Thames Water

Presentation to Secured Creditors

Consent Solicitation process launched 22 April, 2014

April 2014

www.thameswater.co.uk/creditinvestors

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Copyright© 2014 Kemble Water Holdings Limited

The information and opinions contained herein were prepared by Kemble Water Holdings Limited or one of its associated

companies (collectively “Kemble Water”) and have been obtained from or are based upon sources that are believed to be reliable.

However, no reliance should be placed upon the information contained in this document by prospective investors, as the

accuracy cannot be guaranteed. The information contained in this document has no regard to the specific investment objectives,

financial situation or particular needs of any person. This document does not constitute an invitation to acquire, or an offer to sell,

or an offer of the subscription, purchase or otherwise of any securities of Kemble Water. It does not comprise a prospectus

approved under the Prospectus Rules made under Part VI of the Financial Services and Markets Act 2000 of the United Kingdom

(the "Prospectus Rules"). This document is an advertisement for the purposes of the Prospectus Rules and no person should

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should act or rely on this document or any of its contents.

Disclaimer

2 Beckton Sewage Treatment Works

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Thames Water

1. Introduction

2. Overview of IP delivery model

3. Implication of finance lease accounting treatment

4. Process

Agenda

3

1. Introduction

5

Consent Solicitation Process

TWUL has launched a consent solicitation process to ask its Secured Class A bondholders to vote to approve a

proposal to make certain technical amendments to its financing documents as part of a STID process (the

“Proposals”)

The amendments address the unintended accounting consequences in relation to the proposed delivery of the

Thames Tideway Tunnel Project (the “Project”); specifically how over time TWUL will have to account for its

relationship with the Infrastructure Provider, the independent company that will ultimately deliver the Project

The key benefit of the proposed amendments is to allow the Project to be delivered in a way which protects

TWUL and its Secured Creditors from, inter alia, the construction risk associated with the Project. This is

achieved by the establishment of an entirely new, separately owned and wholly independent company to deliver

the Project

TWUL has undertaken significant engagement with its secured creditors prior to launch of the consent process

on 22 April, 2014:

– We have been in consultation with the Special Committee of the Association of British Insurers (the

“ABI”), the committee members represent approximately a third, in aggregate, of the outstanding nominal

amount of relevant bonds

– As a result of these discussions, the Special Committee has informed us that they intend to vote in favour

of the Proposals in respect of their holdings and that they will be inviting other ABI members to consider a

similar course of action

– The Special Committee together with the parties with whom we have had a positive engagement

represent approximately 60% of the total Qualifying Class A Debt

Introduction

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6

Accounting Implications

The accounting treatment of the payments from TWUL to the IP will have consequences for TWUL’s

financial ratios, which will no longer function as originally intended when established in 2007

During the period up to Acceptance of the TTT, which is currently expected to be in 2028, TWUL would have

additional headroom under its PMICR ratio due to the increased revenues (being received on a pass

through basis)

Following Acceptance of the TTT, TWUL would face a substantial increase in its RAR ratio due to the

consolidation of the long term liability related to the IP (if the IP's RCV is not recognised in the ratio)

TWUL's intention is to maintain the functioning of these ratios as originally intended and leave creditors in a

"no better, no worse" position that reflects the commercial and legal substance of the IP

TWUL has therefore launched a STID Proposal for majority creditor vote offering revised covenants which

exclude the IP from the calculation of these ratios

No proposed changes to ratio levels in these new covenants, only to covenant definitions

Implications and proposed amendment

7

Regulatory update

The summary outcome of OFWAT’s risk based review of TWUL’s business plan:

Our water costs are substantially below threshold value

Our wastewater costs are above threshold although this is mainly comprised of TWUL TTT costs, NEP5 and

Counters Creek, where we need to provide additional evidence

For outcomes we need to provide better linkage between our research and willingness to pay data and our

outcomes and performance commitments

We will provide an update to our business plan on 27 June - our preference is to use this later date (rather

than 2 May) to allow incorporation of updated TTT cost and to facilitate possible treatment of all TTT

expenditure as part of a separate TTT price control

Expected draft determination on 29 August, 2014 and final draft determinations

scheduled for December 2014

PR14

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Risk based review test Wholesale water Wholesale wastewater Household Retail

