So, what’s in the money pot?

The water sector is often viewed as a dull, predictable utility business. However, in the past 12 years, the industry has raised and invested some £17B on the debt markets to finance considerable capital programmes designed to improve the quality and reliability of the water networks. Privatisation shaped the water industry that we recognise today. This transferred the responsibility for water supply (except as

performed by the separate water-only companies) and sewerage services to water service companies under licences granted by the regulator, the director general of Water Services (Ofwat).

Shares were offered for sale to the public with effect from March 31, 1989. Privatisation was intended to allow significant funds to be raised on the financial markets to pay for extensive investment in the water networks. This became increasingly important in the light of European and UK environmental and drinking water quality legislation. In order to ensure the share offerings were well-received and also to recognise the impact of this future investment, £1.5B cash was injected into the water and sewerage companies by the government and £4.9B of debts were written off as part of the so-called green dowry. The investment required following privatisation was expected to be raised by a combination of debt and equity issued on the markets.

However, significant changes have arisen since privatisation and the structure of the industry has evolved considerably. Water companies remain cash hungry, due to the continued need to fund water quality and other environmental capital expenditure programmes. With new legislation in both Britain and the EU, water companies are required to meet ever more stringent environmental and quality tests, resulting in increased capex requirements to create an infrastructure capable of providing the performance demanded.

Graph 1 reflects the increase in the regulatory capital value (RCV) – the regulator’s view of the value of the companies, as well as the market indicator for purchase or sale of companies – compared to the net debt held by companies and year on year capital requirements. As can be seen from the graph, the average RCV for the industry as a whole has increased from £8B in 1991 to £32B on March 31, 2003. Gross capital expenditure of £39B has been the key driver of this increase, with the increase in net debt of approximately £17B being the main source of funding for this investment. Yet, pressure has developed in the financial markets, making it more difficult to raise the amounts of financing required.

The regulator slashed water bills in the last regulatory review, in order to force companies to become more efficient. The average water and sewerage bill reduced from £246-£228 in nominal terms from 2000-2003. Although benefiting the customer, the regulator’s action was not well-received in the financial markets. As customer billings dropped, so did the returns generated by water companies and in turn the market price of companies’ shares.

Shares were dismissed as being unexciting, underperforming and offering little growth. Water companies became undervalued in the stock market, finding it hard to raise new equity. This in turn has led to a change in the funding of companies.

Increasingly, water companies have become reliant on debt financing, rather than equity-based funding. This arose in part because equity was difficult to raise but also because shares had been taken out of the public arena. In addition, it was an attempt to increase the equity return by taking advantage of the lower cost of debt compared to equity. The regulator assumes an average cost of capital, based on a roughly 50% geared structure. By gearing up to higher levels, companies have been able to take advantage of the lower cost of debt to increase the percentage returns paid to shareholders.

GEARING

Gearing is an indicator of a company’s ability to service its debt. A company with a high proportion of debt to equity (high gearing) is more vulnerable to fluctuations in business activity. It therefore represents higher risk for equity holders and offers greater return. Whether gearing is acceptable or not is often judged by comparisons with companies in similar industries or sectors. Graph 2 demonstrates the increased reliance on debt financing by the water industry, as the return on capital has been reduced by regulatory pressures and capital investment has continued. In particular, this chart shows clearly the crunch time for companies was the new regulatory review, PR99, when the average return made dropped from 9.3-6.6%. Although returns had been gradually squeezed prior to this, cuts in regulated revenues of an average 13% led to returns plummeting.

This reduction has led to an acceleration of the trend to increase gearing subsequent to the 1999 price review. Net debt increased by £8B in the four years since that price review, while it had taken nearly twice as long to rise by £9B prior to that. The structures chosen by companies to raise debt have varied substantially and have evolved as different companies have tried out different methods or negotiations with the regulator.

The following are examples of these structures that developed in the past few years and which have had an impact on the structure or operation of the industry:

l mutualisation model – mutilisation was an attempt to circumvent not just the equity markets but in many ways, the regulator himself. By exchanging the traditional equity-based structure for a solely debt-financed one owned by local members Glas Cymru (controlling Welsh Water or Dwr Cymru), argues it can concentrate on its primary aim to provide water supply and sewerage services to customers at an efficient cost, without being distracted by the need to keep a separate body of shareholers happy.

Run by a board consisting of Wales’ great and good, the company is a not-for-profit company, returning any profit made to its main stakeholder, the customer, by reducing the water bill in future years.

Operations are outsourced to reduce the risk to the company and diversification is prohibited by the articles of the company, again reducing the risk to stakeholders.

The low risk nature of the business is also designed to enable the company to obtain its debt financing at low rates, reducing the capital cost of the business and helping to cut bills. In theory, it could be argued this makes the regulator redundant – there is no longer any need for the company to be told to cut returns to reduce customers’ bills if any return is already being returned to the customer.

The regulator requires that, prior to any restructuring, injection of debt or significant issue of capital, he be consulted for his views and approval.

Since privatisation, the view of Ofwat has consistently been that an efficiently managed water company, which can cope with shocks from the financial markets, will have a substantial amount of equity finance. This is in obvious contrast to the Glas model, as well as an earlier failed attempt at mutualisation by Kelda Group. The Glas structure succeeded where Kelda had failed, mainly due to the significant benefits that would be passed onto customers, but also due to the Welsh factor.

This factor related to the number of exceptional circumstances, which the regulator felt justified the new structure for Glas, while making it clear this was not a precedent for other companies to follow.

In particular, he highlighted the discount to RCV for which the company was being purchased, providing implicit reserves in terms of the borrowing capacity of the company, the desire of the seller to exit the water industry, and therefore the independence of the new entity and the support of a democratically accountable body in the form of the National Assembly for Wales.

