Bonds from regulated industries should give fixed income investors comfort, as the companies that issue them can only veer off a chosen course so far before receiving a stern talking to. The debacle in the UK water sector shows, however, just how damaging a regulator can be when it meets the reality of the financial markets.
The UK water sector is holding its breath. Next month, its regulator Ofwat will release its final determination — a set of rules and regulations governing how these companies can operate for the next five years.
The final determination includes lots about how water companies must adhere to a standard of service, but there is also much in there that relates to the financial markets.
For example, in July, Ofwat said it was assuming companies will pay 3.36% in real terms for new debt, or 5.42% in nominal terms. This assumption is expected to be finalised in the final determination.
But it is not up to Ofwat, or the companies it regulates, to decide how much they pay for debt. This was seen most clearly in Southern Water paying a nosebleed inducing yield of just below 10% a few weeks ago for £300m seven year debt.
And Thames Water looks like it is going to pay a 9.75% interest rate, not including hefty fees, to secure a £3bn funding lifeline from creditors.
UK water companies have themselves to blame for the state they are in, with creaking infrastructure that is no longer fit for purpose, all while paying dividends to shareholders and in many cases adding debt.
Regulatory uncertainty is expensive
Having a regulatory sword of Damocles hanging over them while waiting for Ofwat’s final determination is only feeding the uncertainty in an already financially precarious industry.
It’s no wonder investors demand sky high yields, if they even agree to finance the sector at all, when the entire industry could change overnight.
Draft determinations are among the bit of information drip-fed to the market. But even those at the highest levels of the water companies themselves have said this month that they have no idea what the final determination will contain, and whether their yields will stay unmanageably high as a result.
Having a five year regulatory system in place sounds reasonable on paper, and works fine when the industry it governs is in good health.
But when capital is expensive and when such a severe, industry changing, deadline meets the reality of financial markets — where investors can make access to liquidity vanish in an instant — it is clear that at least part of this process needs to change or disappear to allow these companies continuous access to vital, reasonably priced, debt.
The financial markets need to know whether a company will be able to continue as a going concern without the need for government intervention.
This is something they cannot be certain about until the final determination is published. And yet, these companies still need to raise capital.
One of the key numbers in the final determination is by how much water companies can increase customers' bills. It is asking a lot of the market that they wait for this to be bundled into one information dump alongside investment allowances and what a company must do to combat pollution.
It would be better to have a series of final deadlines for various parts of the sector, rather than one be-all-end-all deadline.
Ofwat works to secure the best water service it can for the UK, but, by the very design of the shape of a five year regulatory period being revealed overnight, it will never be able to achieve this goal.