Outcomes – customer engagement and Willingness To Pay C C C

Outcomes – performance commitments C C C

Wholesale cost assessment A C n/a

Wholesale evidence on costs and modelling B D n/a

Retail cost allocation n/a n/a B

Average Cost to Serve adjustments n/a n/a D

Affordability – current and future C

Board assurance B

AMP5 adjustments A C n/a

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Thames Water

It is our understanding that in August 2014 S&P will review companies (including TWUL) that do not have agreed

business plans by then. In our opinion, S&P are comfortable that TWUL’s credit quality is insulated from the TTT

Project as a result of the Infrastructure Provider delivery model

On 16 April, 2014, Moody’s affirmed TWUL’s ratings (CFR: Baa1; senior secured Class A notes: A3;

subordinated Class B notes: Baa3), however they changed the outlook from “stable” to “negative”. Moody’s

noted that the change in outlook was as a result of two factors:

1. Despite the fact that delivering the TTT Project by way of an infrastructure provider will ring-fence TWUL

from the main construction risk - which they note as a credit positive - TWUL will face unique,

incremental risks which other companies in the sector do not face; and

2. TWUL may not be able to exhibit sufficient headroom within its financial profile to absorb these

incremental risks particularly in the context of already lower cash flows envisaged for the AMP6

regulatory period which will reduce the financial flexibility for all water companies

Given such incremental risks, Moody’s state that they expect TWUL to require solid financial headroom to

maintain current ratings with Net debt / RCV in the low 80s or lower, and a Moody’s adjusted interest coverage

ratio of around 1.4x or higher (Moody’s note that historical performance has been in-line with or better than this

guidance)

Rating agencies views

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Ratio March 2013 March 2012 March 2011 March 2010

Senior Net Debt to RCV 77.4% 78.3% 77.4% 68.3%

Senior Adjusted Interest Cover Ratio 1.7 1.4 2.1 2.1

Source: TWUL Investor Reports

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Regulatory update

Ofwat has been progressing and pursuing an alleged sewer flooding misreporting case relating to AMP4

They have concluded that there has been misreporting and we are in discussions over the level of penalty, if

any, and the amount of RCV adjustment for customer detriment which would be applied as part of PR14

Pending the conclusion of these discussions we have made provisions in our accounts for the maximum

possible fine of £6m. We are also in discussion with Ofwat about whether or not a potential log down / shortfall in

the region of £80 - £100m should be applied, the basis of this is a matter under discussion

Section 203 update

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2. Overview of IP delivery

model

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Overview

TWUL has been working with HMT, Defra and Ofwat to design a solution for building the Thames Tideway Tunnel,

TTT has to be built

– UK must comply with the EU UWW Directive or face substantial fines

If TWUL were to build TTT it could impact on its ability to provide core services to customers

– Exposes TWUL and its stakeholders to significant risk outside of its usual risk profile

– SIPR regime devised and enacted into law

The Infrastructure Provider (“IP”) route is a good solution for both TWUL and its stakeholders

Protects TWUL

– Allows for HMG support to be provided to cover exceptional risks associated with the project

– Provides regulatory transparency and ensures value for money

TWUL cannot own the IP

– Only a pre-defined contractual relationship will exist between TWUL and the IP

• Revenue collection: TWUL collects revenues from customers and passes to IP on a “pay when paid” basis

• TWUL will connect its network to the IP assets

– TWUL is however the sole user of the IP assets which gives rise to a technical accounting situation which could not

have been envisaged when the current financing structure was put in place

Thames Tideway Tunnel Project (“TTT”) – progress to date

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The Board of TWUL has resolved to protect stakeholders and allow

management to maintain focus on the core business

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The infrastructure provider (IP) Overview

Equity Debt Secretary of State

Ofwat TWUL

Insurers Construction Contractors

Project Manager

West Central East

Revenue collection / Operations contractor

Regulation

100% ownership Government Support Package

IP

Regulatory Ringfence

Regulatory Ringfence

The IP will become a new OFWAT regulated entity that is separate

from Thames Water

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Overview of the Project Separation of Responsibilities

Application for

Development Consent

Order (DCO)

Launch of Ofwat

consultation

Launch of DEFRA

consultation

Start IP

procurement

DCO decision

OJEU for IP

Binding bids due

before end 2014

IP financial close

and licence award

Construction

contracts award

Start early works /

mobilisation

2016 2023 2013 2015 2028

IP financial close

and licence award

Start construction

on site

Complete

construction

Start of acceptance

testing

Post-construction

regulatory review

period for IP

On-going overall

system operation

IP undertaking c.£2.7bn*of main construction work

TWUL undertaking c.£1.4bn* net of land sales (including AMP4 and AMP5 expenditure) which form part of TWUL RCV TWUL‘s

