Investment in UK water companies has continued to grow in recent years, particularly with an influx of funding from overseas investors.
To name just a handful of deals, Japan’s Itochu took a stake in Bristol Water in 2012, and last year Aquila Infrastructure Management of Canada invested in Thames Water. That transaction followed the acquisition of a stake in Thames by China Investment Corporation a year earlier. Meanwhile, some publicly-listed UK water companies have also been the subject of rumours suggesting they may attract investment.
It is not difficult to understand the attraction of water utilities for investors. First, the regulatory regime provides investors with stability and visibility. This is not to be underestimated, because not all nations offer such a favourable environment. Another benefit is Ofwat’s five-year price review. The regulator is currently nearing the end of its consultation before setting the parameters for the 2015-20 period, AMP6. While this may change the pricing climate, it will provide all involved in the water industry with stability, something highly valued by investors.
Finally, there is the reality that the UK remains a stable place to invest, even if investors will watch the outcome of next year’s general election with interest.
Two features in particular have encouraged investment in recent years. First, equity returns have been protected by layering in debt at intermediate holding companies positioned above target companies, sometimes at up to 95 per cent or more of the regulatory asset value of the utility. Meanwhile, the operating companies themselves were often fully leveraged and had securitised their assets, offering investors greater protection and, importantly, providing credit ratings agencies with the justification to assign robust ratings, such as BBB+ and A-.
As we approach the end of the Ofwat review and the beginning of AMP6, Ofwat chairman Jonson Cox has suggested that the regulator will look closely at investments in water companies. While stressing the importance of UK utilities continuing to attract funding – not least to help fund huge capital expenditure – Cox has said the regulator will consider recent investments, along with the commitment to consumers, in the review.
There is a continuing debate about what Ofwat will recommend, particularly in regard to how future deals are structured. This has had a knock-on effect on some of the finance options around current valuations.
Ofwat has also argued for a broader stakeholder approach. It has emphasised the duties of companies and their boards to adopt a more reasonable and “through the cycle” approach to their financing structures, and to share the challenges and opportunities of long-term ownership. Operational performance – measured in service levels, customer satisfaction, cost control, cheap financing, access to debt and measured dividends – are the primary yardsticks.
Consequently, companies need to consider all aspects of the climate in which they operate, for example in respect of covenants and liquidity. To be viewed as responsible shareholders by the regulator, companies should demonstrate they have strong credit metrics, whether in respect of net debt, regulatory asset value or interest cover.
This does not seem to mean necessarily that regulators are looking for companies to fall into a uniform line. There appears to be no particular barrier for an efficient company to maintain a leveraged structure with reasonable and sustainable dividends, coupled with low cost of debt.
The external landscape is changing swiftly. There is greater emphasis on delivering value to customers – rather than simply on outputs – and the development of customer focus groups, for example, has been a resounding success. It is to Ofwat’s credit, therefore, that the response of companies to the review cycle has been imaginative.
Overall, opportunities for future investment remain and the prospects of further funding for water utilities to continue improving their infrastructure should on balance be considered positive.
Nick Walker is head of regulated utilities at Lloyds Bank Commercial Banking