Southern Water: 2023 Update

July 11, 2024

Posted by Macquarie Asset Management

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.

Funds managed by Macquarie Asset Management (“Macquarie” or “we”) have held a majority stake in the Company since September 2021. After extensive consultation with Ofwat, the economic regulator for water and waste-water companies in England and Wales, we made public commitments outlining our ambition to help start an operational transformation at the Company during the remainder of the regulatory period, which runs until March 2025.

This document provides an update on progress for the financial year ended 31 March 2024. 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. 

To access our 2022 update, please click here. Please note, we have amended our reporting period this year to align with the publication of Southern Water’s 2023 annual report and audited financial statements. Information provided in the below update has been sourced from the Company’s public materials or its internal analysis, unless otherwise stated.  

Improve Southern Water’s financial resilience

General inflation, materially higher energy prices and a step-change in interest rates have combined to create significant external pressure on Southern Water’s operating, maintenance and funding costs. To manage their impact and maintain the momentum of the Company’s Turnaround Plan, Macquarie announced in August 2023 that it would invest a further £550 million of new equity in Southern Water and its holding companies.

This additional investment brings the total equity injected into Southern Water by Macquarie to more than £1.6 billion. Importantly, all of this has been injected into the Southern Water group with none of this £1.6 billion being paid to previous shareholders. In addition, Southern Water has temporarily suspended dividends to shareholders. Following these investments, Macquarie-managed funds now hold an 82 per cent stake in Southern Water.

Macquarie’s equity funding has enabled Southern Water to significantly increase capital investment in its network and improve its operational performance during this regulatory period (2020-25), as detailed below. The equity funding has also reduced group leverage from 95 per cent of regulatory asset base to approximately 80 per cent at 31 March 2024, whilst leverage for Southern Water is 69 per cent of regulatory asset base as at March 2024 in spite of the significant expenditure on improving the network.³

Following Macquarie’s most recent equity injection, Southern Water also successfully accessed the debt capital markets between December 2023 and March 2024 to raise £1.1 billion of funding to support the ongoing capital investment programme as well as refinance an existing loan that was maturing. As a result, the Company ended the year to March 2024 in a strong liquidity position with over £0.5 billion of cash and cash-equivalents.

Increase investment in the network 

Southern Water has increased forecast capital investment in its network to more than £3 billion during this regulatory period. This is equivalent to investing circa £1,500 per household and represents a 50 per cent increase on the initial £2 billion investment commitment announced upon Macquarie’s acquisition in 2021.

Southern Water delivered capital investment amounting to £828 million in the financial year to March 2024,³ representing a 31 per cent increase on the financial year to March 2022 when Macquarie first invested in Southern Water.

Combined with an increase in operating expenditure to improve operational performance, Southern Water will have expenditure of more than £1 billion above its regulatory allowances for this regulatory period. Despite this significant increase in expenditure over recent years, average bills have declined in real terms, as detailed below. This must be addressed to ensure Southern Water has a sustainable financing model in place to facilitate its ongoing turnaround.

In its business plan for the next five-year regulatory period, due to start in April 2025, Southern Water has proposed another step-change in investment amounting to approximately £8 billion of expenditure. This would be equivalent to investing circa £3,500 per household and would be the largest investment programme in the Company’s history.

More detail on Southern Water’s proposed 2025-30 investment plan is provided in the following sections. If you would like to read the Company’s plan in full, please click here. These plans are subject to and dependent on Ofwat approval.

Strengthen a zero-tolerance mindset towards environmental pollution

Upon its initial investment, Macquarie set an ambition for Southern Water to reduce pollution incidents by more than 50 per cent (compared to 2019 levels) by 2025.

Following a 35 per cent reduction in 2023 compared to the prior year, the Company has reduced pollution incidents by 46 per cent since 2019 and is on-track to exceed our original 2025 ambition. The ongoing improvement in Southern Water’s environmental performance has been achieved despite 2023/24 being one of the wettest winters on-record which we understand has led to a deterioration in the performance of some of the Company’s peers.