Ro

le (

and

licensed a

ctivitie

s)

IP's

Ro

le (

and

licensed a

ctivitie

s)

TWUL

collect revenue on

behalf of the IP

Pass this revenue

onto IP

2014

* Denotes costs shown in 2011 prices

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Structured to protect the creditors of TWUL

Specification of the TTT under legislation which prohibits TWUL from carrying out the Project, thereby

preserving TWUL’s ability to provide its core services

If the TTT is not so specified, the obligation to deliver a complex construction project would remain with

TWUL, leading to uncertainty and potential exposure to construction risk

delivery of the Project by an infrastructure provider which is a separate entity to TWUL

amendment of TWUL’s licence to allow TWUL to recover IP Charges from customers as part of TWUL’s

charges

“pay when paid” principle: no obligation on the part of TWUL to pay revenue to the IP until such revenue

has been received from customers

no circumstances where IP Charges from TWUL can be accelerated

no circumstances where TWUL is liable to the IP or its funders for any debt raised by the IP

if the TTT Project is despecified, TWUL is not required to complete the TTT Project as specified, albeit

that TWUL will be required to bring forward new proposals as to how the Urban Waste Water Treatment

Regulations will be satisfied in such circumstances

The IP removes the construction and financing risk

3. Implications of finance lease

accounting treatment

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Lee Tunnel

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TWUL has received advice that it will have to account for the payments to the IP in a way that is inconsistent

with the legal and regulatory reality of the IP delivery model

Notwithstanding the legal position, the overriding considerations determining the financial accounting

treatment are that:

– TWUL will be the sole user of the tunnel; and

– public perception may be that TWUL will be providing an “end to end” service to customers

Therefore despite the fact that TWUL’s relationship with the IP is a pay when paid model

- TWUL may recognise:

• Increased revenues with no corresponding expense in its profit and loss account during

construction which will have implications for the PMICR

• A long term liability on its balance sheet (may be either a finance lease or other long term

liability) from completion of construction and corresponding imputed interest charge in its profit

and loss account

Summary of accounting implications Accounting for payments from TWUL to the IP

TWUL is keen to address the accounting implications now to avoid any uncertainty

whilst maintaining an open and honest approach with stakeholders

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Accounting treatment Overview of finance lease accounting treatment

Period

Accounting treatment

During construction

Income statement

Cash flow

Balance sheet

• Credit TWUL revenues – reflects total TWUL revenues including the L Factor collected from customers

• There are no off-setting costs in the P&L account reflecting money paid to the IP

• TWUL has higher profits, a higher tax charge (all funded under the regulatory settlement), and higher retained profits

• Cash inflow – cash received from customers

• Cash outflow – cash paid to the IP

• Debit prefunding in favour of a future finance lease, reflecting amounts paid to the IP

• Credit increased retained earnings

During operations

Income statement

Cash flow

Balance sheet

• Credit TWUL revenues - reflects total TWUL revenues including the L Factor collected from customers

• Debit deemed interest charge for a finance lease

• Cash inflow – cash received from customers

• Cash outflow – cash paid to the IP

• Leased fixed asset recorded on TWUL’s balance sheet from the point asset is made available for use by TWUL

• Finance lease liability recorded (value of leased asset less prefunding accumulated on balance sheet)

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IP-related entries in TWUL financial statements Finance lease accounting treatment example

• During construction:

– Income statement: revenue with no corresponding

expenses, therefore “super profits” which aren’t

backed by cash recorded during construction

– Cash flow reflects pay-when-paid cash in and out

to the IP

– Balance sheet reflects prepayments in favour of

the future finance lease and corresponding

increased retained earnings

• During operational phase:

– Leased fixed assets recorded on balance sheet;

prepayment built up netted-off corresponding

finance lease

– Imputed interest charge recorded in income

statement

Illustrative numbers only

Construction Construction Construction Operation Operation

Year 1 Year 2 Year 3 Year 4 Year 5

Income statement

Revenue 40 80 120 120 120

Interest on finance lease liability - - - (86) (85)

Profit 40 80 120 34 35

Cash flow statement

Cash received from customers 40 80 120 120 120

Total cash inflow 40 80 120 120 120

Cash paid to IP (40) (80) (120) (120) (120)

Total cash outflow (40) (80) (120) (120) (120)

Cash inflow / outflow - - - - -

Balance sheet

Leased fixed asset - - - 2,400 2,400

Fixed assets - - - 2,400 2,400

Prepayments: future finance lease 40 120 240 - -

Finance lease - - - (2,126) (2,091)

Net assets 40 120 240 274 309

Retained earnings 40 120 240 274 309

Reserves and retained earnings 40 120 240 274 309

Interest cover ratio

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• The purpose of this worked example is to demonstrate the implications of the finance lease accounting

treatment on the financial ratios of TWUL.

