Thames Water Part 1, How the Tap Ran Dry

Welcome to the 153rd Pari Passu Newsletter, 

Since launching the newsletter three years ago, we have never received so many requests to cover a situation like what we are finally publishing starting today. These requests have reasons to exist; this is an evolving situation with over $30bn of debt, multiple private equity buyouts, political and national involvements, and so much more. Here we can really say it: this is the perfect intersection of finance, law, economics, and politics; some are calling it The Restructuring of the Decade. So without any further ado, ladies and gentlemen, we are so excited to bring you a three-part (true) deep dive of Thames Water.

Thames Water needs little introduction. It supplies water and wastewater services to 16 million people, almost a quarter of the UK population, and sits on almost £23bn ($31bn) of debt. Its ongoing restructuring is one of the largest corporate restructurings ever in Europe. The case has attracted enormous political and media attention, with questions over who ultimately pays for decades of underinvestment and financial engineering. For investors, regulators, and policymakers, Thames Water has become the defining test case for how essential infrastructure is managed in the face of financial distress.

This is Part 1 of one of the biggest write-ups we’ve ever done for the newsletter, reflecting the scale and complexity of the Thames Water story. In this edition, we cover the privatization of the UK water sector in 1989 and lay out the regulatory framework that underpins the industry. From there, we track Thames Water through successive ownerships from RWE’s take-private in 2001, to Thames’ Whole Business Securitization structure under Macquarie. The themes of value extraction, regulatory limits, and chronic underinvestment form the backdrop of today’s crisis. Parts 2 and 3 will pick up in the late 2010s and dive into the ongoing restructuring, where creditors, regulators, and politicians are now locked in one of the most high-stakes corporate dramas Europe has ever seen.

Quick note before we get started, Pari Passu Research subscribers, check your inbox for an email including Parts 2 and 3. If your firm is interested in accessing the entire 18,000+ word research piece, including over 150 sources, you can simply upgrade and receive the entire deep dive today. You do not want to fall behind the competition!

Despite hundreds of requests, I was always a bit hesitant to take on Thames, given the complexity of the situation and the sheer amount of information to process.

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Thames Water’s origins can be traced back to the 1600s, and its history is littered with scandals and tragedies. However, our story begins in 1973, and at this time, England & Wales had around 160 different water companies (a mix of private and publicly owned), 130 sewerage authorities, and 29 river authorities (public entities responsible for sewage efficacy and water conservation) [1]. The localisation of the water supply to this level made it very difficult to regulate and threatened the long-term health of the country’s water supply. For example, 60% of all sewage treatment works were estimated to have failed to meet 19^th-century standards in the 1960s [2]. So, Prime Minister Edward Heath introduced the Water Act 1973, which established 10 new regional water authorities (RWAs), which were based on the country’s dominant regional river systems [1]. These 10 RWAs were state entities that were given control of the water supply and sewage systems, effectively taking water completely into public hands. 

Fast forward to 1989, and these RWAs were very underfunded. The late 1970s and early 1980s marked periods of very high inflation in the UK, which meant the government became less willing to allow the RWAs to increase borrowings or increase charges to consumers to meet capital expenditure requirements [2]. An environment minister underscored how the “water industry needed a very large amount of investment, and it simply wasn’t going to get that if it had to compete with the demands for schools, police, roads, and the health service.” [3] Furthermore, the European Economic Community (which today is the European Union) introduced the Bathing Water Directive 1975, which set higher quality and environmental standards for bathing water, requiring significantly more capex [4].

The graph demonstrates the relative underinvestment in the water industry compared to 1974-75 levels. While daily operational expenditure remained steady, capex declined sharply from the late 1970s and stayed low throughout the 1980s. This was mainly because the government, facing high inflation and tight budgets, limited how much the RWAs could borrow or charge customers. This led to the water system and water quality seriously deteriorating. 

In one of the most radical and unpopular moves of her premiership, Prime Minister Margaret Thatcher (a Neoliberal who was much like Ronald Reagan in the US) privatised the 10 RWAs under the Water Act 1988. The RWAs were sold by issuing shares on the London Stock Exchange (LSE). In doing so, the government: (a) wrote off all debts of the RWAs that were worth £5bn, (b) gave the new companies a one-off subsidy tottalling £1.6bn across the water sector, and (c) sold the companies at a substantial discount of roughly 22% of the undertaking’s market value (the market value being the share price after the first week of trading) [6]. 

Thatcher’s plan was to make the water industry attractive to private investors to meet the sector’s capex needs, due to the UK’s restricted ability to borrow. These new privatised companies were responsible for the country’s water supply and distribution, sewerage, and sewage disposal [2]. Just so that you grasp the magnitude of this move, England & Wales were the only countries in the world at that time to have fully privatised their water supply and sewerage in this way [1] [4]. The largest of these new water companies became Thames Water, which traded on the LSE.

Almost every issue with Thames Water’s financial distress today can be linked to this key moment. This is one of the most unique companies you will ever see, so we should spend some time developing a conceptual understanding of the challenges in having a privatised water and sewage sector. There are three interrelated points to understanding the optics around Thames Water’s controversy.

