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Direct ProcurementWill the tide of investor appeal rise or fall as the water industry takes on direct procurement?
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Until now, UK water companies have themselves raised finance for their major projects and investments. But that’s changing as Ofwat starts to drive more competition into the sector. Under direct procurement, for the first time companies can now competitively tender project financing - opening new possibilities for innovation. So what will this mean for companies and investors?
In its ‘Water 2020’ report, Ofwat states: “Our shared vision for the water sector in England and Wales is one where customers and wider society have trust and confidence in vital public water and wastewater services.
Delivering this vision relies on everyone in the sector working together, listening to customers and tackling long-term challenges. We are making changes to the way we regulate in future to play our part in building trust in water. [And we] will build on the successes of our previous price review and go further, for the benefit of customers, the environment and wider society.”
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So how will this bold vision from Ofwat unfold in practice?
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Guy Ledger, business development director, Atkins
“It’s already here. Companies are now busy preparing their business plans for AMP7 and Ofwat will be expecting direct procurement to be part of the mix to deliver best value for customers.
Direct procurement is an exciting opportunity. Essentially for very large projects, with a value of £100 million or more, water companies can go to the marketplace not just for design and construction as they’ve always done – but also for project financing; opening up the opportunity for new consortia to deliver the industry’s biggest and most exciting projects.
Building large, new infrastructure is a costly and risky business, and Ofwat is more than aware that eventually the customer foots the bill. Raising project specific finance from new investors and consortia could change the dynamics of the market, leading to commercial innovation and ultimately better value for end users.
This model is already being used in the £4.2 billion Thames Tideway ‘super-sewer’, London’s second biggest infrastructure project after Crossrail. The 25-kilometre sewer will prevent an average 20 million tonnes of untreated sewage being discharged into the River Thames each year and is being funded through a combination of increases
in Thames Water customers’ bills together with a £2.8 billion investment from Tideway, whose investors have invested £1.2 billion of equity.
There are other projects too, albeit somewhat smaller in scale, that Ofwat cites as having had the potential to be funded by this new direct procurement model. These include the Severn Trent Birmingham resilience scheme, which will make water supplies for Birmingham more resilient – at a cost of around £260 million – and the Wessex Water project to create an integrated supply grid at a cost of more than £100 million. So, the crucial question is, will very large infrastructure projects of this type, such as a large treatment works, and pipelines being laid over long distances, actually attract direct investment?
Tideway is certainly being seen across the industry as a litmus test for what good could look like, but that was a mega-project with a £4.2 billion price tag.”
Water company Scheme Claim value Notes
Large enhancement project in the 2014 price review
Severn Trent Water Birmingham resilience main scheme £265m
United Utilities Thirlmere and West Cumbria £215m
Thames Water Thames Tideway Tunnel £404m
Thames Water Counters Creek sewer flooding scheme £257m
Total: (2012-13 prices) £1,141m (£1,210m in 2015-16 prices)
Large enhancement project in the 2009 price review / commenced in AMP5
Thames Water Lee Tunnel £555m
Thames Water Deephams STW £264m An AMP5-AMP6 overlap project
Southern Water Brighton & Hove STW £192m
Wessex Water Integrated supply grid £271m An AMP5-AMP6 overlap project
United Utilities Vyrnwy LDTM cleaning £172m An AMP5-AMP6 overlap project
Source: Ofwat 2016 Total: (2007-08 prices) £1,454m (£1,808m in 2015/16 prices)
Schemes with capex exceeding £100 million in previous price reviews
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Peter Hall, partner, Norton Rose Fulbright “To my mind direct procurement is better suited to the larger projects; those well in excess of £100 million. In that scenario, I am of the view that incumbent water companies are going to be encouraged, or maybe even required, by the regulator, to put out to tender some of their capital projects.
In some respects, water companies are doing this already, by financing projects through the weighted average cost of capital (WACC), now regarded as the Holy Grail of financial modelling in the sector and a key share price driver and determinant of utility charges. In other words, the cost of debt plus equity as determined by the regulator.
It seems that the reason Ofwat is promoting direct procurement is that there’s a perception that the market could set an equivalent cost of finance that is below that set by the regulator in its five yearly reviews. If we look at the Thames Tideway Tunnel, the type of equity that was targeted was ‘institutional’ pension-fund type equity.
This kind of investment model is one that seeks less risk, and a steadier return, with funders taking a much longer-term view of the asset.
