In May 2022 we opened an investigation in relation to two inter-company loans that Yorkshire Water has in place. The loans, totalling approximately £940m, are from Yorkshire Water, as the regulated water company (the lender), to an associated company within the same corporate group structure (the borrower). We were concerned as to whether the inter-company loans met requirements set out in Yorkshire Water’s licence in order to protect customers by ensuring the regulated company has adequate resources to carry out its activities as a statutory water company. These obligations included having appropriate consent from Ofwat for such loans and, ensuring the loan arrangements are on arm’s length terms (that is, to avoid the risks of cross-subsidy which would disadvantage its customers).
All water companies are required to ensure that they have adequate resources in place to carry out their regulated activities. A company’s financial resilience is key to its ability to do this, better enabling it to protect customers and the environment from the potentially adverse consequences of financial or other risks a company takes or is exposed to. Transparency about a company’s financial arrangements is key to ensuring that any potential risks are clearly understood and that customers can see and trust that companies are being run in their interest.
In November 2021 Ofwat’s Monitoring Financial Resilience report concluded that Yorkshire Water had weak levels of financial resilience and had work to do to strengthen this to the level reasonably expected of a provider of essential public services.
During our investigation Yorkshire Water took steps to address our concerns about the inter-company loans. These include Yorkshire Water securing a structured plan for the repayment of the loans by the end of March 2027 (bringing equity back into the regulated business), and making a series of additional commitments to improve the company’s financial resilience and invest a further £100m at shareholders expense) to reduce storm overflow spills by 2025. As a result, in October 2022 we decided to close our investigation.
Summary of Ofwat’s decision to open the case
It is set out in a water company’s licence that it must not, without prior approval from Ofwat, make a loan to an associated company. In 2008 and 2009 Ofwat provided consent for two loans Yorkshire Water had made to associated companies within their corporate group. Since that time the corporate group that Yorkshire Water sits within has restructured and Yorkshire Water novated the loans to a different associated company within its corporate group structure. The wider circumstances for them have also changed (since Ofwat granted consents for the original loans), with their relative position within the corporate group’s wider debts having been lowered. The novation to a different associated company and the related changes in the position of the loans had effectively created new loans. As a result, Ofwat considered that Yorkshire Water was in breach of its licence obligation to have Ofwat consent for the new loans.
In addition, Ofwat was concerned about the arrangements for the repayment of the loans and the ability for Yorkshire Water to call back the loaned resources. Whilst both loans enabled Yorkshire Water to call in the loan, there was no contracted repayment date otherwise specified for them. Ofwat was concerned that these loan terms did not appear to reflect obligations within Condition P of Yorkshire Water’s licence that transactions between the regulated business and any associated company be at arm’s length. We were also keen to ensure that any uncertainty about the recoverability of the loans did not compromise Yorkshire Water’s licence obligation to ensure it has adequate resources to enable it to carry out its regulated activities. Having accepted the undertakings outlined in this document Ofwat closed its investigation of the matter without having reached the point of making any findings in relation to these obligations.
In February 2020 Ofwat published guidance to protect the interests of customers and the financial resilience of water companies. This included strengthened guidance in relation to inter-company loans, stating that Ofwat would only consent to inter-company loans from a water company if the arrangements clearly serve customers’ interests. A number of water companies subsequently took steps to unwind legacy inter-company loans they had had.
Commitments from Yorkshire Water
During our investigation Yorkshire Water entered into a dialogue with its corporate group about the repayment of the loans. As a result, it has secured a repayment plan that will see a staged repayment of the full value of the loans. At least £300m will be repaid by the end of June 2023, a further £200m by the end of March 2025, and the remaining balance (around £440m) by the end of March 2027. This will return significant equity to Yorkshire Water, resulting in a reduction in the company’s gearing and an improvement in the company’s overall financial resilience. These improvements are in the interests of customers.
Yorkshire Water has also committed to reducing its financial regulatory gearing to no higher than 72% by April 2025; to undertake a financial structure review; and to ensure that it will fully consider the company’s performance when making decisions on whether to pay out dividends from the company
Yorkshire Water has also agreed to invest an additional £100m to further reduce spills to the environment from storm overflows. This is additional to investment Yorkshire Water has already committed to deliver by 2025 through its 2020-25 business plan and its commitments in the Government’s Storm Overflow Reduction Plan. This additional investment will target reducing storm overflow spills to an average of 20 spills per storm overflow each year.
Yorkshire Water has formally provided these commitments by means of enforceable undertakings under section 19 of the Water Industry Act 1991.
To enable the undertakings to be delivered, Yorkshire Water requested and Ofwat granted a time-limited consent for the loans. This consent is until April 2027 and is conditional on Yorkshire Water delivering the commitments in the undertakings. Ofwat made this decision on basis that it is in the interests of customers for the loans’ repayment plan to have greater certainty, and that package of commitments Yorkshire Water has put forward will improve its overall financial resilience.
We have taken into account the way in which Yorkshire Water has positively engaged on this matter to address our compliance concerns. As a result, we have now closed our investigation. The temporary nature of the loan consent Ofwat has now granted, will enable Ofwat to consider taking further action against Yorkshire Water if it fails to deliver the undertakings it has given.
Wider lessons for water companies
In a long-term sector providing an essential service, such as water, it is vital that companies have ready access to the financial resources they need to deliver their obligations and commitments to customers at all times, both now and into the future. Weak financial resilience puts customer money at risk and undermines the ability of companies to focus on delivering for customers and the environment.
mpanies are responsible for determining an appropriate capital structure and for ensuring that they remain financially resilient. Where we have concerns about their financial position we will intervene to protect customers.
We expect companies to be clear about the financial arrangements that they have in place and to transparently explain how the returns that are paid to shareholders, in the form of dividends take account of their performance for customers and the environment.
Where Ofwat has concerns that a company’s financial arrangements are not in the best interest of customers or could compromise the ability of a company to fulfil its obligations, we will act to protect customers.
Sections 18 – 22 Water Industry Act 1991
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