Ofwat, the Water Services Regulation Authority, is the regulator for water and sewage companies in England & Wales and was established as the RWAs were privatized in 1989. Its mandate is to achieve three things: protect customers, protect the environment, and make sure water companies can finance their long-term total expenditures. How it achieves and balances between these goals is key to understanding its role in Thames Water’s financial distress. However, regulation is extremely complicated (and delving too deep into it isn’t that fun), so here is a simple mental model followed by a breakdown:

Every five years, Ofwat runs a price review. The result of these reviews is to create a revenue cap for water companies, effectively determining the price level they can bill to consumers. These five-year periods are also referred to as Asset Management Plans (AMPs)

The rough building blocks for the revenue cap calculations are [9] [10]:

Two core terms outline what ‘fair’ investor returns in a regulated utility:

Altogether, as RCV grows with inflation and new capital expenditure, companies are incentivised to invest in long-term assets: each pound of efficient investment increases the RCV base on which Ofwat allows them to earn a regulated return (the WACC). In this way, RCV functions as both a measure of asset value and a mechanism that rewards continued infrastructure spending.

Outcome Delivery Incentives are like the ‘carrots and sticks’ that influence water companies behaviour by tying returns to outcomes the public cares about. It’s simple: meet or exceed targets to increase the revenue cap; miss or fail to meet targets, and the revenue cap will decrease [10]. For example, leakages and pollution levels falling foul of targets would incur penalties, reducing maximum revenue going forward.

‘Ring-fencing’ typically involves setting legal or financial barriers that are designed to isolate one part of a company’s operations from the risks or activities of another part [12]. In the context of water companies, Ofwat imposes a ring-fence to ensure that the regulated company (the OpCo) maintains sufficient financial and management resources to enable it to carry out its functions in a sustainable manner [13]. It achieves this by setting license conditions, which OpCo needs to comply with to qualify as a water provider. 

The key ring-fencing rule for us to take away is that the OpCo must maintain an investment-grade credit rating, which was at least Baa3 [13]. If a water company falls foul of this, then there is an automatic cash lock-up. This cash lock-up blocks the OpCo from sending any money up to its parent company unless Ofwat approves it [13]. Thus, dividends or other similar payments are heavily restricted to keep cash inside the OpCo so that it can continue running the network and serving its consumers.

In sum, these four levers are the operating system of the privatised water industry. They decide how much money flows in, how much can flow out, and what happens when performance or finances stumble. Hence, we would be falling short in our analysis of Thames Water’s financial troubles without considering these key regulations. Let’s now return to Thames Water’s story.

Now that we understand the framework Thames Water operates in, we can dive back in the story. Privatization in 1989 left the company debt-free and cash-rich after the government cancelled its debt and provided its subsidies. Sector infrastructure spending doubled in the early 1990s, and Thames Water completed its ring main (80 miles of new tunnels to transport drinking water) and upgraded its major treatment works in London [14] [15]. However, customer bills also rose roughly 33% in the first five years (5.9% CAGR). In response, Ofwat’s price reviews in 1994 (PR94) tightened control over the price increases, and in PR99, Ofwat actually cut bills by an average of 12% [14]. 

How was Ofwat comfortable cutting prices when capex was increasing? Originally, gearing (the industry-specific measure for ‘leverage’, which expresses Net Debt as a percentage of RCV) was expected to stay below 35%, but the bond market’s appetite for monopoly utilities and Ofwat’s willingness to tolerate higher leverage led to rising debt levels across the sector [14]. The justification was that if a company’s actual borrowing costs were below the level Ofwat assumed, the savings could be passed to customers at the next price review, enabling lower bills. In short: higher gearing → lower WACC → lower allowed return → lower bills. This shift towards embracing more debt created the financial environment for RWE’s 2001 takeover.

In 2001, RWE, a German electricity and utilities company, made a move into water services by acquiring Thames Water for £4.3bn in cash [16]. RWE was acquiring several water companies around the world, including America’s largest water company, American Water Works, en route to becoming the third largest water utility in the world [17]. But focusing on what this meant for Thames Water, let’s see the impact of the transaction on the water company’s capital structures.

The 2001 deal was financed largely with new borrowings at this group level. You can see net debt rising from £1,810mm to £3,193mm. What is key to understand is that the transaction significantly increased obligations outside the regulated business. We will now look at the regulated operating company’s capital structure to judge financial resilience and the constraints on upstream cash.

Thames Water Utilities Limited (TWUL) is the licensed, ring-fenced operating company that provides water and wastewater services. Ofwat assesses financial resilience using gearing = Net Debt / RCV. The cap stack indicates pro-forma net debt of £2,169mm against RCV of £4,326mm, resulting in a gearing ratio of approximately 50%. Do note that Figure 6 also shows that net debt only increased in TWUL by £220mm, from FY 2000 to FY 2001 [19], illustrating that the £1.4bn increase in net debt across the group was mostly acquisition debt.

