Staying Afloat: To what extent is high leverage to blame for the water sector’s financial resilience issues?

Excessive financial risk-taking through elevated levels of gearing is often cited as a regulatory failure in the water sector that has led to the near collapse of Thames and the categorisation of ten firms as ‘Elevated Concern’ or ‘Action Required’ for financial resilience by Ofwat. In this note we discuss:

• The extent to which the use of debt is likely to be efficient, e.g. by enabling access to deeper and wider pools of capital, despite increasing the risk of financial distress;•
• The problem of externalities arising from the financial distress of a water company and how this may distort gearing levels above the optimum level, if not adequately
  addressed by the regulator;
• The importance of unpacking the relative contribution of the potential drivers of the current lack of financial resilience in the water sector, in particular the role of high leverage versus a miscalibration of PR19 by Ofwat; and
• Possible additional controls to further ensure the social costs of financial distress are internalised by companies when making gearing decisions (to the extent that a robust assessment of the drivers of the current financial resilience issues finds that further controls are justified on a cost benefit basis).