Thames Water has published a detailed analysis of risk and analysis warning Ofwat that its AMP8 business plan is simply not financeable without allowing an increased rate of return for investors to raise the financial capital needed.

Thames Water’s full AMP8 Business Plan – belatedly published on Thursday, 3 days after Ofwat’s formal publication deadline of 12pm on 2^nd October – is accompanied by a detailed and separate Appendix on risk and return outlining its reasons.

The water company also expresses its broader concerns about the risks for the water sector as whole with regard to the upcoming AMP8 2025-30 investment programme.

Commenting in its overview to the full AMP8 Business Plan, Thames Water says that due to the step up in the amount of activity, the financing requirement it faces through to 2030 is £10 billion or more, considerably higher than the financing it has needed to secure in previous years.

“The challenge for the industry in securing the amount of capital needed should not be under estimated"

Going on to point out that the company initially finances this infrastructure investment using financial capital provided by investors, the Business Plan says:

“The challenge for the industry in securing the amount of capital that is needed should not be under estimated. Assuming that other companies’ plans bear some similarity to our own, the sector as a whole could be looking for in excess of £50 billion of additional investor capital by 2030 as the industry regulatory capital increases from £100 billion (as at March 2023) to more than £150 billion.

“In order to make a commitment of this scale, investors will need to be persuaded that the future returns that they can expect on their capital are commensurate with the risks that they are being asked to bear. They will also need to see that these returns are sufficient to offset the opportunity costs that they will suffer when they choose the water industry and forego the profits that can be made on alternative investments with similar risk profiles elsewhere.”

In the separate accompanying TMS41 Aligning risk and return, Thames Water also suggests that the risk exposure of the sector has grown in PR24, with changes in risk since PR19 including external and macroeconomic risks.

Commenting on operational risks, the Plan warns that an ageing asset base, combined with higher expectations from customers and the public as regards service and environmental outcomes, is “making for operational challenges on multiple fronts.” 

This is clearly seen in the difficulties that the sector has had meeting the performance improvement targets Ofwat set in 2019 even despite an unprecedented overspend against PR19 totex allowances,” the Plan says.

Greater scrutiny from media and campaign groups “is arguably the biggest change since PR19”

It also specifically warns over the growth in political risks, suggesting that the greater scrutiny that the sector is receiving from the media and campaign groups “is arguably the biggest change since PR19” and that while the risk that this might result in politically driven intervention is “difficult to quantify” this has become “a major issue of focus” for investors.

On its own Business Plan, Thames considers that the level of enhancement investment included in the plan, (and unforeseen by Ofwat at the time it published its methodology) creates a heightened risk of cost overruns. Thames warns:

“Large-scale capital projects tend to be inherently more complex and subject to greater budgetary and timetable uncertainty than smaller, repeatable base expenditures. This, in turn, creates both a higher variance in cost outcomes and a greater likelihood of overspending rather than underspending.”

“... ,we consider that the notional company operating in the Thames region during the period 2025-30 will find it impossible to meet Ofwat’s PR24 target for customer experience. A combination of geography, operational challenges and negative public perception, together with our AMP7 starting position, are currently coming together to make C-Mex a sure lose proposition for at least the next five years.

“Taking these things together, we do not think it is tenable to think that Ofwat’s published methodology puts us in a position where the risk of under-performing is equally balanced by opportunity to out-perform. This, in turn, presents a major problem in terms of financeability.”

To address financeability problems, the water company has proposed the following changes to a number of regulatory arrangements as part of its PR24 plans for Ofwat to consider for its PR24 determinations:

• a switch to company-specific targets for six of the common PCs;
• a continuation of PR19 ODI rates, in preference to the proposed ramp up in already powerful incentives;
• an overall downside floor on ODIs and C-Mex over AMP8; and
• the introduction of a Risk Adjustment Mechanism to taper out- and under-performance on totex, retail costs, ODIs and experience measures by 50% when aggregate RORE reaches +/-300bps and by 90% when aggregate RORE reaches +/-400 bps of the base level of return.

In Thames’ view, the proposed regulatory arrangements simultaneously reduce the downside risk the company will face over the next five years to “a more bearable level” and also create a more even balance between the scope for under-performance and the opportunity to out-perform.

The utility also wants Ofwat to revise its current view of the allowed rate of return for the period 2025-30. The regulator’s early view of the cost of capital set out in December 2022 provided for a return on debt of 4.65%, a return on equity of 6.22% and an overall weighted average return of 5.36%.

Ofwat subsequently wrote to the industry on 8 September 2023 and confirmed that the water companies could use more up-to-date market data, provided that the allowed return was “calculated using the same methodology used to derive our early view”.

"We have concluded that there are insurmountable difficulties with the relative sizes of the allowed cost of debt and the allowed return on equity"

However, Thames Water says in the Appendix:

“...having considered the workability of this suggestion, we have concluded that there are insurmountable difficulties with the relative sizes of the allowed cost of debt and the allowed return on equity within this calculation....

"The clear message ... is that it we – and, later, Ofwat – have no choice but to take a fresh look at the estimated cost of equity if our plan, and plans across the sector, are to be financeable.

“It is Important that Ofwat’s determination is financeable – i.e. that we are able to obtain the capital that we need to deliver our plan…..

“The Ofwat methodology is also not financeable from an equity perspective. Maintaining gearing at 55% would require the notional company’s shareholders to inject equity worth more than £4.4 billion over a five-year period. However, the returns on offer fall a long way short of justifying this level of equity commitment ...

“We can therefore be categorical in our assessment that Ofwat’s methodology is not financeable.”

"Our proposals for fair rate of return and a set of proposed regulatory arrangements are absolutely crucial”

The water company conculdes in the Appendix:

"The financeability of the plan is therefore crucially dependent on equity investors’ willingness to inject a substantial sum of new shareholder capital into the company (either at or potentially above the level that we have factored into our modelling). This will only be feasible if investors see the prospect of making a return that is commensurate with the cost of capital, which is why our proposals for a fair rate of return and a set of proposed regulatory arrangements are absolutely crucial.”

Click here to download TMS41 Aligning risk and return

The clear message that we take from the comparison between the cost of debt and cost of equity lines in the table, therefore, is that it we – and, later, Ofwat – have no choice but to take a fresh look at the estimated cost of equity if our plan, and plans across the sector, are to be financeable.