UK water is a troubled sector but Deepesh Marwaha explains why there are investment opportunities, particularly through the bonds of what the team considers to be the market leader in making efforts to improve their environmental impact.
October 8th saw the release of the annual Water Company Performance Report by the sector regulator Ofwat, which they described as disappointing. It is a stark reminder of the troubles facing the sector, which has been plagued by decades of underinvestment.
The regulator has been in focus this year following the release of their draft determination, a provisional look at their take on both water companies' submitted business plans and their approach to price controls between 2025 to 2030. Cuts to expenditure and proposed bill increases within the draft showed a tougher stance from Ofwat. Those hoping for a relaxing of this stance in the Performance Report were disappointed.
The sector is currently grappling with a significant required increase in investment against a backdrop of past underinvestment and low bills since privatisation. Some are also seeing declining financial resilience, with the effects of complex capital structures and overleveraging coming home to roost.
Given the significant challenges due to poor environmental performance and underinvestment in ageing infrastructure, investing in the sector has meant being more selective. Within our portfolios, we are in names that we believe to be making more tenable efforts to improve. For example, we found Severn Trent to be ahead of peers in starting to restore credibility to the sector, leading others with an equity raise to begin making improvements ahead of final guidance from Ofwat. They are making efforts to improve their environmental impact in a variety of ways, like developing the world's first carbon neutral wastewater hub. Consistent engagement is key to further push companies to better reflect their status as a public utility.
We first met with all of our holdings in 2022 to gain a clearer understanding of what the issues were and what steps water companies were taking to make improvements. Then again at the end of last year, to examine their progress across key areas. We focused on assessing their plans for the next regulatory period and further out, and how credible hitting their targets would be. We also questioned them on biodiversity initiatives, given the rising ability for it to be part of the solution.
Another thing we've asked for is accountability. We are continuing to push for stronger links between environmental performance and executive pay, to ensure that incentives align with both consumer needs and operational performance. Through these engagements, we made the decision to dispose of our position in Thames Water at the start of this year, avoiding the turmoil that has hit since. It has recently been downgraded by the rating agencies and so exited the investment grade index we benchmark our Funds to. The recent fines continue to highlight them as an operational underperformer on top of their financial woes. While these fines, or underperformance penalties, are smaller than last year, it highlights further risk at a time when some, like Thames Water, are battling to raise fresh equity. Attracting investment is difficult. Capital markets are crowded, as utility companies look to raise money and boost spending for the sustainable transition. Despite the urgent need for upgrades, low returns, consumer scepticism and an uncertain regulatory background have deterred new investors.
Saying that, this sector is planning a record £96 billion in the next regulatory period to improve pollution control and water resilience. Going forward, this sector must focus on improving its sustainability before expecting an improvement in public perception. In order to restore public trust and ensure long-term sustainability, water companies must act differently, and we will continue to escalate engagement to support this.
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