Posted by Macquarie Asset Management
January 3, 2022
Southern Water (“Southern Water” or “the Company”) supplies millions of households and businesses in Kent, Sussex, Hampshire, and the Isle of Wight with clean drinking water and waste-water collection and treatment services.
In August 2021, Macquarie Asset Management announced an agreement to acquire a majority stake in the Company via one of its managed funds (“the Fund”). After extensive consultation with Ofwat, the regulator for the water and waste-water industry in England and Wales, we made public commitments outlining our ambition to help start an operational transformation of Southern Water during the remainder of the regulatory period which runs until March 2025.
Since completion of the Fund’s investment in September 2021, we have worked closely with Southern Water and its stakeholders over the first year of our ownership to focus on the delivery of these commitments. We welcome initial progress towards delivery and are focused on maintaining this positive momentum in 2023 and beyond.
This document provides an update on progress for the calendar year ended 31 December 2022. It also explores a range of areas in which Southern Water continues to advocate for greater action so the water and waste-water sector can overcome legacy challenges and continue to evolve to meet the expectations of its stakeholders and the environment.
Increase investment in the network
As detailed in its latest Annual Report and Financial Statements, Southern Water invested a total of £632 million in capital investment in the network in the year to March 2022, an increase of 49 per cent on the prior year.
The significant increase reflects the need for Southern Water to upgrade its ageing infrastructure. It also reflects our commitment to Southern Water to invest approximately £2 billion in the network during this regulatory period.
This investment commitment, of which £230 million is in addition to regulatory allowances for this regulatory period, is equivalent to investing £1,000 per property in Southern Water’s customer base and is aimed at improving treatment works, pumping stations, and areas of the sewer network currently causing the most performance issues.
Strengthen a zero-tolerance mindset towards environmental pollution
Recognising Southern Water’s poor track record of environmental performance, we outlined our commitment to reduce pollution incidents by more than 50 per cent by 2025 (compared with 2019 pollution incidents). The importance of achieving this target and strengthening the way the Company manages its impact on the environment was reinforced by Southern Water’s ‘One Star’ rating by the Environment Agency in its Environmental Performance Report for the year ended 31 December 2021.
Southern Water is on track to meet the 2025 pollution reduction target in 2023, two years earlier than our original plan. This has been achieved through additional investment in equipment such as pumping stations and a new control room, and a range of improvements to operational processes.
Limited remote monitoring has historically contributed to both the number and duration of pollution incidents in parts of Southern Water’s network. We expect a step-change in the Company’s environmental performance will be achieved with the deployment of approximately 22,000 sensors across Southern Water’s sewer network to facilitate real-time monitoring of issues so the Company can better detect and fix issues as they occur.
Southern Water has 3,787 facilities on its waste-water network (comprised of 367 waste-water treatment works and 3,420 pumping stations) operating 365 days a year (i.e. nearly 1.4 million ‘facility days’ per annum). With approximately 260 expected pollution incidents recorded in 2022, Southern Water’s facility efficiency rate is 99.98 per cent. Whilst we aspire for the Company to achieve a 100 per cent efficiency rate, there is a broader issue of ‘storm overflows’ related to urban rainwater run-off.
Working with stakeholders to alleviate urban rainwater run-off
The Victorians designed the UK’s waste-water network to be ‘combined sewers’, carrying both foul-water as well as rainwater run-off from highways and urban areas. This design was changed in the 1960s, with modern waste-water networks designed to transport only foul-water, with rainwater returned to the environment (e.g., watercourses, groundwater or rivers). Since privatisation, there has been significant investment to upgrade the legacy Victorian system. However, there are still over 100,000km of ‘combined sewers’ in England – representing around 25 per cent of the entire UK sewer network.
More intense rainfall because of climate change, as well as a reduction in permeable ground area due to urbanisation, are increasing the pressure rainwater run-off has on the sewer network. During heavy storms, the volume of rainwater run-off into the sewer network risks overwhelming Southern Water’s waste-water treatment works (which were designed for the treatment of foul-water only). Water ingress into the sewer network can also arise where the ground water level – and hence water pressure – is high, which can occur where rainfall isn’t excessive but has been consistently high. When rain-water run-off and/or ingress into the sewer network happens, pressure release valves which are built into the network – known as storm overflows – to stop homes and businesses from flooding. Instead, the excess water is released through screens and via storm tanks through outfalls into rivers and the sea, many of which are some distance from the coastline. There are approximately 15,000 storm overflows in England - 1,000 of which are in Southern Water’s region.