• All the numbers set out are for illustrative purposes only: they are designed to follow the example set out

on page 19 of this presentation. The assumptions used for the IP-related cash flows include:

– the construction phase is for 3 years – the example sets out two further years of operations;

– the leased fixed asset that is recorded on the undertaker’s balance sheet is £2.4bn and the

corresponding finance lease liability is c.£2.2bn; and

– tax has been excluded for the purpose of this illustration.

• TWUL and the IP’s actual figures will be different from the example in this paper, however the figures

used in the illustration are representative of the likely impact.

Impact of accounting treatment Worked examples – finance lease accounting treatment

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Summary income statement extracts Illustrative example – during construction and operational phase

• The example summary income statement above shows year 2 during construction and year 4 during operation to illustrate the

different accounting treatments in the different phases of the IP.

• Construction phase

– TWUL will recognise the net cash collected relating to the IP as revenues, but there is no corresponding expense recorded in

the income statement.

– The result is that TWUL will record a higher accounting profit, despite the fact that the cash has been paid to the IP.

• Operations phase

– TWUL will continue to collect cash and pass it to the IP. The payment to the IP will now be recorded as two separate entries:

• An imputed interest charge on the IP liability recorded in its income statement; and

• A “repayment” of the “principal” of the finance lease.

– The sum of the interest and principal repayment amounts will total the cash paid to the IP.

Illustrative numbers only

Income statement Undertaker IP only Total Undertaker IP only Total

Revenue 1,200 80 1,280 1,440 120 1,560

Operating costs (500) - (500) (600) - (600)

Operating profit 700 80 780 840 120 960

Interest (200) - (200) (240) (86) (326)

Profit before tax 500 80 580 600 34 634

Tax 20% - - - - - -

Profit after tax 500 80 580 600 34 634

Construction phase - year 2 Operations phase - year 4

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Interest cover ratios Illustrative example – during construction and operational phase

Illustrative numbers only

• The example PMICR calculations illustrate that the ratios will no longer function in either the construction or operation phases:

– During construction the inclusion of the illustrative IP cash flows increases the headroom under the ratio from 2.0x to 2.4x

– During operations the ratios are compressed from 2.0x to 1.8x when the imputed interest charge begins

• The table below illustrates how the PMICR calculations will be affected as a result of the IP. It is beneficial to conform the financial

ratios to neutralise the impact of the IP. The “conformed” column suggests a method of adjusting the interest cover ratio to return

secured creditors to a no better, no worse position.

Comparison of senior PMICR calculations Undertaker IP only Total Conformed Undertaker IP only Total Conformed

Net cashflows less sum of CCD & IRC

TWUL net cash flow from operations 700 80 780 780 840 120 960 960

Cash outflow to IP - - - (80) - - - (120)

Covenant net cash flow 700 80 780 700 840 120 960 840

CCD (250) - (250) (250) (300) - (300) (300)

IRC (50) - (50) (50) (60) - (60) (60)

Net cash flows less sum of CCD & IRC 400 80 480 400 480 120 600 480

Senior debt interest

Net interest paid 200 - 200 200 240 - 240

Interest charge on IP liability - - - - - 86 86 -

Senior debt interest paid 200 - 200 200 240 86 326 326

Exclude interest on IP liability - - - - - - - (86)

Conformed senior debt interest paid - - - 200 - - - 240

Senior PMICR 2.0x n/a 2.4x 2.0x 2.0x n/a 1.8x 2.0x

Operations phase - year 4Construction phase - year 2

RAR ratio

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Summary balance sheet extracts Illustrative example – during construction and operational phase

Illustrative numbers only

• The example summary balance sheet above shows year 2 during construction and year 4 during operation to illustrate the different

accounting treatments in the different phases of the IP.

• Construction phase

– during construction TWUL will record the cash paid to the IP as a pre-payment on its balance sheet resulting correspondingly

in higher reserves being recorded in its balance sheet.

– These increased reserves will not be backed by cash – all the cash will have been paid to the IP.

• Operational phase

– During operation, TWUL will record an asset on its balance sheet and will recognise a corresponding IP finance lease liability.

The prepayment built up over the construction phase will be set against this liability.

