UK water companies are in a fix, with an expected £88bn of expenditure needed in the five years to 2030 to fix infrastructure crumbling so badly that this week has brought a fresh round of regulatory fines. But bond investors have shown their hand — they want the debt — and shrewd borrowers need to take advantage.
Thames Water, the most indebted and financially precarious of the UK’s nine water companies, was fined £104m by Ofwat this week for wastewater mismanagement. Yorkshire Water and Northumbrian Water were fined smaller amounts.
Will environmental, social and governance minded investors — which almost all of them in Europe claim to be — care that the three water companies, according to Ofwat on Tuesday, “failed to ensure that discharges of untreated wastewater from storm overflows occur only in exceptional circumstances which has resulted in harm to the environment”?
Recent data suggests not a jot.
South West Water has a ‘2’ rating from the UK’s Environmental Agency. This is an improvement on the ‘1’ rating it got last time round — the lowest level possible — but still means the company needs urgent improvement to meet environmental standards.
This was perhaps best shown in May, when its drinking water caused an outbreak of the cryptosporidium parasite that was severe enough to hospitalise people. South West Water is paying compensation.
Investors took that in their stride, however, pumping £1.1bn of orders into the company’s £400m 6.375% August 2041 green bond last week.
This is at a time when ESG funds — like the ones that would buy a sterling high grade corporate green bond — have seen $32bn-equivalent of inflows already this year, more than in all of 2023.
Spread > ESG
So, what is causing investors to overlook the obvious and well documented environmental failings of UK water companies and still pile into the books?
The first answer is they offer better returns. The UK water sector has seen heavy selling in its bonds, meaning that a Baa1/A- rated South West Water 17 year bond sold 75bp wide of a A1/A 27 year bond from Motability a few months earlier.
On top of paying a wider spread to other sectors, the new issue concession on South West Water was around 20bp, adding to the extra juice on offer.
This spread pick-up is proving to be a tempting proposition for the chronically undersupplied high grade corporate sterling market.
This is far from the first time that spread has been enough to make ESG investors overlook serious misgivings about borrowers.
A broken essential service
However, there is a more benevolent possibility. The second answer, and the one ESG investors are most likely to offer, is that companies with failings as bad as the UK water sector are precisely the ones that need green funding. Water usage is not going to slow, so the best thing an ESG focused investor can do is fund the sector's upgrades and enhance its environmental profile.
UK water companies need to lean into that as hard as possible. Spreads and new issue premiums ebb and flow, but helping ESG investors do the mental acrobatics necessary to fund highly polluting companies will get orders in the book and keep pricing as tight as possible.
With an £88bn spending cycle ahead of them, UK water companies are going to need lots of access to the debt markets.
Ofwat expects around £7bn of the needed funds to come from equity investors, but Thames Water has shown that equity involvement has its limits — its investors said a regulatory plan to sort the company out in March was uninvestable and withheld a £500m injection.
The bond market will be more important than ever if other equity investors agree with Thames Water’s and shy away. Luckily for the water companies, fixed income investors have shown they are more than happy to look past the litany of problems, as long as the spread is right.
Investors have shown in recent deals that, in the bond market at least, the industry is in the swim, even if operationally it is in the drink.