Ofwat has amended the licence for the Thames Tideway Tunnel to reflect the impact of the coronavirus pandemic on costs and an “unprecedented” reduction interest rates since the project began.
The changes will mean customers absorb a greater proportion of the additional costs resulting from the suspension of construction during the spring of 2020, whilst revenues and costs to consumers will no longer be affected by changing interest rates.
Progress on the Tideway project was extensively impacted by Covid-19, leading to delays in construction and additional costs. Ofwat said it is satisfied the steps taken by Tideway at the start of lockdown, when it closed all sites other than for essential works and continued to pay its supply chain, were in the best interests of billpayers.
Therefore, Ofwat said instead of customers bearing 60% of pandemic-related costs from delays as previously agreed, they will now cover 85% of costs incurred from the initial months of lockdown.
The regulator has also agreed to change how the Financing Cost Adjustment Mechanism (FCAM) works after Tideway warned that historically low interest rates, falling outside of its stress testing of the mechanism, would lower its revenues to such an extent that they would affect the financial resilience of the project.
The Weighted Average Cost of Capital (WACC) for the Thames Tideway project is fixed 2.497% real for the expected construction and testing period of nearly 15 years.
To limit investors’ exposure to interest rate risk, which would otherwise need to be fully priced into the WACC, the FACM transfers some of this risk to consumers.
The impact of interest rates diverging by more than 0.5% from the 1.3% reference rate is borne fully by Tideway, with the next 0.5% being shared equally between Tideway and Thames Water customers. The impact of any movement beyond this range of 1% on either side of the reference rate is borne by customers.
Since being agreed in 2015, Ofwat said interest rates have diverged significantly from the reference rate, with the real annual average yield for the year to March 2021 coming in 218 basis points lower at -0.88%.
Although it has been to raise debt more cheaply, Tideway said the mechanism is forecast remove around 25% of its revenues for every year from 2024/25 until 2031/32. The company also argued that the impact would be unfair, equating to 120% of its debt outperformance, meaning customers would recover all of the outperformance and more.
If left unaddressed, Ofwat said this situation could affect Tideway’s ability to finance the project or lead to delays if the company considers it necessary to reschedule activities to control its net debt.
The regulator has therefore agreed to freeze the application of the mechanism at March 2021, meaning adjustments will be based on the inputs at that time rather than being calculated each year. It said customers will retain 62% of the current and forecast future benefits of debt outperformance – amounting to £18 million per year 2022/23 to 2031/32.
Ofwat said this will prevent customers’ exposure to future interest rate rises, adding that the overall impact of the project on bills following its latest decisions is still expected to be within the £20 to £25 range first predicted when it was announced in 2015.
Underground work to build the 25km tunnel will completed this year and the connection and testing works are due to be finished by 2025. This month Tideway announced funding of the project to completion in 2025, with the agreement of another £300 million in Green Bonds.
“We are really pleased with the response from investors to this issuance,” said Tideway chair Neville Simms at the time. “Sustainability is core to our mission so we have aligned the financing of the company to our sustainability goals.
“Tideway’s green and sustainable debt issuance seeks to demonstrate to investors that in addition to our core purpose to reduce pollution in the river, we also hope to reconnect London, and Londoners, with the river and how the financing of the project supports that vision.”