Balance sheet Undertaker IP only Total Undertaker IP only Total

Non-current assets

Fixed assets - owned 8,000 - 8,000 9,600 - 9,600

Fixed assets - leased - - - - 2,400 2,400

Prepayment - against IP finance lease - 120 120 - - -

Total non-current assets 8,000 120 8,120 9,600 2,400 12,000

Non-current liabilities

IP liability - finance lease - - - - (2,126) (2,126)

Borrowings (7,500) - (7,500) (9,000) - (9,000)

Total non-current liabilities (7,500) - (7,500) (9,000) (2,126) (11,126)

Net assets 500 120 620 600 274 874

Equity and reserves 500 120 620 600 274 874

Construction phase - year 2 Operations phase - year 4

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RAR ratio Illustrative example – during construction and operational phase

Illustrative numbers only

• The example RAR calculations illustrate that the ratios will continue to function normally during the construction phase but will no

longer operate properly in the operating phase.

• In operations, a finance lease is recorded on balance sheet but there will be no corresponding RCV, thus in the illustrative example

above the RAR ratio goes from 75% to 93%.

• The table below illustrates how the RAR calculations will be affected as a result of the IP. It is beneficial to conform the financial ratios

to neutralise the impact of the IP. The “conformed” column suggests a method of adjusting the interest cover ratio to return secured

creditors to a no better, no worse position.

Comparison of senior RAR calculations Undertaker IP only Total Conformed Undertaker IP only Total Conformed

IP liability - finance lease - - - - - 2,126 2,126 2,126

Borrowings 7,500 - 7,500 7,500 9,000 - 9,000 9,000

Sub-total 7,500 - 7,500 7,500 9,000 2,126 11,126 11,126

Exclude Financial Indebtedness due to IP - - - - - - - (2,126)

Senior net indebtedness 7,500 - 7,500 7,500 9,000 2,126 11,126 9,000

RCV 10,000 - 10,000 10,000 12,000 - 12,000 12,000

Senior RAR% 75% n/a 75% 75% 75% n/a 93% 75%

Construction phase - year 2 Operations phase - year 4

4. Process

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TWUL has the ability within its finance documents, following a Periodic Review or any material change in the

regulation of the water and sewerage industry in the UK, to change the level of the ratios. TWUL has the ability

to do this by way of a majority creditor instruction; it will not trigger an Entrenched Right.

TWUL’s proposition as set out in the STID Proposal is therefore:

– on the basis that the coming into force of the Specified Infrastructure Projects Regulations (SIPR) has

resulted in a material change in regulation propose a change to the levels of existing financial ratios to

effectively neutralise them;

– to offer new “conformed” financial ratios to secured creditors set at the same levels as existing financial

ratios to leave them in a “no better, no worse” position;

– to offer additional protections to restrict TWUL from entering into or agreeing to any amendments to the

project documents which would have a material adverse effect on TWUL; and

– to seek authorisation for the Security Trustee to approve any other amendments to the financing

documents that may be necessary to implement the project - subject to Entrenched Rights, ratings level

and maintenance of certain key features of the Project.

Explanation of approach Summary of amendments set out in STID Proposal

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Thames Water Voting process and support for proposals

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Thames Water is keen to ensure that there is a broad base of support from

secured creditors and accordingly would welcome your vote in favour of the

proposal

Secured Creditors Votes (% of Class A)

Financial Guarantors 21%

Bondholders 54%

Banks 21%

USPP 4%

The members of the Special Committee of the ABI, representing 14% of Class A votes, have informed us that

they intend to vote in favour of the Proposals and that they will be inviting other ABI members to consider a

similar course of action

TWUL has secured large scale support in favour of the proposals from all other creditor groups

The Special Committee, together with the parties with whom we have had a positive engagement represent

approximately 60% of the total Qualifying Class A Debt

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Thames Water Key dates and fees

30

Fees key dates:

– TWUL will be paying an instruction fee to Unwrapped bonds (as set out in the CSM) of:

• 15 basis points for all votes (for or against) by 8 May 2014

• 5 basis points for all votes (for or against) by 13 May 2014

– Fees will be payable following the successful passage of the STID Proposal (as announced by the

Security Trustee)

– The deadline for submitting block voting instructions through a proxy is 5 pm on 13 May 2014

– Custodians may set earlier deadlines than those outlined above

Bondholder meetings are arranged for 15 May 2014

Quorum for each bondholder meeting is 50% and 75% must vote in favour to carry meeting in favour of the

proposal

All other creditor groups (non-bondholders) will register votes directly with the Security Trustee