Investment in turnaround driving improvement at Southern Water

Southern Water has today published its annual report and financial statements for the year ended 31 March 2023 available here: Annual Report.

Overview

In September 2021, funds managed by Macquarie Asset Management invested £1.1 billion of equity into the Southern Water group. This recapitalisation by a new majority shareholder was to facilitate Southern Water’s turnaround, including capital investment of £2 billion during the current regulatory period (2020-25). This planned investment programme was in excess of the regulatory funding that Southern Water has received, equivalent to circa £1,000 per household in its catchment area.

With this additional investment and the leadership of a new executive team, Southern Water is making progress on its Turnaround Plan, which is focused on ensuring a reliable supply of water for its customers; protecting and improving the health of rivers and seas by building capacity and resilience at its waste-water treatment works and sewer network; making its customer service easy and trusted; and becoming an industry-leader in health and safety. We are making good initial progress; for instance, we fully expect to be awarded two-star Environmental Performance Assessment rating by the Environment Agency for 2022, which compares to one-star for 2021. We recognise we have further to go, and the Turnaround Plan sets out our ambition to reach a three-star EPA rating in 2025.

In April this year, Southern Water published additional detail on our Turnaround Plan, reconfirming our determination to deliver on a series of ambitious targets, supported by a continuation of the step-change in investment and innovation.

In common with many companies and consumers, Southern Water has faced significant cost pressures over the last 18 months. These include above-inflation increases for energy, additional costs for the maintenance and upgrade of its network, and higher funding costs, even with significant de-leveraging in 2021. Under the current regulatory framework, water companies are not able to fully recover these significant cost increases.  

Given these inflationary cost pressures and our ambition in the Turnaround Plan to go further, we are now planning to invest £3 billion of capital investment during the current regulatory period (2020-25), equivalent to circa £1,500 per household in our catchment area.

As such, we are engaged with our shareholders around a further £550 million of equity support for the Southern Water group, of which £375 million is anticipated to be injected into the Southern Water regulated entity ensuring that we maintain a prudent gearing ratio. Southern Water anticipates that this equity will be received by October 2023. However, as the process has not yet concluded, it has been disclosed as a material uncertainty in Southern Water’s annual report.

Southern Water group shareholders have not received any dividends since September 2017 and although Southern Water’s gearing remains below 70%, the company does not anticipate paying a dividend for the remainder of this regulatory period to March 2025.

Our CEO and CFO have both declined a bonus for the year to March 2023.

Financial and Operational Highlights

Key Financials

Key Financial Highlights

• Operating loss of £18.4 million compared to £16.1 million profit in 2022
• Revenue decreased to £815.7 million (2022: £844.5 million), principally due to additional Outcome Delivery Incentives (ODI) payments to customers, and reduced consumption by households during the drought and generally
• Operating costs increased by £74.2 million. Inflation accounted for around £30 million of this increase and £22 million related to unplanned expenditure related to adverse weather and incidents
• £31 million of costs to support customers and environmental improvement in water and waste-water operations. This was partially offset by reductions in bad debt and debt collection costs
• Capital investment of £708 million in the year to March 2023, a 22% increase compared to the prior year
• Southern Water is on-track to deliver more than £3 billion of capital investment during this regulatory period, the equivalent of more than £1,500 per household in its customer base
• Net financing costs increased by £82.4 million to £278.6 million, largely driven by higher indexation on inflation-linked debt. As with other companies in the sector – and consistent with the regulatory framework – Southern Water has a proportion of its debt linked to inflation
• Actual interest paid remained broadly flat at £176.8 million
• The fair-value gain on derivative financial instruments is a non-cash accounting movement on legacy interest-rate and inflation-linked derivatives and is primarily driven to the increase in forecast interest rates
• The actuarial pension valuation has been agreed with our pension trustee. Following a £77.7 million accelerated deficit payment in the year to March 2022, there has been a further significant reduction in the deficit
• The company notes the decision of Fitch, earlier today, to downgrade Southern Water to a BBB (Negative Outlook) rating from a BBB+ (Negative Outlook) rating as a result of the lower interest cover ratios
• Southern Water maintains 3 investment-grade credit ratings of BBB+ (S&P), Baa3 (Moody’s), and BBB (Fitch)
• The planned £550 million equity raise (£375 million investment into Southern Water) will maintain a prudent gearing ratio. However, given the method in which the interest cover ratios are calculated, the additional equity injection does not improve the interest cover ratios, which are forecast to be lower in this regulatory period due to the additional expenditure in the Turnaround Plan. Southern Water expects that the interest cover ratios will normalise in the next regulatory period