In other circumstances and when benefit is passed not to customers but to shareholders, the regulator has been less than enthusiastic,

l thin equity model – the Anglian Water Group spent many months and millions of pounds investigating a potential split of its water company into two companies – one owning the assets (asset co) and the other being responsible for operating them (opco).

Although the equity structure would have remained in place under Anglian’s proposed model, separating the business would have enabled the asset company to have a so-called thin equity strip with finance largely coming from low-cost debt. The operations business would use equity finance. A contract would have been awarded to the opco to maintain the asset company’s infrastructure, allowing it to be viewed as a more favoured support services company. This would have required equity financing but would have received a better reception in the financial markets. In the end, the

company stopped short of its original plans, limiting the restructuring to splitting out the water business from the rest of the company and using ring-fenced financing to a more significant level than previously. The company paid a special dividend to shareholders of £132M in order to increase its gearing, although debt did not reach the levels originally anticipated, with the company only 68% geared on March 31, 2003,

l foreign ownership – part of the reason Anglian did not fully implement its original asset or operations model was due to the views of Ofwat, which did not support the proposed restructuring.

Any restructuring within the industry has to have regulatory approval. In particular, the regulator’s desire to maintain the current form of regulation via 22 comparators, effectively preventing water companies merging, coupled with the need to raise significant amounts to fund capital expenditure, has forced UK water companies to look elsewhere for funds. This has resulted in a large number of UK water companies, both water-only and water and sewerage, passing into foreign ownership and being de-listed from the stock market.

The takeover of such a vital UK industry by foreign owners has excited much adverse comment in the press.

Benefits had been envisaged by large foreign conglomerates, such as Suez Lyonnaise (purchased Northumbrian Water), RWE (Thames Water), Azurix (Wessex Water) Vivendi/Veolia (Three Valleys, Tendring Hundred) and Maquarie (South East Water), where experience exists in managing capital programmes and operating utilities. The drop in the price of water company shares had excerbated this trend.

However, recently, even such large multi-nationals have baulked at having on their balance sheets companies with such vociferous demands for cash as UK water companies. As a result, first Northumbrian and recently South East Water have been sold. This has continued the trend started by Azurix’s disposal of Wessex and continued in Scottish Power’s sale of Southern, of cash-strapped parent companies disposing of their water interests, albeit for different reasons. Northumbrian Water’s sale resulted in the company moving back towards the more traditional structure, with the company initially achieving an AIM listing and recently applying for a full listing on the London stock exchange.

This was portrayed in the press as a move away from avaricious venture capitalists who were seeking to gear up the nation’s assets in order to increase profits. Yet, despite the hype, this move too required the new structure to inject significant elements of debt, increasing gearing from 64% to approximately 80%.

Moreover, although regulatory approval was gained for the new structure, it soon fell out of favour with Ofwat.

Prior to the restructuring, the company had an A-rating by analysts but this fell to a BBB rating and the regulator has issued a paper expressing concerns this will not be sufficient to enable the company to raise financing at an efficient level in the future,

l high gearing model – yet even the most highly geared of the water and sewerage companies – Wessex at 74%, Dwr Cymru at 76% debt – appear low compared to the statutory water-only companies. Mid Kent Water recently underwent a re-financing exercise, which injected approximately £135M of debt into the water company, resulting in it being 81% geared. South Staffordshire Water also re-financed in 2002-2003, increasing its gearing from 24% in 2001-2002 to 89% in 2002-03. These sharp increases are not solely indicative of the capex position for the companies. Although the net debt position in Mid Kent Water itself has increased, the re-financing simply pushed down into the water company debt that had been held by its holding company from a previous acquisition. However, the trend to hold the debt in the company itself is also an attempt to cut the cost of finance. Mid Kent Water, Bristol Water, Dee Valley and Sutton & East Surrey have all recently obtained financing based on loans provided under the Artesian arrangements. This financing is provided for water companies indirectly via bonds issued on the market.

The loans are generally long-term and index linked. Thus they are intended to provide a natural hedge against RCV, which increases in line with inflation. Cash interest is paid at a low rate, while the index-linked portion accrues until repayment of the loan, typically 30 years later.

This provides companies with some stability in the financing, but they are also able to obtain further financing on similar terms when the loan provider issues further bonds to the market. So long as index-linked bonds are purchased in the market place, additional financing can be provided,

l equity-based model – so are we left with any companies still supporting the original equity-based funding model?

United Utilities’ recent rights issue reiterates the company’s belief in the more traditional method of raising finance on equity markets. Severn Trent has maintained lower levels of gearing, with current debt levels of 51% compared to RCV.

Yorkshire Water’s debt to RCV level was only 41% on March 31, 2003. The regulator has expressed support for maintaining a strong equity base amid concern that using high debt levels will reduce the flexibility of companies to respond to economic shocks.

The regulator’s model for the recent periodic review based the reference plan model on a 50% geared

company rather than actual balance sheet structures for individual companies.

Yet the trend over the past few years has been to move away from the safety net of equity and increase the gearing of companies to reduce cost. Debt raised has tended to be long-term and will commit companies to their current strategy. Arguably, without a reversal of the downward trend in shareholder returns, it will be difficult for companies to raise significant equity in the financial markets and this trend will continue.

Yet much hinges on the forthcoming price review covering the period 2005-2010. Companies have asked for significant price rises and there have been some indications from the regulator that he may be more generous than last time. This would certainly help the regulator’s cause in trying to maintain a significant equity base in the industry.

If, however, price increases prove lower than expectations, this will have repercussions on the share price of the remaining listed companies and the attractiveness of the industry to investors. The reaction of the regulator could well shape the economic structure of the industry for years to come