A new report published today by Severn Trent says that the aggregate debt for the water industry in England and Wales could triple – from £30 billion today to £90 billion by 2035. Severn Trent believes that key drivers of the water industry’s investment programme, such as the adoption of private sewers, climate change and the need for increased network resilience, will continue and that the level of investment required will not reduce in the foreseeable future but require further substantial borrowing.The paper says that factors such as the continuing (and worsening) Credit Crunch, and the likely reduction in “uphill capital flows” mean that the ability of companies to raise finance are at best uncertain, and could well deteriorate.

Financing water investment in changing capital markets looks at the key economic and market drivers behind the cost of capital calculation for PRO9 (the price review for the AMP 5 investment cycle from 2010 to 2015) and potential future trends, which it says should guide Ofwat when it sets prices for AMP5. Severn Trent believes that Ofwat’s determination of the water industry’s cost of capital will be critical in ensuring that sufficient investment is attracted to the Industry in order to continue to deliver high standards to customers.

The paper takes the view that although the Ofwat approach to setting the cost of capital used since privatisation, and most recently in 2004, has served the water industry well, a number of market indicators in the light of the changed economic situation should now be taken into account. According to Severn Trent

“For the water sector in England and Wales, with a large and continuing requirement to  make capital investments in infrastructure, the new, more uncertain, economic environment could have profound consequences and presents both the industry and its regulator with some difficult decisions as the next Periodic Review approaches.”

Severn Trent estimates that, given the substantial amounts of new money the sector needs to raise to fund planned investment, within the next thirty years the aggregate debt for the water industry in England and Wales could triple - rising from around £30 billion today to almost £90 billion by 2035. With some of the industry’s traditional sources of capital (e.g. leasing) either now no longer available, or severely limited, the report says that bond markets will remain the key source of funding for the water sector. The paper highlights the fact that the debt which is required to be financed is not just the additional debt of around £60 billion. With much of the sector’s debt existing at 2006/7 maturing and requiring to be refinanced (some of it several times over the same period), Severn Trent believe that the amount of  debt finance which industry will need to attract is closer to £90 billion than £60 billion.

The Report also says that water companies’ credit rating by credit rating agencies (CRA) like Moody’s and S&P is also likely to play a more important role than in the recent past. Severn Trent believes CRAs will come under significant pressure to become more cautious in their ratings as a result of their involvement in the factors leading up to the Credit Crunch.The paper highlights the perception of regulatory stability as a crucial factor in allowing the water sector to maintain its strong credit ratings and suggests that if  there were to be a major change to the regulatory regime, or a pricing regime that is seen as establishing a new, much tougher, environment for the industry, the ratings could suffer. Severn Trent believe that is possible that the whole sector could be downgraded by the CRAs  if a highly geared company were to fail to refinance debt it had taken out when market conditions were more favourable. Interestingly, the example cited in this context is that this could occur

“if the market believed the company poorly placed to survive in a newly competitive environment”.

With regard to Severn Trent’s own investment programme and future funding requirements, the Report says that Ofwat’s assumption about the regulated cost of capital, which uses the Weighted Average Cost of Capital (WACC) calculated for the Industry, is a crucial factor. Severn Trent says that the WACC is an important part of the regulatory price settlement Based on a regulatory capital value that will be around £6.5 billion over the next five year AMP, a WACC of 5% would be worth approximately £1.6 billion in stakeholder returns for Severn Trent. The Report points out that a 0.25% variation in WACC can make a difference of £75 million over five years and that

“This could represent the difference between Severn Trent being a stable well-funded business or one experiencing difficulties in satisfying its lenders and shareholders whilst it attempts  to fund its investment plan”.

The Report was prepared by Severn Trent following consultation with economic financial consultants Oxford Economics and Deloitte and its own bankers (HSBC, RBS and Barclays) and corporate finance advisers (Rothschild and Citigroup), although the company has emphasized that the views expressed are entirely those of Severn Trent.