industry on a stable pathway, and which will then be the substance of a new Water Act.
The PR29 clock starts ticking in late 2025 and into 2026, when business plans will need to be assembled and a new methodology will be needed too. Legislation in 2026 will be too late unless the government decides to prevent PR29 and move away from periodic reviews.
There is a better way, but it is radical, and it is questionable whether either the Cunliffe Commission will have the time and will, or whether the government will be willing to invest its political capital in it. It puts the public interest first. The Catchment Regulatory Model[3] offers an integrated solution to the pollution in rivers, and a way out of investing large sums in end-of-pipe solutions, notably lots of big storage tanks for storm waters. Better to find the cheapest ways to reduce pollution, and better to slow the storm flows than try to build really big tanks at sewerage works. The catchment approach is likely to be both significantly cheaper and have lots of ancillary additional payoffs, including for flood defence and for biodiversity. The snag is that farmers would have to play a much bigger role, and the government has alienated the farmers through its Budget measures.
Early indications are that the Cunliffe Commission is not much interested in radical changes, and it is perhaps inevitable that it will be minded to focus on tweaks to the existing system, and tweaks to the regulatory regime. If the government’s aim is really to use Cunliffe to buy cover to pass through bigger price increases to customers (and to give cover by blaming the Conservatives), that might buy a bit more time. PR24 could be partially reopened.
The problem is that it is not enough, it will entrench the “big tanks” approach and it will not solve the fundamentals. The government’s task is a huge one: to rebuild confidence amongst investors that the UK regulatory system is predictable and investable, just as the RABs are expropriated, in a sustainable structure that serves the public interest. The political temptation to be time-inconsistent is just too great. The chances that faith in the solidity of RABs will return are actually quite small, and, as a consequence, there will be a slow slide towards a contracting model. Investors in contracts (like the Thames Tideway) arguably have a better security than directly in the water companies (like Thames).
Perhaps the result will be that a Special Administrator finally steps in. Having put so much effort into preventing calling in the Special Administrator as the licence at Thames was breached, the government and OFWAT may yet fail to head it off indefinitely. The longer it takes, the worse the outcome. Out of the ashes, there are obvious freedoms of manoeuvre that a Special Administrator has. The Special Administrator doesn’t have to let the zero-sum game of the existing investors dictate what happens, and doesn’t have to let the A-class bondholders determine the sale process – and the emerging structure of a broken-up Thames – as they reach for the exit. As I have argued elsewhere, a Special Administrator could split the business between London and the rest, and between sewerage and water.[4] It could go for a partial or complete public listing, setting the scene for Thames and potentially others to return to the discipline of the public equity markets. It could re-set a regulatory balance sheet on the basis of the pro-forma balance sheets from privatisation, based upon the actual capital expenditure not paid for by customer bills and not already capital-depreciated. It could wipe Thames’s slate clean, provide a sound basis for the next 30 years, and get on with the day job of dealing with the sewage and the leaks, providing the clean water supplies, and doing all the mundane things that running a water company efficiently requires. It might even manage to convince investors that, going forward, there is again a sound, predictable and reliable regulatory framework in place and that they should have faith in the commitment to the RABs once again.
[1] Environmental Select Committee (2021), “Water Quality in Rivers – Oral evidence”, 13th October.
[2] The ratio between the market value of a physical asset and its replacement value.
[3] For more on this, see Helm, D. (2019), “The systems regulation model”, 12th February.
[4] Helm, D. (2024), “Putting Thames Water into special administration and-breaking it up”, 7th March.
