EFRA Committee report: The future of Thames Water and special administration

The EFRA Select Committee has published a report on reforming the water sector

https://committees.parliament.uk/publications/55076/documents/305292/default/

Summary

The dire situation at Thames Water, and longstanding performance issues at other companies, have laid bare the deficiencies in the regulatory regime intended to protect water sector customers from entrenched financial instability and poor performance.

Proposals for a new supervisory water regulator and rapid turnaround regimes are welcome. Such regimes should concern themselves with operational issues, allowances and powers over shareholders in serious circumstances: they must not reward failure by suspending performance commitments and legal requirements that apply to the rest of the sector. This is grossly unfair and would make a mockery of both the regulatory system and the public.

Yet regulatory forbearance is exactly what the potential buyers of Thames Water, London & Valley Water (L&VW), are reportedly asking for.

We are concerned that due diligence has not been carried out on this consortium of the company's senior creditors; their demands, however, demonstrate that they will not prioritise the swift turnaround in performance that Thames Water so desperately needs.

Whilst keeping the company in limbo by drawing out negotiations, these creditors are simultaneously reaping millions in debt interest and fees.

We have grave concerns about the creditors' behaviour during the bidding process in which they have exercised unchecked power over prospective new owners and rescue packages.

L&VW is an opaque consortium which is failing to live up to the transparency the public expects of the water sector. What we do know of its composition suggests it is mostly distressed debt specialists who lack the proper investment strategies and expertise needed to save a major infrastructure company and protect a vital national resource.

The fact that the suspension of regulatory requirements is being considered makes it clear that it is too late for any turnaround regime to save Thames Water from the financial engineering and mismanagement that has engulfed it.

After years of being loaded with debt while paying large dividends, followed by a failure to raise equity or turn performance around, it is now effectively controlled by a group of creditors whose agenda does not align with the public interest.

Given this, Ofwat and the government should withdraw from negotiating with the consortium.

We recognise this may trigger an insolvency Special Administration Regime (SAR), but believe they must draw a line under the Thames saga and look to a future under new and well-intentioned ownership.

It is difficult to see why SAR has not already been instigated for Thames Water.

A SAR should be cost-neutral to the taxpayer in the long run and must be a realistic deterrent to encourage sustainable company management across the sector, offering a reliable backstop when turnaround regimes fail.

If the threshold for a SAR on performance grounds has not been crossed, and the grounds for an insolvency SAR are easily sidestepped by Thames Water's own prospective owners piling on further extortionate loans, then the enabling legislation is clearly not fit for purpose.

To prevent such situations arising again, future reforms must ensure that the performance grounds for the SAR are clearer and usable.

Establishing more specific triggers under a more robust turnaround regime could also enable an insolvency-based SAR to be instigated sooner, helping to prevent creditor takeovers and unnecessarily drawn-out negotiations in the future.

Conclusions and recommendations

Turnaround regimes for failing companies

1. Many water companies are struggling to turn around their performance without stronger intervention. Thames Water has demonstrated that Ofwat's turnaround regime is imposed too late and has limited capacity to tackle vicious cycles of penalty and failure. The IWC's report contains useful recommendations to facilitate the turnaround of companies, including a supervisory regulator that would intervene sooner, alongside a stronger Turnaround Oversight Regime that would review allowances and give the regulator powers of direction over company owners. These proposals may be controversial for shareholders but are broadly palatable to the public if a privatised sector is going to deliver for customers and the environment.

The IWC's proposal to include regulatory forbearance in turnaround regimes is, however, objectionable. It would be loathed by campaign groups and customers, would be unfair to other companies that abide by the rules and is contrary to the polluter pays' principle. A well-regulated system would never need such a measure. (Conclusion, Paragraph 16)

2. Given the longstanding and compounding issues that some water companies are facing in the sector, a future supervisory water regulator must have the powers to intervene sooner when companies are beginning to demonstrate a lack of financial resilience or persistent performance issues that are not improving rapidly enough. The suggestion of an improved turnaround regime that can be implemented quickly and resolve fundamental funding concerns is welcome. It must not, however, exempt companies from environmental and customer protections. Instead, the new regulatory system must intervene far sooner to avoid companies beginning a vicious cycle of penalties and chronic underperformance. (Recommendation, Paragraph 17)

