Market View: Working capital for water

Non-household water retailers must be proactive to ensure they have addressed their working capital financing requirements for market opening, say Tahir Chaudhary and Richard Scicluna.

Water companies are preparing for the non-household (NHH) market in England to be opened up to competition on 1 April 2017. NHH customers will be able to switch their water and sewerage service supplier, although wholesale water will continue to be provided by the incumbent in each region on a regulated monopoly basis.

Ofwat hopes that, like in Scotland, this will encourage new entrants to the water market, and deliver better service and lower bills to customers. Funding arrangements in the sector will be central to this.

With the deadline fast approaching, stakeholders – wholesale water providers, NHH retailers, new market entrants and Ofwat included – are working to ensure a smooth transition. For existing water companies, their newly created NHH retail businesses must operate at arm’s length from their regulated operations. This is important to ensure they meet Ofwat’s requirement for a level playing field.

From a finance perspective, each NHH retailer must be treated equally in terms of tariff, credit terms and level of service. Ofwat has proposed several credit and trading arrangements for NHH retailers and wholesalers to consider.

New funding challenges

Ofwat’s funding guidelines ensure new market entrants are not disadvantaged. However, they do throw up challenges for existing companies, which will have more significant funding needs from day one.

Under the new regime, NHH retailers will be separated from wholesalers, with retailers likely to pay wholesalers in arrears. This leaves the NHH retailer needing to cover a significant working capital requirement, as well as the cost of any bank guarantee, to cover payment risk between the two.

These developments, in turn, create challenges for lenders to the sector.

To provide some context, let us use an example. A typical NHH within an established water utility business may contribute around 20-25 per cent of a parent water company’s revenues. Imagine our NHH retailer has a turnover of £200 million, a ten-day prepayment agreement with the wholesaler and typical extended debtor collection payment terms of 60 days, made up of 30 days’ billing cycle and 30 days for collection. Our NHH business could have a working capital requirement of as much as £40 million.

Under the current setup, the wholesaler and retailer are a single, combined entity, with no payment risk between the two. Both the availability and cost of working capital is supported by the strength of the wider company, effectively subsidising the NHH business and providing access to funding at a rate equivalent to that of a stronger, investment-grade business.

Banks will be asked to consider financing newly established companies with limited track records of trading on a standalone basis in a market that has not previously existed in England. Also, water companies have been accumulating one-off restructuring and setup costs that Ofwat has opted not to give a full allowance for. This is likely to affect underlying profits in the first year when there could be some uncertainty about how the market will evolve.

Some comfort can be taken from the successful implementation of competition in Scotland, but the experience north of the border is not a fair comparison. The Scottish market is smaller and retailers are allowed a higher margin. Moreover, the largest retailer on day one was Scottish Water Business Stream, which is supported by the Scottish government.

Solutions for a new market

Banks will be keen to continue to support the sector, although NHH retailers will have to be structured in the right way with meaningful support from shareholders, either through equity or a parental guarantee.

There is a variety of working capital solutions available to NHH retailers.

For example, to address the prepayment requirement, an NHH retailer could request an advanced payment guarantee from its bank. It may also be able to renegotiate the issuance of a performance guarantee from its wholesale water provider to ensure certainty of supply.

From a balance sheet perspective, many NHH retailers will benefit from a strong and diversified debtor book. Where possible, NHH retailers should consider using this as a means of advancing cash or de-risking debtor book concentrations through receivables purchase and invoice financing facilities. An NHH retailer will also have to secure a supporting overdraft or a committed revolving credit facility.

Meanwhile, another area of focus will be the choice and implementation of payment and receivable channels. NHH retailers should take advantage of the recently increased faster payments limit (currently £250,000 but expected to rise to £1 million) and also promote the use of the Bacs direct debit scheme as an efficient means of collection.

Caution and consolidation

It remains difficult to speculate about how the market will evolve. Already United Utilities and Severn Trent have formed an NHH joint venture, while new entrant Castle Water has acquired customer lists from Portsmouth Water and Thames.

Although most companies are likely to adopt a cautious approach, further consolidation is expected.

The one certainty at this stage is that between now and next April, wholesalers will be busy ensuring that their NHH retail operations have their structural operations and IT systems – as well as their working capital solutions – in order.

There are many reasons to believe that a competitive market can be delivered successfully and bring meaningful benefits to consumers. Nevertheless, stakeholders involved in the sector must be awake to the challenges and access to working capital should not be taken for granted.

 

Tahir Chaudhary, global corporates relationship manager for utilities; Richard Scicluna, director, global transaction banking client propositions team, Lloyds Bank Commercial Banking