The Company remains focused on improving its performance on Serious Pollutions,⁴ which are unchanged from the level in 2021. This is not acceptable and Southern Water is implementing additional actions to improve performance in 2024.

Southern Water’s improved performance on total pollution incidents follows focused investment to enhance asset resilience and a strengthening of management and operational processes. It has reduced the failure rates at its wastewater treatment works, with 99.4 per cent compliance for 2023 compared to 97.1 per cent in 2020.

In July 2023, the Environment Agency gave Southern Water a two-star rating (out of four) in its annual Environmental Performance Assessment (EPA).⁵ Upon Macquarie’s initial investment, Southern Water had a one-star rating. The Company has an ambition to achieve a three-star EPA rating by 2025, which it has not achieved since 2017, noting that the criteria to qualify for a three-star rating are more onerous than those in place in 2017.

As part of its proposed business plan for 2025-30, Southern Water aims to invest over £4 billion in its wastewater network to reduce pollution incidents by a further 67 per cent and eliminate Serious Pollution incidents altogether.

When water companies in England and Wales were privatised in 1989, only 28 per cent of bathing waters in the Southern Water catchment area met public health standards.⁶ Following the step-change in investment delivered over recent decades, that figure has risen to 99 per cent, with 88 percent rated as ‘good’ or ‘excellent’.⁵ Macquarie is supporting Southern Water’s efforts to drive continued improvements across its region.

Working with stakeholders to alleviate urban rainwater run-off

The water sector has been pressed to play its part in addressing urban rainwater run-off. Southern Water has outlined ambitious plans, subject to funding approval from Ofwat, that will utilise both nature-based and engineering solutions to redesign the Victorian-era combined sewer network and limit the use of storm overflows.

Contrary to statements in some parts of media, water companies have not been funded previously to meet the new UK Government targets on reducing storm overflows, as acknowledged by government.⁷ Indeed, the original intent and design of the combined sewer network was to accept a level of dilution. Whilst we support the change in approach, it will need time and resourcing to hit the interim targets between now and 2050, with climate change and population growth making the challenges ever greater. Southern Water also recognises the challenge for our customers in seeking environmental improvement but feeling the strain of affordability, which is why the Company’s proposed 2025-30 business plan has been prepared following significant customer engagement and includes an expansion to its Social Tariff. Furthermore, continual improvements to the health of our rivers and seas will require action from a broader group of actors than just water companies, including reducing run-off from agriculture and highways, amongst other things.

As part of its contribution, the Company has established a Clean Rivers and Seas Task Force comprised of environmental scientists, engineers and industry experts to oversee the delivery of 7 Pathfinder projects across Kent, East Sussex, West Sussex, Hampshire and the Isle of Wight. These projects use solutions including the construction of wetlands, installation of rain gardens, provision of slow-drain water butts, relining and sealing of sewers and private pipes, removing misconnections to the sewer network and upgrades to treatment facilities to demonstrate more sustainable and cost-effective ways exist to reduce the use of overflows. The pilots are delivering impressive results, with storm releases cut by 70 per cent at a single overflow site following the roll-out of free water-butts to nearby homes on the Isle of Wight.⁸ This is a creative and environmentally friendly approach to reducing storm overflows without a cement-only ‘grey’ solutions and has been delivered with support from local stakeholders.

In its proposed business plan for 2025-30, Southern Water aims to invest £682 million to facilitate a reduction in the need to use its 978 overflows as frequently, with investment targeted in initiatives to reduce overflows at 286 priority bathing and shellfish water sites. This forms part of a £1.5 billion strategy announced by the Task Force during this regulatory period, which aims to address the root causes of most storm releases by 2035.

Approximately 50 per cent of Southern Water’s 982 overflow sites are already meeting the government’s stated 2050 target for 10 or fewer storm releases each year. If its investment plans are approved, Southern Water is targeting that 75 per cent of its high priority overflows will meet the government’s target by 2035, reducing spills by an average of 8,000 a year. These ambitious plans have been accompanied with the publication of the industry’s first-ever interactive online map, enabling its customers to see how and when storm releases will be reduced across every overflow site in its catchment area.

