Despite immense infrastructure challenges, the recently completed London Olympics and Paralympics have gone smoothly. They certainly have compared well with their predecessors, particularly the notorious Montreal Olympics in 1976, which fell victim to massive cost and time overruns.
While many UK super-projects have been a financial shambles in recent years – think the Scottish Parliament, the West Coast Main Line upgrade and currently Edinburgh’s calamitous tram scheme – London has a proud record of infrastructure investment. Among the most celebrated is the London interceptor sewerage system – the work of Sir Joseph Bazalgette – in the years following the infamous Great Stink of 1858.
More than 150 years later, Thames Water plans to add new capacity to the capital’s sewerage system to accommodate the major increase in population – now over three times the 1858 figure, when average water use was far lower. Detailed discussions are continuing with various parties to determine both the precise route of the proposed Thames Tideway Tunnel, which has already brought about considerable controversy, and the projected cost. In terms of timing, Thames is working on a completion date in the early 2020s, which may be optimistic.
Inevitably, there are fundamental questions about how such a gigantic programme can be financed. Thames has indicated a capital cost for the project of £4.1 billion at 2011 prices, a figure that will surely rise as consultations proceed. By way of comparison, the total annual water sector investment programme in England and Wales is similar to this indicative number.
It would be very difficult for any single water company to secure finance for such a massive project under current financing arrangements. Thames is already heavily geared after its transfer into private equity in 2006. Its results for 2011/12 show net debt of £7.8 billion, compared with £6.8 billion in 2010/11, although part of this increase is due to technical factors. Clearly, if Thames were to face an average extra £600 million a year of investment in the Tideway Tunnel from, say, 2015/16 to 2022/23, this would be a step-change in its capital expenditure outlay.
Since 1989, customers have been expected to finance much of the cost of their local water company’s core investment programme. At privatisation, the large financial headroom for gearing-up enabled a major increase in debt-funded investment – the gap now is much smaller. There are, though, various capital grants that could be offset against the total cost. Moreover, the new Green Investment Bank may lend funds on preferential terms.
Perhaps significantly, Thames’ bills have been among the lowest in the country for years, partly due to a relatively concentrated population. Hence it could be argued that Thames’ customers should expect to pay significantly more for their sewerage services.
Nevertheless, at a recent meeting in the City, Ofwat admitted that reg ulatory separation was difficult, but seemed disinclined to include the Thames’ Tideway Tunnel project within the standard regulated asset base regime. Keith Mason, the veteran guardian of Ofwat’s “Book of Numbers”, noted that the risk profile of such a large project was different from that of normal water company investment schemes. As such, he considered third party involvement a likely outcome, presumably using a variant of the much-criticised private finance initiative model.
Furthermore, Mason poured cold water on the view that the Water Industry (Financial Assistance) Bill, while including certain provisions for the Tideway Tunnel project, would give rise to a wall of public money to finance it. With the UK’s economy stagnant, its triple A sovereign debt rating under real pressure, and national debt now through the £1 trillion mark, government largesse for the project is unlikely.
Instead, the most likely scenario is some form of standalone regulation that deals with a single asset. Such a system has been periodically suggested for regulating new-build nuclear in the UK, assuming it eventually sees the light of day.
Perhaps the most obvious comparator is the regulation of Heathrow Airport. Projected operating costs are assessed and investment programmes are analysed; a weighted average cost of capital (Wacc) assumption is then implemented to determine any changes to landing charges.
On the railways, the regulation of HS1, which is now owned by leading infrastructure players, incorporates a form of long-term regulation that may be suitable for the Tideway Tunnel project.
As with so many other infrastructure projects, politicians will be calling for major financial investment from pension funds, but they are likely to be disappointed unless the regulation regime passes muster. Such long-term investors tend to prefer to become involved once the project has been completed, thereby absolving themselves of complex construction-related risk.
Assuming some form of standalone regulation is chosen to fund the Tideway Tunnel project, potential investors will need to be reassured that the financial criteria, notably the Wacc, is sufficiently attractive to warrant investment. Given the risk profile of the project, there will be particular interest in the “cost pass-through” criteria that Ofwat may need to apply. If construction cost overruns are material, the size of any subsequent interim determination award could be considerable. The durability of any regulatory regime is also crucial, as the current shambles over planned cuts in renewable energy subsidies amply demonstrates.
Irrespective of the form of financing for the proposed Tideway Tunnel – and the regulation to accompany it – the chances of Thames’ customers enjoying a free ride are low. There may be modest increases in water charges from April 2015 onwards as a result of the next periodic review, excluding the Tideway Tunnel project. But, in reality, part of the financing of the Tideway Tunnel project will surely fall on Thames’ customers.
Given that current water charges in the capital are way below the national average – and that the London economy is outperforming the rest of the UK – this upward movement in charges could be justifiably accommodated, providing it is not excessive. Nonetheless, to deliver the Tideway Tunnel project by the early 2020s at a cost of below £5 billion will be immensely challenging.
Nigel Hawkins is a director of Nigel Hawkins Associates, which undertakes investment and policy research
This article first appeared in Utility Week’s print edition of 14th September 2012.
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