Note, we are not using leverage ratios (Net Debt / EBITDA) because Ofwat fixes Thames Water’s allowed earnings as a set return on its RCV. Thus, this asset base is effectively what services the debt, not a ‘market’ EBITDA. Here, credit analysis on water companies focuses on allowable revenues (and by extension RCV) because it represents the predictable baseline from which debt service is met, whereas the actual revenues can introduce noise (e.g., weather-driven consumption changes or operational disruptions that don’t affect RCV and thus earning capacity), obscuring the underlying regulatory strength of the business.

Another question you may have is, why is gearing only measured for TWUL and not the entire Group? Well, RCV exists only for the licensed business (TWUL), as that is where the ‘regulatory capital’ (the assets that provide water services) is. Assets elsewhere in the group are not regulated, hence do not form part of RCV.  Still, there are borrowings at holding and other subsidiaries outside the ring-fence. Those liabilities are serviced only if cash can be upstreamed from TWUL; therefore, it is still important to be aware of the whole group’s net debt.  This also makes it important to track TWUL’s dividend payments, since they represent cash leaving the regulated business, both to service parent company debt and to provide returns to shareholders.

There are many storylines to follow during this period that led RWE to sell Thames Water in late 2006. It also introduces us to several recurring patterns and behaviours of players in the Thames Water saga. Below is the company’s financial performance under RWE, and we will fill in the gaps to explain what was happening.

From FY 2001 to FY 2005, Thames Water’s finances were under persistent strain from low revenue growth and high operating demands. Revenues only rose from £1,029mm in FY 2001 to £1,336mm in FY 2005 (6.7% CAGR), constrained by Ofwat’s PR99 price review, which reduced allowed prices to consumers. 

Throughout the period, capital investment stayed high to address leakage and asset renewal. In particular, 2003 saw three major mains bursts, severe flooding, and one of the driest summers in a century, all of which needed increased capital spending. [22] Furthermore, by FY 2005, Thames had missed leakage targets for six consecutive years, prompting Ofwat in 2005–06 to impose a legally binding undertaking for Thames to spend about £150mm replacing 230 miles of mains by 2009-10, in addition to an already large 770-mile renewal plan for 2005–10 [23] [24]. As the table shows, all of this pushed capex above £500mm from FY 2003 onward. FCF even fell to £8mm in FY 2004 as a consequence of this increased capex.

Despite persistent cash flow pressure, TWUL continued to distribute large dividends, a lot of which were for RWE. In FY 2004 and FY 2005, it paid £137mm and £155mm respectively, even though FCF was minimal and substantial interest payments increased cash outflows (£130mm and £133mm in interest payments in FY 2004 and FY 2005 respectively). Once both interest and dividends were deducted, the company recorded sizeable cash outflows of (£259mm) in FY 2004 and (£45mm) in FY 2005. These distributions were therefore not entirely funded by an internally generated surplus but also by additional borrowing at the group level. The Group’s net debt increased from £2,876mm in FY 2003 to £3,433mm by FY 2005, while TWUL’s own net debt fell slightly and its gearing ratio dropped to 36% in FY 2005. At the same time, the group’s total dividends were significantly higher than those declared at TWUL: £259mm in FY 2004 (versus £137mm) and £325mm in FY 2005 (versus £155mm) [21]. This highlights how RWE extracted large sums from Thames Water by leveraging debt outside the regulated operating company, preserving compliance with Ofwat’s gearing level guidance while pushing indebtedness up at the group level.

This leads us to 2006. According to our estimates, FY 2006 was a poor year for Thames, especially when we look at its cash flows. Capex surged to £683mm, FCF fell to only £7mm, and net interest of (£140mm) left the company in negative cash flows before dividends†. However, this does capture the severe public and political criticisms Thames Water was under. During a severe south-east drought, the water company imposed hosepipe and sprinkler bans and sought (then withdrew) a drought order to reduce water supplies [25] [26]. Media coverage centred on the contrast between service restrictions and record leakage levels on the one hand, and continued profits (£432mm operating profit) and dividend payouts to RWE on the other. Members of Parliament (UK equivalent of congressmen/congresswomen) condemned  ‘the group’, which is beyond the TWUL dividends in our table, for paying about £270mm in dividends in 2006 to its German parent and more than £1bn over five and a half years, arguing this prioritised shareholder returns over infrastructure improvement [26]. With operational underperformance, hostile public opinion, and intensifying regulatory pressure, RWE opted to sell Thames Water later in 2006.

In October 2006, Macquarie’s infrastructure funds acquired Thames Water from RWE for around £8bn, comprising roughly £2bn in equity and £6bn of third-party debt [27]. Ownership was transitioned to Kemble Water Holdings Limited (KWHL), led by Macquarie and backed by institutional investors around the world.  

Beneath the surface, the acquisition also introduced one of the most complex and misunderstood financial structures at the time. Macquarie put in place a Whole Business Securitisation (WBS) structure. We have a post on WBS that is 100% worth checking out, but we will need to break WBS down in detail here, given how regulated water assets are and how unique this WBS is. Understanding how the structure worked is not only fascinating, but it also played a huge role in the Thames' financial challenges. First, here is a diagram of Thames Water’s corporate structure, which is still the same today.

We have three points we need to cover about this financing structure, which are the following: