EDHEC: Low tide, what did the data show about Thames Water?

May 28, 2024

By Frédéric Blanc-Brude, Abhishek Gupta and Tim Whittaker, Director, Associate Director and Research Director at EDHEC Infrastructure & Private Assets Research Institute respectively

In recent research[1], we asked what investors in Thames Water and its holding company Kemble Water would have learned about the level of risk of their investment and its likely market value had they compared its characteristics to market and peer group data.

A large water and wastewater utility like Thames Water epitomises the ‘stable and predictable’ cash flows that attracts investors to the infrastructure asset class. Yet, in December 2022, the value of this investment was impaired by almost 30%, an abrupt and unexpected loss of approximately £ 1.5 billion. The company was previously valued at circa £ 5 billion by its owners). Only nine months earlier, in March 2022, the same investors in the same asset were still increasing the valuations of their stakes.

High risk/low return

Our research showed 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.

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 was likely to decline more from the current reported valuation.

Without this analysis, investors fell prey to a form of self-referencing or ‘absolute thinking’ that unfortunately remains very common in infrastructure investment: it’s only about the one asset, not the market or peers. This narrow vision can obscure the big picture and the role played by market dynamics, in other words 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. But taken in isolation, a single asset is often more of a story than a hard quantitative assessment.

We argue that benchmarking the key characteristics of the asset would have allowed a much better understanding of its risk profile. Taking a relative view requires representative and robust information to build benchmarks and points of reference to which the risks and performance of infrastructure assets can be compared. When this information is available, investors can better understand the kind of investments they have made, because they can compare them to the right benchmark. In our research, we used such a database of financial data for similar and comparable investments and examine the difference between robust but representative benchmarks and the data available for Thames Water and Kemble Water.

Most infrastructure assets are in some ways unique and will differ from the average in their sector or country. However, when compared with a large and robust sample, any large differences from the benchmark provide indication of not only how unique an infrastructure company is, but also of how confident (or worried) investors should be about its ability to deliver ‘stable and predictable cash flows’. The difference between an investment’s characteristics and its benchmark does not necessarily signal problems, but it is something that investors should be able to understand and explain. And, yes, in some cases it can be a red flag.

We discussed three red flags that investors could have considered long before Thames Water had to be brutally impaired at the end of 2022. Had these red flags been identified up front, they could have been a cause for remedial action or a revaluation of the asset earlier on.

1. Red flag 1: The company should not have been expected to behave ‘normally’, because its incentives were twisted by an extremely low regulatory weighted average cost of capital (or WACC) that could logically only push it to take on too much risk to achieve the level of returns required by the market. While this is true of the whole sector, the gap between Thames Water’s market WACC and its regulated version was the largest of all of its peers.
2. Reg flag 2: As a response, investors in Thames Water created a structure to extract the maximum amount of cash as fast as possible, which also created a huge debt pile, leading to a necessity to conserve capital. It should have been clear from 2016 onwards that there would be no potential for further payouts for many years.
3. Red flag 3: Thames Water’s exposure to key risk factors that have been shown to drive market prices has been high, and rising, for a significant period of time: this leads to an increasingly higher market risk premium and therefore discount rate and a likely loss in value that was not recognised for years.

Check the data

These findings should have at the least led the lats investors to question the reported value of the company – not to mention the fact that the reported valuation had in fact increased over time – because they all signal that Thames Water should have instead been losing value for many years.

Using our own benchmarks to generate a comparable set of data points for a typical company with the same characteristics as Kemble Water, our measures of risk factor exposure, duration (exposure to interest rate risk) and likelihood of dividend payouts signal that the firm is likely to have lost between 30% and 50% of its value over the past decade, in large part due to the evolution of its risk profile and the market price of risk.

While this does not constitute a formal assessment of the fair value of Thames Water and its holding company, it is a robust point of reference from which investors should have questioned what they knew and the valuation of the asset.

[1] F. Blanc-Brude, A. Gupta, and T. Whittaker, Low Tide: What the Data Showed about Thames Water, EDHEC Infrastructure & Private Assets Research Institute Publication, January 2024.