Why the crisis at Thames Water may be just the beginning

When Margaret Thatcher privatised Britain’s water industry in the late 1980s, the then prime minister wrote off its £5bn of debt.

The decision cleared the way for water companies to embark on a new era, unshackled, with a further £1.5bn government subsidy to help them on their way. 

Three decades later and Britain’s water companies have amassed a whopping £60bn of debt built up during years of lower interest rates. With credit conditions tightening as rates continuing to rise, the whole water industry is now struggling under a financial millstone. 

But concerns are growing that the water industry’s woes could act as a harbinger for a wider crisis brewing within corporate Britain. 

Dozens of top flight companies, from Asda to Aston Martin, also loaded up on cheap debt when times were good. While politicians and regulators have been focusing on the recent mortgage crisis, the real challenge facing Britain may prove to be a looming corporate credit crunch.

Thames Water, which has £14bn in borrowings, sits at the epicentre of UK Plc’s current debt-driven dilemma. 

A large proportion of that debt was acquired when the company was owned by Macquarie, an Australian investment bank, between 2006 and 2016. Under its ownership, Thames Water’s debt rose to over 80pc of its regulatory capital value (RCV), a metric used to determine the value of its assets.

While Macquarie points to the billions of pounds it invested in upgrading Thames Water’s infrastructure during its ownership of the company, critics have argued that the group also stripped billions more out of Thames Water via dividends and loans. 

The company is now owned by a group of investors including the Ontario Municipal Employees Retirement System (Omers) and the Universities Superannuation Scheme (USS), Britain’s biggest pension fund. 

Its issues burst into the open this week after Sarah Bentley, its chief executive, unexpectedly quit on Tuesday after less than three years at the helm.

Bentley was brought in to deliver an eight-year turnaround plan, but it is thought that this was complicated by the company’s shareholders being unwilling to provide the additional capital required. They injected £500m into Thames Water last year but are so far resisting handing over another £1 billion requested by the business.

Thames Water said earlier this week that it was “continuing to work constructively with its shareholders” as it seeks more funding for its turnaround plan.

Yet Thames is not alone in facing issues owing to a huge debt pile. In December, water regulator Ofwat warned that it had concerns about the financial resilience of five water companies, including Thames. 

Providers are laden with more than £60bn of debt, much of it taken on during the long period of low interest rates that followed the global financial crisis in 2008.

With the Bank of England’s rate increases leading to higher borrowing costs the finances of water companies are set to come under extreme pressure over the coming months. To make matters worse, more than half of Thames Water’s debt is also linked to inflation, which is a common trend across the sector. 

In the watchdog’s latest financial resilience report, it warned that a key driver for the increase in debt among water companies was the impact of high inflation on index-linked debt. 

It said: “The value of index-linked debt generally grows with inflation. With more than 50pc of debt in the sector indexed to inflation, and with the vast majority being linked to [retail prices index], the impact as at 31 March 2022 has been material.”

While Thames Water remains in talks with investors about injecting fresh capital into the company, others have been more successful. Yorkshire Water raised £500m from shareholders this week to shore up its finances. 

Meanwhile, the recent issues facing the water industry, triggered by rising interest rates, also threaten to expose a wider debt problem across the broader economy. 

Warnings about high levels of corporate debt are nothing new, but concerns are intensifying. Back in 2019, the Bank of England warned that a vast corporate debt bubble posed a fundamental threat to financial stability.

And in 2021, Andrew Bailey, the Governor of the Bank, issued a further warning, saying: “Companies that increase their leverage beyond levels that are safe and sustainable are in a much less resilient position when a shock comes along – and we’ve had a very big one.

“The very clear message should be to companies – leverage matters. It matters to the resilience of your own financial position. Therefore you need to have regard to it.”

As interest rates continue to rise from record low levels, companies face the prospect of significant cost increases as they seek to refinance debts. 

In its latest financial stability report, Threadneedle Street cautioned: “There are a number of vulnerable companies with low liquidity, weak profitability, or high leverage. And some businesses are facing other pressures from higher costs of servicing debt, weaker earnings, and continued supply chain disruption. 

“These pressures are expected to continue to increase over 2023, especially for smaller companies that are less able to insulate themselves against higher rates.”

Major British companies that have amassed significant debt piles in recent years through financial engineering include supermarket giant Asda and Aston Martin. There is no suggestion that either company is facing financial difficulties at present. 

In March, Aston revealed that its annual losses more than doubled, driven, in part, by expensive debt. The cost for servicing its high interest debt for the year hit £139m. Lawrence Stroll, its chairman, has sought to cut its crippling debt pile. 

Asda is also lumbering under the weight of a £6bn debt pile and the supermarket’s £2.3bn petrol station deal with EG Group – another business owned by Moshin Issa and his brother Zuber – has led to the supermarket being loaded up with yet more debt.

The EG deal will result in the Blackburn billionaires loading up Asda with £770m of high interest loans from private equity firm Apollo, alongside a £450m equity injection by Asda’s owners –  the Issas, private equity backers TDR Capital and US retail giant Walmart. The Apollo loans are thought to have a 2029 maturity.

They are far from alone. Morrisons was left with around £6bn of net dent after the supermarket was bought by private equity house CD&R; Heathrow Airport’s holding company has debts of £19bn; and the AA, which has shifted repeatedly between private equity and the stock market, has £2.3bn of net debt.

None of these companies are currently in difficulty. However, servicing debt piles is becoming increasingly expensive.

While political attention remains focused on rising mortgage costs, the impact of higher interest rates risks causing havoc in quieter sections of the economy too. Highly leveraged companies could soon trigger alarm bells.