‘Is the UK Water Industry ‘financeable’ in the bond ma rkets in the future?

1. ‘Is the UK Water Industry ‘financeable’ in the bond markets in the future? Marc Watton BNP Paribas Water UK, City Conference 21 January 2004

2. Who am I and whose views do I represent? • Previously Standard & Poor’s in the Utilities area; • Role is to advise buyside bond investors on fundamentals and the relative value of one sector versus another, one name against another and within the universe of one issuer’s bonds (e.g 2007 bond versus 2020 bond); • BNP Paribas has been successful in building up its utilities business and in 2003 was a significant player in EUR and GBP. • Award winning Utilities Research • Bank 2003 • Bank 2003 2002 • Bank 2003 BNP Paribas 1 2 BNP Paribas 1 BNP Paribas 1 UBS Warburg 2 UBS Warburg 2 Goldman Sachs 2 1 Morgan Stanley 3 UBS Warburg 3 3 CSFB 3 RBS 4 19 Barclays Capital 4 Source: Institutional Investor All-Europe Fixed Income Research Rankings, June 2003 Deutsche Bank 5 7 Morgan Stanley 5 Morgan Stanley 6 5 HSBC 6 Source: Euromoney Research Poll, April 2003 Source: Credit Awards, June 2003

3. How important are the bond markets for UK Water Ltd? • Currently of total £20bn of debt, some 75% sits in bond markets; • With annual capex of £3bn in AMP4, bond markets will remain of key importance; • Bond markets provide key long-dated maturities which are not available in bank market; • Bond markets have shown appetite for different tranches of debt AAA, A-, or BBB; • Bond markets have shown themselves to be broad and deep - USD, GBP + EUR (AWS 10 year EUR in summer 2003) - Maturities to 30 years - Subordinated Mezzanine debt GBP bp EUR bp

4. Are there any generic risks for bond market? • Significant structural shift by pension funds towards bond markets (and away from equity markets) - In GBP 70% 50% equity component. • External shocks have in the past ‘closed’ bond markets (e.g. Enron/WorldCom) but diversity and scope of markets usually means not closed for long. • The availability of access is of great importance to highly-leveraged structures whose very survival depends on the availability of the bond markets. • Availability of bond markets, during difficult times, may come at a punitive cost. Does that cost reflect regulatory assumptions? Utility Spread

5. Attitude of Debt investors in UK Water industry on eve of next regulatory review • Heard comforting noises emanating from Defra and Ofwat about water bills; • Not expecting any nasty surprises as in 1999; • Ofwat’s position paper on Northumbrian provided significant and tangible comfort; ‘BBB.....unsustainable‘Comfortably within investment grade • IDOK’s appear more achievable and frequent - this mechanism reduces cost risk; • Much reduced event risk for bondholders - takeovers or financial restructurings

6. The Debt Perspective on UK Water Ltd - Solid Credit Metrics • Solid and predictable cashflow - guaranteed by UK regulator and a government which sees the need for strong companies to meet its environmental programme; • Entities generally more focussed in 2004 versus 1999 - buying into cleaner and purer credits; • Narrower range of credit ratings to attract potential restructurers - most ratings A, A- or BBB+ and those at higher end (Thames, Severn Trent and United Utilities) all wedded to equity route. Any credit deterioration, therefore modest and gradual; • General acceptance - Ofwat (?), agencies, bond investors - that A-/A3 is a ‘sensible’ level for restructured entities. Against backdrop of current industry ratings, this means modest credit deterioration if management decide to take corporate action; • Various ownership-options - not for dividend, thin equity or fat equity - none has scared off bond investors.

7. The Debt Perspective of UK Water Ltd • Differing attitudes to best ways to finance allows bond investors to achieve further diversification within sector (e.g. Anglian versus Severn Trent); • More mature and seasoned attitude. Were ‘AA’ ratings in sector really ever sustainable? • More experience at lower rating levels - markets happy to provide substantial amounts of capital at lower rating level; • Equity markets may still not completely accept AMP3 pricing (see discount market cap vs RCV) but happy to take up United Utilities’ rights issue; • Or is this the same smug attitude we all had in 1999 with prospects for prices? - More transparent regulatory process - Not a new government this time around (political aspect to AMP3); - Less flexibility in rating levels; - Less corporate action or diversification.