The Department for Environment, Food & Rural Affairs has acknowledged that a system redesign is required, with a target to eliminate storm overflows by 2050 (except for in periods of unusually heavy rainfall) and is now working with stakeholders – including water companies – on trial schemes to establish more efficient and cost-effective solutions to enable this redesign. Given this is how the system is designed and used by multiple parties, it cannot be addressed without the cooperation of local councils and the highways agency.
We are supporting Southern Water’s continued engagement efforts with the regulators, government, and regional and local communities to examine how the use of combined sewer overflows can be reduced and ultimately eliminated by addressing the issue of urban rainwater run-off. We believe water companies could deploy their expertise to be part of this solution. This could be achieved through investment in additional storm tanks and household water butts or through the deployment of nature-based, sustainable drainage systems such as ponds, wetlands, and rain gardens. In addition to solving the issue and improving biodiversity, these solutions are likely to be more sustainable and cost-effective longer term than increasing the capacity of Southern Water’s waste-water treatment facilities – in turn helping to maintain affordable customer bills.
The intense drought conditions experienced across much of England and Wales in the summer of 2022 highlight the urgent need to reduce leaks and invest and operate the network in ways which address water scarcity more effectively.
Southern Water’s water leakage is low relative to other UK water companies, at a rate of 17% (compared to 23% across the sector). However, we believe leakage should be reduced even further and faster, particularly given the growing issue of water scarcity in the South East. This will require collaboration with Ofwat to ensure the corresponding funding is allowed to fund renewal or replacement of water mains. As highlighted by Water UK, the rate of replacement of water mains in England and Wales has been significantly lower than European peers, and this can be attributed to lower funding being allowed (rather than the industry underspending its regulatory allowances).
As our climate changes and population grows, there will be additional pressure put on water supplies in the years ahead. We believe it is vital that the UK also invests in new supply initiatives and will continue to advocate for this investment alongside amendments to the environmental and planning regimes so that new reservoirs can be built to supply Southern Water’s customers. This will include the South East Strategic Reservoir, that is planned to be built in the Thames Water region but is a critical component of Southern Water’s future water resilience.
Ensure affordable customer bills
In 2022/23, Southern Water’s average water and wastewater customer bill is approximately £402 per annum. This is equivalent to £1.10 per day despite customers using an average of 133.6 litres of clean water per person, per day.1 For 2022/23, Southern Water customers saw a reduction in their bills and have amongst the lowest bill of the combined water and wastewater companies in England and Wales. For 2023/24, Southern Water’s average customer bill is expected to stay flat in real terms.
We are also supporting Southern Water’s engagement with Ofwat and other stakeholders to explore additional measures which support vulnerable customers. This includes the increased discount on the Company’s social tariff, which has reduced the average combined bill from £402 to £221 this year for more than 103,000 vulnerable customers.
We also remain engaged in supporting Southern Water to identify appropriate solutions to balance cost-of-living pressures whilst ensuring we can deliver the investment in the network that customers and other stakeholders expect.
Improve customer service
Although it is early in Southern Water’s transformation programme, our continued focus is to move the Company from 16th (of 17) in the industry on customer service to an average performer by the next regulatory period.
We believe that a key component of better customer service is improving the underlying operational performance of the network, which is on-track following the changes implemented over the past year. Our focus is to continue to support further improvements, including Southern Water’s plans to develop the quality of its technology, with a view to enabling more customers to manage their account and pay their bills online.
Adopt a sustainable financing strategy and conservative distribution policy during transformation
Water and waste-water utility companies – like companies operating in any sector – must provide a reasonable economic return to those who provide the capital to finance their operations. Without appropriate risk-adjusted returns, utility companies will be unable to secure continued access to the capital needed to finance their investment programmes.
Southern Water’s shareholders have not received any dividends since 2017. Although it is our intention for Southern Water to deliver a reasonable economic return to the institutional investors we represent, including pension funds and insurance companies who invest in our managed funds and rely on this income, we expect the Company to maintain a conservative distribution policy whilst the transformation plan is underway. We have also made a commitment that any distributions made during the current regulatory period will represent a yield lower than 4 per cent per annum.
We remain focused on working with Southern Water to deliver against the commitments made at the time of acquisition and would be happy to further discuss our progress or any area of particular interest to you.
Head of Real Assets EMEA, Macquarie Asset Management
On behalf of the Fund