Bond navigators: Can Ofgem make gas more solid?

Although the UK water sector has faced widespread controversy in recent years, as well as significant volatility in issuers’ bond prices, the UK gas sector has remained relatively stable.

As Ofgem concludes its regulatory review for the next five years, it has a clear opportunity to learn from Ofwat’s mistakes. We believe the gas regulator must consider direct lessons from Ofwat’s failings and underpin these learnings in its sector financing. 

In August, we participated in an investor roundtable with Ofgem to discuss the draft determination for gas distribution and transmission, engaging with the regulator on several key areas and urging them to act now to future proof the sector’s finances.

We are engaging with the regular Ofgem on several key areas and urging them to act now to future proof the sector’s finances.

Accelerated depreciation

Encouragingly, we’ve already observed a series of supportive regulatory developments in the sector, particularly following the 2023 legislative change requiring Ofgem to consider how its decisions contribute to achieving net zero. Since then, a key change is the proposed use of accelerated depreciation, which we discussed in a previous blog. The draft determination confirms Ofgem’s intention to implement this approach for new investments in the gas network, a move we support, as it demonstrates proactive consideration of the long-term implications of net zero.

Crucially, accelerated depreciation also supports a just transition by helping to ensure that the fixed costs of maintaining the gas network are not disproportionately borne by a shrinking pool of customers, including those who may be unable to switch away from gas due to financial constraints. The sooner the reduction in asset value is addressed, the larger the customer base will be to help bear the cost, ensuring a fairer and more sustainable outcome for all.

Sector leverage

Both Ofgem and Ofwat focus on the regulated operating company (OpCo) when looking at leverage; however, many owners of regulated utilities also borrow outside of this OpCo in an attempt to boost financial returns. As we have seen over the last two years in the water sector, debt issues at this higher level can present a significant risk, reducing equity “skin in the game” and making additional equity injections far more complex and time consuming.

We believe a holistic focus on leverage is vital for the gas sector and its significance will be heightened by declining regulated asset values caused by accelerated depreciation. A “real world” assessment of true economic leverage can only become more important against this backdrop.

Accelerated depreciation supports a just transition by ensuring the fixed costs of maintaining the gas network aren’t unfairly shouldered by those least able to switch away.

Reliance on credit ratings

Another area of concern is the regulator’s reliance on credit ratings to monitor financial resilience. Ofwat requires water companies to maintain an investment-grade rating at the OpCo level. Ofgem’s draft determination mirrors this, proposing a requirement of two investment-grade ratings for gas distribution network operators, again at the OpCo level. Ofgem believes rating agencies provide sufficient oversight to prevent excessive gearing and distributions, negating the need for other potential protections such as a leverage cap.

While we support stricter rating requirements, we caution against overreliance on ratings as a regulatory tool. Thames Water’s experience is instructive: the Ontario Municipal Employees Retirement System (OMERS) began writing down its investment in late 2022, culminating in a full write-down by March 2024 — months before Thames Water received its first sub-investment-grade rating in July 2024. This highlights the limitations of ratings as lagging indicators, which should only ever serve as one data point in a more comprehensive assessment of financial risk.

Ratings should only ever serve as one data point in a more comprehensive assessment of financial risk.

Conclusion

We remain constructive on the UK’s gas distribution sector, particularly in light of steps taken to address stranded asset risk. However, we feel it would be short-sighted and a waste of the painful lessons from the water sector if the relative stability of the gas sector bred complacency. As responsible long-term lenders, we are keen to play our part in financing much needed enhancements to UK infrastructure. We will continue to engage with stakeholders to help shape an effective system of regulation that protects long-term investors and consumers.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. Capital at risk.  The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.