Partial debt guarantees- Reviving Investment in UK Water Infrastructure

Is it Time for Public Sector Major Infrastructure Debt Guarantor?

Ofwat, Government and Industry have identified that the UK’s water sector urgently needs substantial investment to modernise ageing infrastructure, tackle critical environmental issues, and comply with increasingly stringent regulations.

The capital requirement could be as much as £12 billion per year. Recent high-profile incidents of sewage pollution, severe leakage rates, and insufficient reservoir capacity highlight the immediate and considerable scale of required investments.

With existing water companies overly levered, outsourced delivery models are required. The main delivery model is direct procurement for customers (DPC).

DPC is a regulatory model used in the UK water sector, introduced by Ofwat, where water companies competitively tender major infrastructure projects rather than financing and building them directly.

Under DPC, water companies procure services from third-party providers who finance, construct, operate, and maintain new assets. The model is akin to PPP in the water sector.

Key features of DPC include:

• Competitive tendering: Projects are openly tendered to attract the best value offers from the market.
• Third-party delivery: The winning provider assumes responsibility for funding, construction, operation, and maintenance.
• Regulatory oversight: Ofwat ensures the tendering process and contractual arrangements benefit customers directly.
• Asset ownership: Typically, the water company retains ultimate asset ownership, with the third-party provider operating under a long-term contractual arrangement.

DPC is a viable model, but estimates suggest billions are needed over the coming decade to ensure infrastructure resilience, reduce environmental harm, and secure sustainable water supplies for future generations.

Securing affordable financing remains the most significant barrier.

In this regard, there is a question as to whether the state or NWF can take any steps to make these major projects more deliverable, mitigating the cost impact for customers.

Our view is that the reintroduction of partial debt guarantees could be an attractive and transformative solution for the industry.

These guarantees balance effective risk management with prudent public resource allocation, potentially enabling essential projects that might otherwise be financially unviable.

Understanding partial debt guarantees

Partial debt guarantees involve a credible entity, often a government agency or a development bank, agreeing to cover a predetermined fraction, typically between 20% and 50%, of the debt repayments owed by a project.

This means that if the borrowing entity defaults, the guarantor is obligated to repay only the specified portion of the outstanding debt.

Unlike full guarantees, which can unintentionally encourage irresponsible lending by entirely removing the lenders’ exposure to risk, partial guarantees deliberately ensure that investors retain significant financial responsibility.

By maintaining investor exposure, partial guarantees preserve market discipline and ensure rigorous risk assessments and careful project management by lenders and borrowers alike.

This balanced approach promotes prudent lending decisions and incentivises efficient project delivery, as investors continue to bear meaningful risk.

At the same time, the guaranteed portion substantially reduces investors’ perceived risk, significantly lowering borrowing costs by elevating the project’s credit rating to investment-grade levels.

The European Investment Bank’s Project Bond Initiative exemplifies this model effectively. By covering around 20% of senior project debt, this initiative successfully raised credit ratings from sub-investment grade to investment-grade, attracting a broader range of institutional investors.

Note – the EIB Project Bond Initiative isn’t technically a guarantee. It provided subordinated debt rather than an explicit debt guarantee.

However, the idea is the same, namely, the subordinated debt improves senior debt ratings by absorbing losses first, indirectly lowering risks for senior lenders but not guaranteeing repayments explicitly.

Crucially, this approach achieves the dual goals of significantly lowering the cost of capital without fully insulating investors from financial risk, thus maintaining their incentive to carefully manage and monitor project performance.

Addressing affordability and consumer benefits

Implementing partial debt guarantees in the UK water sector could directly reduce borrowing costs, as evidenced by the UK Guarantees Scheme, where projects obtained financing at rates just above UK government borrowing costs.

Lower interest rates directly benefit consumers by reducing bills through savings passed on via Ofwat’s regulated pricing framework.

Importantly, partial guarantees ensure that significant financial risk remains with the private sector, thus avoiding market distortions and ensuring continued responsible financial stewardship.

Application to the UK water sector

Given the current immense scale of investment required, including improving sewage treatment facilities, addressing leaks, expanding reservoir infrastructure, and ensuring compliance with environmental standards, the water sector stands to benefit significantly from partial guarantees.

The Thames Tideway Tunnel project provides an effective precedent, showcasing how targeted government guarantees for extreme risks helped achieve affordable financing without compromising private accountability.

However, there is an argument that TTT is somewhat too nuanced. The Government support package for TTT comprised:

• Supplemental Compensation Agreement: Provides compensation for certain risks beyond the scope of commercial insurance, ensuring that investors are protected against exceptional events.
• Contingent Equity Support Agreement: Allows the Government to inject equity into the project if costs exceed certain thresholds, ensuring project completion without compromising financial stability.
• Market Disruption Facility Agreement: Offers a £500 million facility to provide liquidity in the event of market disruptions that could hinder the project’s access to capital.
• Special Administration Offer Agreement: Ensures the continuation of services in the unlikely event of the project’s insolvency, safeguarding public interest.
• Discontinuation Agreement: Outlines procedures and responsibilities if the project is discontinued, providing clarity and reducing uncertainty for stakeholders.
• Shareholders’ Direct Agreement: Establishes the relationship between the Government and the project’s shareholders, detailing obligations and expectations to align interests.