As a consequence of the Fitch credit rating action, a credit rating downgrade Trigger Event has occurred. Furthermore, the Conformed Class A Adjusted ICR means that a financial ratio Trigger Event is expected under the Company’s financing arrangements. As such, dividends will be suspended until these Trigger Events have been resolved

Key Operational Highlights

• Our Turnaround Plan is targeting areas that are most important to our customers and stakeholders. Whilst we have more to do, we have made good initial progress:

A reliable supply of water for our customers

• Leakage in our area is 17%, significantly lower than the UK industry average of 23% (which itself is comparable to European peers). But we want to go further, reducing leakage in our area to less than 10% by 2050
• We expect to achieve our leakage target at the end of this regulatory period, and are investing a further £100 million in reducing leakage (four times more than the regulatory allowance)
• Improved water quality with a reduction in the Compliance Risk Index score from 6.69 to 6.38

Healthy rivers and seas

• We expect to be awarded a two-star EPA rating by the Environment Agency for 2022 (compared to one-star for 2021). Southern Water is targeting a three-star EPA rating by 2025
• 58% reduction in serious pollution incidents in 2022, reducing the number of incidents from 12 to 5
• 26% reduction in internal sewer flooding and a 5% reduction in external sewer flooding
• Completed roll-out of circa 24,000 sensors, providing real-time monitoring of our sewer network

Trusted and easy customer service

• Increased the discount on our social tariff, reducing the average combined bill from £402 to £221 for 113,000 vulnerable customers - rising to 128,000 by the end of this regulatory period 
• Customers continue to receive a discount as recognition that performance has not met expectations, with significant supply interruption incidents in Kent and Hampshire during the period

Empowered and supported colleagues

• Safety remains a critical indicator, with Lost Time Accident Frequency Rate (LTAFR) reducing from 0.39 to 0.30 (an improvement of 25%)

Lawrence Gosden, CEO said:

“I want to start by acknowledging that this has been a challenging year for our customers and our sector. In my first year I have been listening to what our customers and communities have to say, and rightfully, they have been challenging us to do better and meet their expectations.  

I want to emphasise that we are responding to these challenges, and that I also recognise that we are at the start of a long journey to change our performance as a company, and across the industry.

I thank everyone who works at Southern Water and especially our operational teams for their commitment, hard work, and dedication over the past year, serving our customers every day.  I am pleased with the improvement in our safety performance, and I am committed to driving this even further to achieve an industry leading performance.

We have embarked upon an ambitious multi-year turnaround plan, and I am confident that we have laid strong foundations this year. Whilst I am encouraged by ‘green shoots’ of improvement, with progress on some key metrics that we expect to see reflected in a two-star EPA rating – I am not complacent. We know that we have more to do.  

Succeeding by working together to deliver on our turnaround plan has never been more important for our customers, communities, and the environment - now and for the generations to come.”

Stuart Ledger, CFO said:

‘‘This has been a challenging financial year, with above-inflation rises in many of our cost lines exacerbated by the step-change we are making in investment levels.

Our ultimate shareholders have not received a dividend for the sixth successive year, and do not anticipate receiving a dividend for the remainder of this regulatory period to March 2025. We are grateful for significant support from our shareholders; the £1.1 billion equity injection into the group in 2021 is enabling a step change in investment and an anticipated additional £550 million equity injection into the group before the end of October2023 will ensure that the transformation plan remains on track.”

We also recognise that this is also a challenging time for our customers, with a cost-of-living crisis and above-inflationary costs impacting both households and businesses, so have increased our support package significantly, almost halving the bill for over 113,000 households.”