Tim Short was an investment banker at Credit Suisse First Boston where he specialised in whole business securitisations, including for water companies. He has PhDs in physics and philosophy and has published several books .
The fate of Thames Water should depend on the docs. It’s not just the default risk, but where the corporate structure the terms of default will apply.
There are lots of special-purpose vehicles attached to Thames Water and a large amount of debt liberally distributed between them. Many FT articles have been enlivened by this corporate structure diagram:
This complexity can be rendered down into a more useful distinction: between what is inside the securitisation ringfence and what is not. The ringfence can be seen as a security lockbox around the water company and the assets it needs to provide essential services, which are basically the provision of fresh water and the removal of wastewater.
The Kemble bond that defaulted this month is outside the ringfence. It has no security over water company assets. They are inside the ring-fence and the bond is not. This and every other piece of debt outside the ringfence depend solely for its servicing on dividends coming out of the ringfence. There are very stringent conditions on when these dividends are allowed to be paid, as listed in a section of around 100 pages in the security package .
You might ask why the bond hasn’t been paid. And you might think about what gives leverage against the regulator. In negotiations, when there’s a gun on the table, it’s sensible to at least look like you might pick it up.
This prompts the question as to what would happen if defaults spread inside the ringfence. This is not guaranteed to happen, as the securitisation ringfence can be thought of as a firewall. Hell or high water can come to the financing arrangements outside the ringfence and the company providing water services can continue unscathed .
What we want to know is how bad a default on debt inside the ringfence would be, and here we come to the arcane concept of “protected land.”
The Water Industry Act 1991 defines “protected land” to mean anything that the company needs to provide water services (including plant and equipment — not just the land itself). Section 156 of the act prevents the appointed company from disposing of the land or any interest in it without the consent of the Secretary of State. What this means is that no one has security over the assets or land needed to provide water services.
At this point, readers may be wondering: “Who is insane enough to lend £14.7bn unsecured?” which is a fair question.
The answer is that while lenders don’t have any security over the assets, they have fixed and floating charges over the proceeds of any sale.
So if Thames Water goes into the Special Administration Regime, as seems likely, the probable endgame is that the asset will be sold to a company the regulator deems fit and proper. That is quite likely to be a company like Macquarie . All the debt inside the ringfence would be repaid at par or transferred to the new entity.
But Ofwat is caught between the public’s understandable desire for infrastructure improvements and its lack of enthusiasm for paying for that investment through water bills, which is the standard mechanism.
Another way to pressure the regulator would be to propose an aggressive investment programme it would have had to reject because of its effect on consumers. Threatening higher bills is no way to win friends, but new money has to come from somewhere, and when there’s public opprobrium being heaped on both sides for largely spurious reasons the popularity contest has already been lost.
I once asked a director of one of the main water companies what input they received from the political level. Politicians, he said, “don’t care about anything other than the sector not being in the papers.” The current government will be hoping that this bubbling imbroglio remains just this side of collapse until the election, which is possible, but a new government won’t have extra cards to play.
In the meantime, public hostility is making it unfeasible for the company to raise fresh equity and service its debt. The irony of this situation is that the public looks like it may have created a scenario whereby it ends up owning equity whose value it has inadvertently helped to destroy.
Further reading: — Seven common misconceptions about the Thames Water crisis (FTAV) — Fix your UK water utility with this one simple trick (FTAV) — Let Thames Water die to teach everyone a lesson, says Citi (FTAV) — A quick guide to Thames Water’s serpentine capital structure (FTAV) — FT.com/ThamesWater
Letter in response to this article: Climate goals will leave gas network with costly stranded assets / From Richard Lowes, Research Fellow, University of Exeter and Senior Associate, Regulatory Assistance Project, Falmouth, Cornwall, UK