Green bonds down the drain: What Thames Water’s debt crisis could mean for UK sustainable finance

Thames Water’s financial trouble has been brewing for over a year. The British water utility has been hinging on the prospects of equity injections, following the default of its parent company Kemble in April. On 26 September, the problems came to a head when credit rating agencies Moody’s and S&P took drastic rating actions (downgrades of five rating notches) on Thames Water, following its announcement on 20 September that it could run out of cash by the end of the year.

The company is now on the brink of debt restructuring, with credit factors including its business plans approved by regulator Ofwat, operating performance and financial policy playing a role. Out of its class A secured debt of £15 billion, about £3 billion is labelled green, potentially making the company a green bond default case. Green bonds are structurally no different to conventional bonds under the same class (with the same ranking, covenants and security package among all creditors in the case of distress). However, green bond issuances are often associated with investment-grade issuers of relatively low credit risk: developed countries, development banks, large financial institutions and corporates (they are often more likely to have the resources to develop a green bond framework and execute a portfolio of green assets). For example, in a comprehensive global green bond index, 92.0% are investment grade (4.5% are rated non-investment grade and 3.5% are unrated). Two months before September’s downgrades, Thames Water was still rated at investment grade. This reminds green bond investors once again the green label offers no additional protection in the face of a company’s weakening fundamentals.

Triple-C-rated green bonds: made in the UK

As Thames Water’s troubles emerged, research organisation the Anthropocene Fixed Income Institute warned that its green bond proceeds appeared “insufficient to resolve historic under-investment”. In this case, poor financial returns coincide with poor environmental returns, which seems even more problematic for sustainable investors. In addition, Thames Water’s weakened governance raises concerns about its ability to fulfil its green bond reporting commitment, in IEEFA’s view. The company’s bond prospectus said an externally reviewed report on allocated proceeds and expected impacts would be issued once a year until the green bonds are repaid in full, but the latest available report on its public investors webpage appears to be from 2020/21.

Thames Water is the third-largest UK-based non-government issuer of green bonds (Figure 3), after SSE and HSBC. The company’s dramatic rating downgrade has dragged down considerably the overall creditworthiness of the UK corporate green bond portfolio (Figure 1). The set of bonds now appears much riskier on average, illustrated by the split of credit ratings. This picture isn’t helpful for the continued development of the UK’s green financing landscape as a whole.

Notes:

• Corporate green bonds include issuance by financial institutions and non-financial corporations. The figures exclude governmental finance agencies but include state-owned non-financial entities such as SNCF (France) and Transport for London (UK) for comparative purposes.
• Country and region data refers to the head office of the issuers; for further information, please see Environmental Finance Data’s methodology.

The case for more dynamic, quality corporate green bond issuances

The last UK green financing strategy expected that green gilts would “help catalyse further growth of the corporate green bond market in the UK”—this appears under-delivered. UK corporate green bond issuance volume has remained substantially below its peak in 2021 (Figure 5), while corporate green bond issuances in Europe have broadly been recovering. France and Germany, with a total bond market size similar to that of the UK, have notably larger corporate green bond issuances (Figure 4), although they are more concentrated among top issuers (for example, Engie and EDF account for nearly 30% of France’s, and Deutsche Bank accounts for nearly 20% of Germany’s).

More vibrant corporate green bond markets can promote more advanced corporate green strategies: Companies tend to set comprehensive targets and improve disclosure by engaging in sustainable finance. This plays a particularly crucial role in supporting the UK’s 2050 net-zero goal. FTSE 100 heavyweights and high emitters Shell and BP are sizeable corporate bond issuers but are absent from the green bond markets, somewhat a reflection of a lack of credible green investment strategy and pipeline. But even if a company offers a significant amount of green bonds, like Thames Water did, the credibility of these bonds may be at risk if they are not backed by a coherent environmental strategy and meaningful expected environmental impacts from their proceeds. For example, see another case study of Czech fossil fuel utility EPH, whose investment grade-rated green bonds are highly incompatible with its transition plan.

Better use of labelled funding would not have offered protection against the backdrop of Thames Water’s multiple years of underperformance, elevated leverage and aggressive financial policy. But coherent business, investment and financing strategies and actions, demonstrated by a track record of credible green bond issuance, could indicate a credit strength. Anglian Water exhibits better sustainable finance credentials than Thames Water: It explicitly ties the use of proceeds to its asset management plan and reports project descriptions for each debt instrument. Anglian Water also has a larger green bond offering relative to regulatory capital value and sets multiple sustainability performance targets by issuing sustainability-linked bonds, which serve as a useful tool to substantiate its asset management plan.

More work needed to advance the UK’s sustainable finance strategy

The UK should take comprehensive actions to address any perception of inconsistent quality in UK corporate green bonds, which still have strong growth potential (for example, see a recent IEEFA report that shows how European power utilities have utilised green bonds to support growth in renewables). The country should begin by refining and implementing its overall sustainable financing strategy. IEEFA observes some positive developments, such as the launch of its Transition Finance Market Review. The strategy must aim to coherently support a range of government environmental initiatives and, in IEEFA’s view, should at least expand the role of green gilts and standard setting.

Green gilts are an important fundraising tool to support public investment needs and are a catalyst for private investments. For example, they can be well-structured to help expand the UK National Wealth Fund (initially backed by £7.3 billion of funding and aiming to attract £20 billion of private investments), which could in turn nurture a dynamic green funding environment for corporates and infrastructure projects. The UK government has accounted for more than half of total green bond issuances by UK-based issuers (Figure 2)—there are further opportunities for green gilts to create benchmarks and market liquidity to catalyse the growth of corporate green bond issuances. But the green gilts require an update to their three-year-old framework to improve credibility. This should crucially set a best practice to guide corporate markets.

Developing taxonomies, transition finance frameworks and sustainable bond standards will lower greenwashing risks and standardise the quality of labelled instruments (including use of proceeds and an innovative sustainability-linked structure). This will in turn promote credible market growth and support the private investments required. The UK should also aim to catch up with the European Union on standard setting. For example, IEEFA finds that the upcoming European Green Bond Standard will increase credibility by clarifying the use-of-proceeds requirements and requiring disclosure to outline proceeds’ contributions and impacts.

The troubles in the water sector send a warning: The consequences of under-investing in climate mitigation and adaptation will be far-reaching in the years ahead. To prevent these—and in turn the costs of a disorderly transition—concrete policies and strategies require system thinking and swift actions.