Who wants to invest in UK water today?

Investors should embrace the sector’s challenges or look elsewhere for better risk-adjusted returns.

“Mention Thames Water and eyes tend to glaze over,” University of Oxford professor Dieter Helm wrote in an article last week about the embattled utility. Frankly, much the same could be said for the entire UK water sector.

Once seen as your archetypal core infrastructure investment, the sector is starting the 21st century besieged by challenges: suffering from underinvestment, requiring significant environmental capex, its private owners relentlessly targeted by the media, the companies they own increasingly reviled by the public, and their licence to operate flimsier by the day.

So, the question to ask as we near the start of a new regulatory period – APM8, covering 2025-30 – is this: who wants to invest in UK water today?

The question is important because of the unique status of the UK’s privatised water industry. As Sam Pollock, chief executive of Brookfield’s infrastructure business, said in a recent earnings call: “Probably the most well-known prominent water utility investments are in the UK.”

In that sense, UK water commands the spotlight in a way few country-specific sectors do. But it is now seeking large amounts of capital in a fiercely competitive environment, sizing up against the US’s Inflation Reduction Act and the EU’s Green Deal Industrial Plan.

It behoves investors, then, to discard the narratives of yesteryear and look at the sector through the realities of today.

“For the most part, [UK water has] been a challenged sector. And it’s probably one that we would avoid and not find particularly interesting from a risk-return perspective today,” Pollock told analysts. If he was ever sorry that ship had sailed, he’s probably relieved Brookfield’s not on it because it might actually be sinking.

From his vantage point on dry land, Pollock diagnosed the situation succinctly: “It’s been a very challenging environment […] for the most part, because of probably mistakes with capital structures and how people finance those acquisitions, as well as difficult operating and regulatory environments, they haven’t performed particularly well.”

It’s no secret large swaths of UK water is overleveraged, saddled with capital structures that are, arguably, not ideal. While he didn’t admit to any “mistakes”, Martin Bradley, European head of infrastructure, conceded at the end of a recent interview on Macquarie’s ownership of Thames Water: “Have we learned from leverage structures? Yes, we have. We have matured in our thinking around that.”

Leverage structures are not academic. Combined with higher-for-longer interest rates and a tougher regulatory and operational environment, they can have a tangible impact on equity. Just ask OMERS, Thames Water’s largest shareholder, which cut the value of its stake in the utility late last year by 28 percent.

Even if you believe Thames Water is an outlier, anyone thinking of buying into the sector today needs to do their due diligence very carefully, assess all of the risks described above, and assign a value to equity accordingly.

While we have mostly dwelled on the negatives, it’s not like UK water is without merit. After all, we are still talking about essential, regulated monopolies serving millions of captive customers. The current price review (PR24) has, for the first time, tasked companies with putting their five-year business plans in the context of a 25-year development strategy, a “quiet revolution,” to quote Norton Rose Fulbright. The coming regulatory period is also likely to put a heavier emphasis on investment, allowing bills to rise (UK bills are lower than in many European peers).

These are not insignificant developments. But even if they materialise as well as the private sector could hope for, they will still come at a testing time, with ratepayers’ budgets stretched thin by the cost-of-living crisis and the industry’s reputation in the doldrums.

A challenge, then, is what anyone looking at UK water today must be willing to embrace, one requiring considerable industrial chops. If that is what investors are looking for, dive right in. If that sounds more hardcore than super-core, there may be better risk-adjusted returns to be had elsewhere.