8. How does the highly leveraged structure fit into this overall debate? • Dwr Cymru unlikely to be repeated - specific circumstances; • Anglian/Southern - ‘thin equity: whole business securitisation’ ‘highly leveraged structures’ - how likely to be replicated? • 3 represent 25% of WASC’s: • Ofwat’s reward to equity in forthcoming regulatory review will surely be key to whether further companies go down this route; • Most likely candidates - Thames, Wessex and Northumbrian; • How vulnerable would United Utilities or Severn Trent be to a change of management or is the ‘equity’ philosophy sustainable at both companies for foreseeable future?

9. The Thin Equity Route - The Pros for Bondholders • Removal of Event Risk - takeovers - either as prey or predator; • Management Focus - Pure Play - what you have bought into, cannot change in the future; • Management actions - very focussed on bondholder protection - triggers, standstill arrangements and covenants. The focus of management of the business has moved perceptibly from shareholder to bondholder interests; • Bondholders may have powers to remove management; • Management cannot be diverted to work on other group companies business; (Surely operational and financial personnel in diversified groups which have other interests, are distracted away from needs of appointed business on occasion) Reduction of number of conflict of interests. • Company cannot survive without debt market. Surely this focusses the mind? • Subordinated/Mezzanine debt provides a quasi-equity cushion to support the senior debt. (But is it properly priced?)

10. The Thin Equity Route - The Cons for Bondholders In the work done on the complex structurings • All the T’s appear to have been crossed and all the I’s dotted but the proof of the protection will only come when they are tested in a stress scenario; • Would bondholders be experienced enough to carry through a management cull if required. New for bondholders (not for shareholders); • Do these structures provide sufficient incentives for management? In short, does the remaining equity provide the shareholder with enough incentive to ‘beat’ management? For example, is the dividend stream from AWS to its parent awg plc of sufficient importance to awg for it to remain intellectually involved in the financial development of AWS? • Documentation required to build effective structure is vast and complicated - needs some investment of time by bond investor to understand issues.

11. The Thin Equity Route - Summary • Untested but structures seem well-conceived and structured. • Will bond markets always (infinite structures with debt acting as permanent capital) be open to these structures at a price which reflects previous regulatory assumptions. Availability of capital and cost of that capital. • Bond markets seem happy to finance UK Water in its various ownership and financing formats.

12. Other Issues • Outsourcing - some market testing probably necessary to ensure stability of rating methodologies. • Consolidation in sector - probably necessary to keep ultimate threat hanging over management. Current position seems to favour short-term financial investors.

13. Key Issues for bondholders in UK Water Ltd • Is the current regulatory promise converted into reality in AMP4; • Is the equity markets perception of the review positive/neutral; • To what extent will the change of management at UK Water lead to revised attitudes to this equity route? • Is public policy and regulatory framework stable - any knee jerk changes will affect the sector’s financeability; • Rating agencies - no moving of goal posts - please!