However, one wonders would a simpler form of partial guarantee would not achieve the same ends more quickly and effectively.

Expanding such guarantees could substantially mobilise private capital for urgent infrastructure upgrades.

Government-backed guarantees would reassure investors on critical high-impact or low-probability events, significantly improving financial feasibility without removing essential operational responsibilities from private water companies.

Managing public sector risk

A notable advantage of partial debt guarantees is that their contingent nature means actual calls on public resources might never (and likely won’t) materialise.

Historically, infrastructure guarantees have rarely resulted in government payouts because the retained market discipline typically ensures diligent project management.

The UK Guarantees Scheme, for instance, has seen minimal claims against government guarantees, underscoring the low risk of actual taxpayer costs. Transparent, proactive risk management further reduces the likelihood of guarantees being triggered.

Subsidy control considerations

Under the UK’s Subsidy Control Act 2022, debt guarantees provided by the Government must comply with principles designed to avoid unfair subsidies or market distortions.

One effective approach, demonstrated by the UK Guarantees Scheme, is providing guarantees priced at commercial market rates (“at cost”), ensuring that no undue financial advantage is conferred on beneficiaries.

Specifically, by charging guarantee fees aligned precisely with the market price for equivalent commercial coverage (Commercial Market Operator or CMO test), the Government ensures compliance with subsidy control rules.

This method prevents guarantees from constituting subsidies, as beneficiaries receive no advantage beyond standard market terms.

Consequently, partial debt guarantees structured in this way can support critical infrastructure investments without violating UK subsidy control requirements, enabling affordable financing while preserving fair competition.

International precedents and lessons learned

International examples illustrate the effectiveness of partial debt guarantees:

• UK Guarantees Scheme: Introduced post-2012, this scheme successfully mobilised private investment into infrastructure by significantly reducing investor risk premiums. While the use of full guarantees under this scheme raised some concerns around moral hazard, partial guarantees effectively mitigate these concerns by preserving investor discipline.
• World Bank/IFC Guarantees: Regularly employed globally, these guarantees typically cover between 25% to 50% of project debt. By carefully calibrating coverage, these guarantees mobilise private capital efficiently without diminishing financial responsibility or distorting market incentives.
• Multilateral Development Banks (MDBs): Institutions such as the Asian Development Bank and African Development Bank regularly utilise partial guarantees to catalyse infrastructure investments, leveraging modest public backing to attract significant private-sector capital. These guarantees have a proven track record of rarely being triggered, reflecting careful structuring and rigorous risk assessment processes.

Advantages and manageable risks

Partial guarantees provide several clear advantages:

• Reduced financing costs: Directly reducing the cost of debt, thus benefiting consumers through lower bills.
• Enhanced investment mobilisation: Attracting private capital that may otherwise not invest in infrastructure projects.
• Preservation of market discipline: Ensuring lenders and borrowers maintain significant responsibility for performance.
• Targeted risk coverage: Flexibly addressing specific risks without broader market distortions.

Potential risks, including contingent taxpayer liabilities, complexities in risk assessment, and potential unintended subsidies, are manageable through robust governance, clear eligibility criteria, transparent pricing, and proactive management of projects.

Policy implementation guidelines

Successful implementation requires policymakers to:

1. Establish clear eligibility criteria: Guarantees should focus on projects that provide critical public benefits yet are challenging to finance independently.
2. Define appropriate coverage levels: Limit guarantees to 20–50%, carefully targeting specific risks to avoid unnecessary subsidies or market distortions.
3. Implement transparent pricing: Ensure guarantee fees reflect genuine market risk to avoid implicit subsidies.
4. Robust risk management practices: Actively manage risks, transparently disclose contingent liabilities, and ensure regular parliamentary oversight.
5. Integrate with regulatory frameworks: Ensure Ofwat integrates the financial benefits of guarantees directly into consumer pricing.
6. Mitigate moral hazard: Clearly limit guarantees to specific projects and emphasise their temporary, project-specific nature.
7. Establish defined exit conditions: Include clear timelines and conditions for guarantees to end, ensuring projects become independently viable over time.

Conclusion

Partial debt guarantees represent a highly promising and balanced approach to tackling the UK’s critical water infrastructure challenges.

By reducing financing costs, maintaining rigorous market discipline, and efficiently mobilising private capital, partial guarantees deliver substantial long-term consumer and environmental benefits.

Crucially, due to their contingent nature, the likelihood of significant taxpayer cost remains minimal, allowing prudent public resource allocation while securing essential infrastructure improvements.

This article is for general awareness only and does not constitute legal or professional advice. If you would like further advice and assistance in relation to any issue raised in this article, please contact us by telephone or email enquiries@sharpepritchard.co.uk.