A new report is suggesting that Ofwat created "twisted" incentives for management to  “run the company into the ground to maximise short term returns and leave it, bloodless, to the next set of owners” and that investors should have spotted three key red flags.

The report - Low Tide - Thames Water: What Could Investors Have Known Beforehand? - provides a detailed analysis of what the data shows about Thames Water and how to benchmark risks in infrastructure investment.

Ofwat created incentives for management to “run the company into the ground to maximise short term returns and leave it, bloodless, to the next set of owners”

According to the report, Thames Water faced ‘twisted’ incentives in the shape of “an extremely low weighted average cost of capital” imposed by Ofwat. The research paper states:

“The regulator Ofwat set the companies’ allowed return so far from the reality of the market (by a factor 5 to 6 in the case of Thames Water) that, far from creating positive incentives to be an efficient company, the regulator created incentives for the management to run the company into the ground to maximise short term returns and leave it, bloodless, to the next set of owners.

“Indeed, by setting the weighted average cost of capital (WACC) of the firm at 2-3%, very far below the firm’s actual costs of capital in the market, the regulator sent the message early on that investments would be hard to recoup and any returns would be low.

“While it is the mandate of the regulator to incentivise efficiency to minimise tariff increases and private profits, by completely disregarding (in fact, incorrectly modelling) the market cost of capital of the firm by such a very wide margin the regulator instead incentivised owners not to invest in the asset, and instead to extract cash as quickly as possible including by increasing leverage and other forms of financial engineering. This is exactly what happened.

“Thames Water’s market cost of capital, when properly measured and compared to its peers, is in fact the highest of the entire UK water sector (11-12% today). Therefore, Thames Water was a likely candidate to choose this path of lower capex and high leverage, thus changing the risk profile of the firm over time. When new investors took over the company, this pattern and its main driver (the wedge between the regulated and the market WACC) were clearly visible. The consequences were not difficult to predict and indeed led to the latest impairment: unhealthy incentives for the firm eventually led to excessive risk taking and the destruction of shareholder value.”

Describing Thames Water as presented as a large utility epitomising the "stable and predictable" cash flows that investors are attracted by in the infrastructure asset class, EDEHEC says the investment in Thames Water was impaired by almost 30% in December 2022, equating to “an abrupt and unexpected loss” of approximately £1.5 billion for investors including UK, Japanese and Canadian pension plans.

The report says that for such a large water utility to lose so much value so fast, the investment “must in fact have been mispriced for several years.”

Commenting on the regulator's approach to the cost of equity, EDHEC says that Ofwat used the wrong model - the Capital Asset Pricing Model - and the wrong data. The report suggests that Ofwat is “deliberately ignoring market signals, perhaps to try and ‘anchor’ investor expectations in terms of the long-term returns they can expect from a water utility.”

According to EDHEC:

“It follows that those who choose to invest are either willing to take a lot more risk than OfWat expects, or have little understanding of the dynamics between regulated and required return on capital.

“We can now see that over the past two decades, the WACC of Thames (and UK water companies in general) has always been largely underestimated by the regulator. We argue that the regulator of Thames Water has been setting the WACC inadequately, using a long invalidated asset pricing model as well as the wrong data.”

The report says that a straightforward comparative analysis reveals the emergence of a high-risk, low-return profile that should have raised “numerous red flags” and prompted long-term investors seeking a ‘boring’ investment to reconsider.

Three red flags including company creating “not only a structure to extract a lot of cash but also a huge debt pile”

The report says this should have raised at least three red flags:

• Red flag 1: The company should have been expected to take on too much risk as it faced ‘twisted’ incentives in the shape of an extremely low weighted average cost of capital imposed by the regulator.
• Reg flag 2: The company created not only a structure to extract a lot of cash but also a huge debt pile – it should have been clear from 2016 onwards that there will be no payout for many years.
• Red flag 3: Thames Water’s exposure to key risk factors was always high compared to its peers and increased over time: this implied a much higher discount rate and lower value than what was reported until the company’s value was brutally reduced by 30% last year.

