Southern Water faced the Environment, Food and Rural Affairs Committee last week, which is beginning its review of the water industry.
Performance and governance
Chief executive Lawrence Gosden repeatedly referred to Ofwat and successive governments’ focus on reducing bills in real terms rather than allowing investment to improve asset resilience.
In terms of shareholder rewards, he pointed out that the company had not paid dividends to its shareholders since 2017. Despite this, Macquarie had injected £1bn of equity to support the business.
Chief finance officer Stuart Ledger was then asked about corporate governance. Southern Water Group has 14 legal entities. He was asked to confirm how many of these he was a director of, which he struggled to answer. Gosden confirmed he was responsible solely for the operating company.
Gosden also commented on the turnaround plan. Southern had managed to cut the number of pollution incidents from 400 to 240, a reduction of 40% over two years, with the aim of a further 30% reduction.
Southern Water faces significant challenges in water supply. It also needs to redesign its sewer system to solve its combined sewer overflow problems, even though 95% of sewer spills are fully captured and only 5% overflow. Gosden admitted that although the quality of the legacy asset system is well understood, Southern Water had not fully mapped the private sewer network it took over management of in 2011.
Final determination
The witnesses were asked about their initial reaction to the PR24 final determination (FD). They made three points:
There is a £1.1bn shortfall in the allowed totex, which was concerning.
They considered that the cost of capital was too low relative to current market rates which made the industry insufficiently attractive for investors.
The risk-reward framework remains a concern. Southern is committed to its turnaround plan but this would take time. This could mean that early in AMP8, failure to meet targets would lead to the imposition of penalties, which would result in lower revenues, which would hinder the company’s ability to invest to fix problems. This would become a vicious circle for Southern and other companies.
They also noted that the FD was a substantial improvement on the draft determination as £8.5bn of totex has now been allowed. This will permit the company to make a substantial step forward in improving its operational performance over the next five years.
The Committee asked whether Southern would refer its determination to the Competition and Markets Authority. Gosden said it was too early to say but that this is a serious moment for the water industry that merited careful consideration.
Equity injection
The Committee pressed about prospects of further equity injections; Macquarie had committed to invest an additional £650m of equity, subject to the FD. Ledger said he was confident that will come forward, but that he was not in control of the decision-making process.
It is worth noting that Ofwat assumes that a balance of £1,226m of equity support will be needed by the regulated utility for AMP8. This assumes: gearing is reduced to 55%; and that Southern could pay out £955m in dividends, applying the 4% sector-wide divided yield assumption. Ofwat recognises that financeability could be achieved by flexing either of these variables.
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