Insolvency, Special Administration and the future of Thames Water

3. Ultimate Controller undertakings protect regulated entities from poor or unscrupulous behaviour by the company owners, usually shareholders. This will likely underpin any future powers to block ownership transfers if the government accepts this IWC proposal. However, when a company is at risk of insolvency, creditorswho are not subject to the same due diligence checks as shareholdersmay suddenly find themselves in a position of significant control, as is now the case with Thames Water. Yet Ofwat's interpretation of the Ultimate Controller has left Thames Water's economic owners free from these undertakings because its shareholders have abandoned the company. This is a highly undesirable situation for a regulated water company and a critical resource. (Conclusion, Paragraph 22)
4. Those who are truly in control of a water company should be subject to appropriate checks and oversight. Future regulation must recognise the control that creditors can exert over a company facing insolvency and ensure that Ultimate Controller safeguards apply to them when they become, or are likely to become, economic owners in practice. Regulators or the company should be required to carry out appropriate due diligence checks on the suitability of all prospective owners and controllers of water companies, whether they are shareholders or creditors, to inform any future powers to block changes in control. (Recommendation, Paragraph 23)
5. We have serious concerns about the suitability of the London & Valley Water (L&VW) consortium as owners of a critical resource and about the conduct of the negotiation process. Their lack of transparency and the group's insistence on the suspension of regulatory requirements raises concerns that they may not be the low-risk, low-return investors required. To delay a Special Administration Regime (SAR), these same creditors have offered high-interest loans to the very company they intend to purchase. Aside from the ethics of the loans themselves, we have no confidence that a satisfactory deal can be reached, in part due to their unchecked influence over the bidding process. Conclusion, Paragraph 27)
6. Thames Water is at the end of the road. The company's performance and the behaviour of its creditors are unacceptable. Their investment strategies are based on extracting value through debt rather than ensuring long-term success. Any forbearance on their duties to customers or the environment would set a dangerous precedent for rewarding failure: if this must feature in any ownership bid under current circumstances, then the circumstances must change. (Conclusion, Paragraph 28)
7. We recommend that the government reject the proposals from the London & Valley Water consortium and explore all potential alternative options, including the Special Administration Regime or fresh legislation, to draw a line under this debacle and restore stability to the sector by putting Thames Water on a sound footing for new owners. The government should use all powers at its disposal to ensure that, in the long run, water company pensions and taxpayers' money are protected. If emergency legislation is required for Thames Water, it should be limited in scope so this does not become a precedent for widescale government intervention. (Recommendation, Paragraph 29)
8. It is important that the Special Administration Regime (SAR)and the potential loss to investors that it entailsis a credible threat on both performance and insolvency grounds to encourage sustainable company management and provide companies and investors with clarity and certainty. However, performance grounds are so vague that insolvency appears to be the only credible avenue for triggering a SAR. This allows highly distressed companies to operate in unacceptable conditions, with atrocious outcomes for customers, the environment, and the stability of the wider industry. Although automatic triggers under performance grounds might be excessive, clearer thresholds and processes are needed, particularly given the clear fundamental failures at Thames Water.

Furthermore, even the insolvency grounds for starting a SAR were not designed to prevent the drawn-out process we have seen with Thames Water, and this also must change. (Conclusion, Paragraph 39)

9. To ensure that the Special Administration Regime is a credible threat, the grounds on which it can be applied need to be clearer, particularly on performance grounds. There should not be automatic triggers for a SAR, outside of insolvency, as it should remain a matter of last resort that will require some judgement. However, government and regulators should feel empowered to take timely action with the SAR when companies repeatedly fail to meet basic standards and fail to improve outcomes after an attempted turnaround oversight process. (Recommendation, Paragraph 40)
10. We also recommend that an insolvency SAR should be triggered earlier if key provisions of a more robust Turnaround Oversight Regime are not adhered to, such as a direction to inject new equity, particularly if this results in shareholders abandoning a company. These changes should be made as part of wider reforms to the water sector: we caution against a rushed reform of SAR legislation solely to address the Thames Water case. (Recommendation, Paragraph 41)