Thames “likely to have lost between 30 and 50% of its value over past decade”

The research shows that benchmarking the key characteristics of the asset would have provided a much better understanding of its risk profile. Using a comparable set of what a typical company with the same characteristics as Thames Water is like in terms of risk factor exposure, duration and likelihood of dividend payouts, the paper shows that the firm is likely to have lost between 30 and 50% of its value over the past decade.

Commenting on the paper, Tim Whittaker, Research Director at the EDHEC Infrastructure Institute and Head of Data Collection said:

“This case study underscores the importance of a relative/comparative view in assessing asset valuation and risk. Investors in Thames/Kemble Water, rather than isolating their focus, could have benefited from a comparative approach. Identifying red flags sooner and achieving a better assessment of the risks involved would have been possible through a broader comparative view.”

Without a comparative analysis, EDHEC suggests that “investors fell prey to a form of self-referencing that unfortunately remains very common in infrastructure investment.” The report describes this as ‘absolute thinking’ which is about a single asset, not the market or its peers.

According to EDHEC, this narrow vision can obscure the big picture and the role played by market dynamics i.e., the systematic drivers of the fair market value of private infrastructure companies.

“Because infrastructure assets are large and illiquid, once invested, it can be hard not to ‘fall in love with your position’ since it is difficult to change easily or quickly,” EDHEC suggests.

The report states:

“For a large water utility to lose so much value so fast, the investment must in fact have been mispriced for several years leading up to the impairment. Our own assessment is that its value had indeed been decreasing for years and will likely decline more from the current reported valuation….Our own assessment is that its value has likely dropped by more than a third, leaving investors facing additional losses.”

“A 13-year dividend famine; so much for ‘stable and predictable’ dividends”

EDHEC also suggests:

“The importance often given to ‘trophy assets’ (and frequent fascination with ‘real assets’) may be clouding the judgment of otherwise seasoned investors….

“Beyond the psychology of investing in private infrastructure, it is nonetheless true that a series of adequate comparisons would have revealed years ago that Thames Water was an asset that was in bad shape - and not about to get better…

“By the time new owners took over, the ability of the investment (Kemble) to pay dividends at all was frankly questionable. Indeed, it has not paid any since then and is now not expected to before 2030. This amounts to a 13-year dividend famine; so much for ‘stable and predictable’ dividends.”

Since 2019, and with the support of the Monetary Authority of Singapore (MAS), the EDHEC Infrastructure & Private Assets Research Institute has been developing ground-breaking research to document the risks and financial performance of investments in unlisted infrastructure equity and debt, as well as the climate impacts and risks of these essential assets.

The indices and benchmarks produced by the EDHEC Infrastructure & Private Assets Research Institute are recognised by the European Securities and Markets Authority (ESMA) and used by investors representing USD $400 billion in infrastructure assets under management, including Allianz Global Investors, Aegon, BlackRock, BP, Credit Suisse, Goldman Sachs, Legal & General, Omers and UBS.

The same data is used by policy makers and prudential authorities including the G20, the Organisation for Economic Co-operation and Development (OECD), International Association of Insurance Supervisors (IAIS) and UK Pension Protection Fund (PPF). 

Since 2023, new research efforts have allowed the financial database to be complemented with a unique set of climate data for unlisted infrastructure. EDHEC says this is at the heart of the climate transition, since it represents more than 60% of total Scope 1, 2, and 3 greenhouse gas emissions.

Using its infraMetrics database of equity and debt indices, EDHEC finds that its market implied valuations predicted the 30% impairment of 2022 (by several years) and also that existing investors currently hold their valuation at the highest possible valuation bound. The infraMetrics comparables suggest “significant further writedowns.”

“Had investors made greater use of comparable metrics, they might have had a better assessment of the risks of investing in this asset and of the evolution of its fair value over time”, EDHEC says, commenting:

“While this does not constitute a formal or detailed assessment of the value of Thames Water and Kemble Water, it is a robust point of reference from which investors should have questioned what they knew and about the valuation of the asset company.”

Click here to download the full report Low Tide - Thames Water: What Could Investors Have Known Beforehand?

Click here for more information about EDHEC Infrastructure & Private Assets Research Institute and its infraMetrics database of equity and debt indices