Investing in Thames Water: a lesson in infrastructure valuation for investors

Thames Water, the UK’s largest water and wastewater utility, seems to be the epitome of a stable and predictable asset. Yet, in December 2023, the value of this investment was impaired by almost 30%. This unexpected loss of approximately GBP1.5 billion had a great impact on many investors, including UK, Japanese and Canadian pension plans. [update: in the latest accounts of one of its main shareholders, Thames was impaired by 60%, twice as much as the previous impairment, bringing the loss to more than GBP3 billion].

In their EDHEC Infrastructure & Private Assets Research Institute paper “Low Tide - Benchmarking risks in Infrastructure Investments: What the data showed about Thames Water” (1), authors Frédéric Blanc-Brude, Abhishek Gupta and Tim Whittaker explored what investors in Thames Water (and its holding company) could have learned about the level of risk of their investment, had they compared its characteristics to market and peer group data.

The benefits of benchmarking in investing

In their paper, the authors showed that a comparative analysis, also called benchmarking, would have revealed that Thames Water was not a stable investment, but instead a high-risk, low-return one.

As a matter of fact, the asset must have been mispriced for several years leading up to the staggering loss. According to the authors, its value had actually been decreasing for years (2).

Their research shows that benchmarking the key characteristics of Thames Water would have provided a much better understanding of its risk profile. How? By using a comparable set of what a typical company with the same attributes as Thames Water is like in terms of risk factor exposure, duration and likelihood of dividend payouts. This would have demonstrated the fact that the firm is likely to have lost between 30 and 50% of its value over the past decade, which it did, eventually. (3)

Without this analysis, investors failed to see the big picture. They actually fell prey to a form of thinking that is still very common in infrastructure investment, consisting of looking narrowly at the asset, but not at the market or at peers.

The 3 red flags that should have raised concerns among investors

Here are the three red flags that investors should have considered long before the impairment of Thames Water in December 2022:

Red flag #1: Extremely low regulated weighted cost of capital

The company had an extremely low regulatory weighted average cost of capital (WACC), which is the average rate that a business pays to finance its assets. That could only push it to take on too much risk to achieve the level of returns required by the market.

Reg flag #2: A tendency to lever up to pay more dividends

As a response, investors in Thames Water created a structure to extract the maximum amount of cash as fast as possible. This dividend policy, inconsistent with the economic performance of the asset, created significant debt levels and the exhaustion of the balance sheet.

Red flag #3: High systematic risk factors exposures

The company’s exposure to key risk factors identified in EDHEC research as driving returns, had been high and rising for a significant period. This could only lead to an increasingly higher market risk premium, that is to say an additional return investors expect from holding a risky market portfolio instead of risk-free assets. Therefore, a likely loss in value that was not recognized for years.

Had they been identified early on, these red flags could have led to a revaluation of the asset.

Lessons learned from this specific case

So what lessons can be learned from the Thames Water brutal impairment?

First, investors should have questioned the reported valuation of the asset. This specific case underscores the importance of a comparative analysis in assessing asset valuation and risk. Investors in Thames Water could have benefited from a comparative approach, rather than narrowing their focus.

For most investors, owning the water utility of the capital of a G7 country would be the ideal investment. It would be easy to think that this asset would pay regular and predictable dividends to shareholders, and that its valuation should not be too volatile. But, as we have seen, this was not the case with Thames Water. On the contrary, when compared with its peers, the water utility showed some significant risks that were not accounted for when assessing the asset.

The authors also showed that a flawed methodology had been used for estimating the cost of equity capital, which is the return a company must provide to its shareholders in exchange for their investment. They emphasized that this mispricing of Thames Water's cost of capital by the regulator had created unhealthy incentives for the management to maximize short term returns, leadind to excessive risk-taking and the destruction of shareholder value (4).

As a result, the valuation of the asset by its shareholder was held steady or increased until March 2022, before dramatically decreasing. A reminder that the value of such assets can be very volatile.

All in all, Thames Water provides a good case study for investors, reminding them to always take a comparative view of their assets. In this case, this would have helped to identify the red flags sooner and provided a better assessment of the risks involved in investing.

References

(1) EDHEC Infrastructure & Private Assets Research Institute report (Dec. 2023) “Low Tide - Benchmarking risks in Infrastructure Investments: What the data showed about Thames Water”. Frédéric Blanc-Brude, Abhishek Gupta and Tim Whittaker. https://edhec.infrastructure.institute/wp-content/uploads/assets_dbd/Low_Tide_EDHEC2023.pdf

(2) EDHECinfra press release (Jan. 2024) "Thames Water – What Could Investors Have Known Beforehand?" - https://edhec.infrastructure.institute/announcement/press-release-thames-water-what-could-investors-have-known-beforehand/

(3) Press articles selection covering EDHECinfra "Low Tide" publication: Financial Times - Bloomberg - The Guardian - IPE.com - AGEFI.fr

(4) EDHECinfra press release (Jan. 2024) "EDHEC Infra & Private Assets addresses concerns over Ofwat’s role in Thames Water fiasco" - https://edhec.infrastructure.institute/announcement/press-release-edhec-infra-private-assets-addresses-concerns-over-ofwats-role-in-thames-water-fiasco/