By taking the route of direct procurement, there is an opportunity to look beyond the traditional five year horizon and look at cost of capital and revenue requirements over a much longer time frame. This type of longevity, when combined with an appropriate risk profile, is likely to attract the longer term aspirations of ‘institutional’ equity funds.
Such an approach should not exclude the possibility of other financial investment models surfacing; for example, a ‘project’ bond market, as a means to raise finance, could emerge. At present, companies build their new assets, and those new assets add to the company’s overall regulatory capital value and as the regulatory capital value increases, so the company revenue increases as it keeps adding new assets.
However, in a post direct procurement world and with the regulator now looking increasingly at totex rather than capex, the incentives to focus on capital expenditure are diminishing and companies may find themselves delivering new assets, financed, built, and effectively treated as third party assets.
Arguably it means that water companies may not get the benefit of the additional regulatory capital value, and so risk not getting a subsequent return on those assets. So whilst direct procurement could be attractive to an investment consortium, it may not be so attractive to the company. It’s possible this may have an adverse knock-on effect for shareholders, by creating uncertainty for regular investors.”
“This approach is suited to those projects well in excess of £100 million”
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Roddy Adams, managing director, Atkins Acuity
“For developments in the water industry in the UK, what is missing is who is sitting above the water companies and the regulator? Who is taking a broader view of what’s the best direction for large-scale projects that are in the national interest?
For the UK, how are things going to change within the industry to facilitate a real step-change, and make meaningful large-scale projects happen?
We’ve seen worthwhile projects that are initially deemed “too difficult” getting delivered because they are front and centre in the national interest; because they become essential. With Tideway, the UK Government pushed this along because otherwise there would have been fines under EU regulations.
Introducing a mechanism that forces larger projects through to direct procurement is something we would really need to see. If there are big reservoir projects needed, that cut across water companies’ boundaries, direct procurement would prove a good model, and plenty of lenders are prepared to take project finance risk. There’s a market there ready to finance – but we also need the mechanism to push them through.
Looking at projects in this way, from the investor’s angle, could indeed open up new and attractive propositions, and we may even see a raft of inter-sector investment opportunities come to the forefront within a few years.
Imagine the opportunities. Not just sideways investment into housing, but also other possible regulatory changes that could be prompted by a success in the take-up of the direct procurement model, and this longer view of investment. Could it only be a matter of time before we see new entrants or outside investors exploit the deregulation of the sludge market or abstraction market within the water industry too?
There are early signs of significant change ahead and market participants need to be planning for these changes now. As Ofwat stated, delivering this vision relies on everyone in the sector working together and tackling long-term challenges.”
“For investors, this creates new and attractive propositions”
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Guy LedgerGuy Ledger is a business development director at Atkins. A chartered civil engineer with more than 25 years’ experience in the water sector, he is responsible for investments within Atkins’ infrastructure division, focusing specifically on delivering value from digital engineering and helping clients maintain existing infrastructure through digital asset management.
T: +44 7970 476 040
Roddy AdamsRoddy Adams is a managing director within Atkins Acuity, leading on finance and economics activity in an advisory capacity to help get Atkins’ global clients’ large-scale infrastructure projects underway. With a background in project finance, he now manages teams of economists in Singapore and London, and has seen how consortia can come together, span boundaries, and create large-scale projects that are more than the sum of their parts.
T: +65 6675 0904
Peter HallPeter Hall is a partner at global law firm Norton Rose Fulbright based in London where he leads nuclear energy and water groups. Peter advises on the structuring of transactions, tendering procedures and contract drafting. He regularly acts for governments and government agencies, sponsors and project developers as well as for banks and financial institutions involved in project financing and PPP/PFI projects. His extensive experience encompasses projects around the world including Africa, Asia, the Middle East, the UK and elsewhere Europe.
T: +44 20 7444 2710
Atkins is one of the world’s most respected design, engineering and project management consultancies, employing some 18,300 people across the UK, North America, Middle East, Asia Pacific and Europe. We build long term trusted partnerships to create a world where lives are enriched through the implementation of our ideas.
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Acuity is the new advisory business from the Atkins Group. We help to successfully deliver our clients’ ambitions in infrastructure and energy, worldwide. Combining deep business acumen with the engineering expertise of Atkins, we offer seamless, end-to-end advisory services that build higher value, more rewarding partnerships.
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Norton Rose Fulbright is a global law firm. We provide the world’s preeminent corporations and financial institutions with a full business law service. We have more than 3,500 lawyers and other legal staff based in more than 50 cities across Europe, the United States, Canada, Latin America, Asia, Australia, Africa, the Middle East and Central Asia.
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