14. BNP Paribas is incorporated in France with Limited Liability. Registered Office 16 boulevard des Italiens,75009 Paris. BNP Paribas is regulated by the FSA for the conduct of its designated investment business in the UK and is a member of the London Stock Exchange. BNP Paribas London Branch is registered in England and Wales under No. FC13447. Registered Office: 10 Harewood Avenue, London NW1 6AA Tel: +44(0) 20 7595 2000 Fax: +44(0)20 7595 2555 www.bnpparibas.com THIS REPORT IS PREPARED FOR PROFESSIONAL INVESTORS AND IS NOT INTENDED FOR PRIVATE CUSTOMERS IN THE UNITED KINGDOM AS DEFINED IN FSA RULES AND SHOULD NOT BE PASSED ON TO ANY SUCH PERSONS. The information and opinions contained in this report have been obtained from public sources believed to be reliable, but no representation or warranty, express or implied, is made that such information is accurate or complete and it should not be relied upon as such. This report does not constitute a prospectus or other offering document or an offer or solicitation to buy any securities or other investment. Information and opinions contained in the report are published for the assistance of recipients, but are not to be relied upon as authoritative or taken in substitution for the exercise of judgement by any recipient, they are subject to change without notice and not intended to provide the sole basis of any evaluation of the instruments discussed herein. Any reference to past performance should not be taken as an indication of future performance. No BNP Paribas Group Company accepts any liability whatsoever for any direct or consequential loss arising from any use of material contained in this report. All estimates and opinions included in this report constitute our judgements as of the date of this report. BNP Paribas and their affiliates (“collectively “BNP Paribas”) may make a market in, or may, as principal or agent, buy or sell securities of the issuers mentioned in this report or derivatives thereon. BNP Paribas may have a financial interest in the issuers mentioned in this report, including a long or short position in their securities, and or options, futures or other derivative instruments based thereon. BNP Paribas, including its officers and employees may serve or have served as an officer, director or in an advisory capacity for any issuer mentioned in this report. BNP Paribas may, from time to time, solicit, perform or have performed investment banking, underwriting or other services (including acting as adviser, manager, underwriter or lender) within the last 12 months for any issuer referred to in this report. BNP Paribas, may to the extent permitted by law, have acted upon or used the information contained herein, or the research or analysis on which it was based, before its publication. BNP Paribas may receive or intend to seek compensation for investment banking services in the next three months from an issuer mentioned in this report.Any issuer mentioned in this report may have been provided with sections of this report prior to its publication in order to verify its factual accuracy. This report was produced by a BNP Paribas Group Company. This report is for the use of intended recipients and may not be reproduced (in whole or in part) or delivered or transmitted to any other person without the prior written consent of BNP Paribas. By accepting this document you agree to be bound by the foregoing limitations. Analyst Certification Each analyst responsible for the preparation of this report certifies that (i) all views expressed in this report accurately reflect the analyst’s personal views about any and all of the issuers and securities named in this report, and (ii) no part of the analyst’s compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed herein. United States: This report is being distributed to US persons by BNP Paribas Securities Corp., or by a subsidiary or affiliate of BNP Paribas that is not registered as a US broker-dealer, to US major institutional investors only. BNP Paribas Securities Corp., a subsidiary of BNP Paribas, is a broker-dealer registered with the Securities and Exchange Commission and is a member of the National Association of Securities Dealers, Inc. BNP Paribas Securities Corp. accepts responsibility for the content of a report prepared by another non-US affiliate only when distributed to US persons by BNP Paribas Securities Corp. United Kingdom: This report has been approved for publication in the United Kingdom by BNP Paribas London Branch, a branch of BNP Paribas whose head office is in Paris, France. BNP Paribas London Branch is regulated by the Financial Services Authority (“FSA”) for the conduct of its designated investment business in the United Kingdom and is a member of the London Stock Exchange. This report is prepared for professional investors and is not intended for Private Customers in the United Kingdom as defined in FSA rules and should not be passed on to any such persons. Japan: This report is being distributed to Japanese based firms by BNP Paribas Securities (Japan) Limited, Tokyo Branch, or by a subsidiary or affiliate of BNP Paribas not registered as a securities firm in Japan, to certain financial institutions permitted by regulation. BNP Paribas Securities (Japan) Limited, Tokyo Branch, a subsidiary of BNP Paribas, is a securities firm registered according to the Securities & Exchange Law of Japan and a member of the Japan Securities Dealers Association. BNP Paribas Securities (Japan) Limited, Tokyo Branch accepts responsibility for the content of a report prepared by another non-Japan affiliate only when distributed to Japanese based firms by BNP Paribas Securities (Japan) Limited, Tokyo Branch. BNP Paribas (2004). All rights reserved.