Enhance water quality and resilience 

As noted in our previous update, population growth and climate change will place ever-increasing pressures on water supplies across England and Wales in the years ahead, with the South-East of England particularly impacted by these trends. By 2050, Southern Water expects it may lose a third of its water sources due to climate change.

In line with recently introduced legislation, the Company must reduce the amount of water it takes from rivers and underground sources, including from the River Test and River Itchen, perhaps the two best known of the eleven British chalk streams which are Sites of Specific Scientific Interest. Over the same period, the population in Southern Water’s catchment area is forecast to grow by as much as 25 per cent, representing one of the highest rates of housing growth to be supported by any water and waste-water company.⁹

In the year to 31 March 2024, the Company achieved its best-ever score for drinking water quality since the Drinking Water Inspectorate introduced the measure in 2017, with a reduction in its Compliance Risk Index score to 3.07 from 6.38 in the prior year. Southern Water’s reservoir cleaning and maintenance programme helped to increase compliance at its reservoirs to 99.9 per cent.³

However, Southern Water is aiming to go much further. Subject to the approval of its plans by Ofwat, Southern Water aims to spend £3.4 billion on water supply including over £2 billion of investment to improve water quality and resilience of supply through the full upgrade of the Company’s four largest water works. To reduce abstraction of water from the environment by 30 per cent, it aims to develop five water recycling plants and build new interconnections in the South-East while delivering leakage and consumption reductions. If its plans are approved, these investments aim to deliver 189 million litres of extra water per day by 2035.

Reduce leaks

Southern Water currently leaks about 19 per cent of the water that it puts into supply, with roughly one-fifth of this occurring on the customer side.

The Company has launched initiatives focused on finding and fixing leaks while using technology and advanced pressure management to reduce overall leakage. Around 3,000 additional acoustic sensors have been deployed and a new geographic information system (GIS) system is helping find and fix more complex issues on the network.

With around one-fifth of leakage occurring on the customer-side, Southern Water conducted 13,500 visits during the year to March 2024 to help identify leaks and provide behavioural advice. These visits identified 1,100 leaky toilets and a further 241 leaks, helping Southern Water and its customers reduce water consumption by a further 300 cubic metres per day.

The Company’s business plan submission for the next five-year regulatory period includes significant investment to replace approximately 300 kilometres of water mains. Southern Water also aims to reduce leakage further through the rollout of 1 million smart meters, which will amongst other things help identify and reduce customer-side leakage.

Ensure affordable customer bills

In 2023/24, Southern Water’s average combined household water and wastewater bill was £439 per annum. This compares to £438 for the year to March 2020 and £434 for the year to March 2015 (respectively the final years of the last two regulatory periods). This represents a 43 per cent decrease in real terms over the last decade.¹⁰

As a result, the average household is paying around £1.20 per day for treated clean drinking water alongside the collection and treatment of wastewater. Despite significant investment delivered by the company and significant increases in external costs, such as energy and construction, the average customer bill in 2023/24 remains at the same level in nominal terms as it was in 2014. This compares to a 43¹¹ and 42¹² per cent increase in the average combined energy bill and average council tax bill, respectively, over the same period.

As part of its proposed business plan for 2025-30, Southern Water has indicated its average combined bill will need to increase by approximately 70 per cent by 2030, the highest in the industry. There are several reasons for this:

• Roll-off of customer rebates: During the current regulatory period, customer bills have been discounted by around 8 per cent due to historic penalties. Given the significant improvement in performance since Macquarie’s investment, these rebates are forecast to decline significantly.
• Rebasing to reflect significant external cost pressures: Over the past year alone, energy costs have risen by 60 per cent while the cost of chemicals used to treat water has doubled. Furthermore, interest rates have increased by nearly 4 per cent, increasing the cost of equity and debt financing. Unlike the energy sector, where these increased costs have already been passed through to customers, water companies must bear them until the regulatory reset in April 2025. Furthermore, for the current regulatory period to March 2025, Southern Water received the second lowest operating cost allowance per person for its water business in the sector; its operating cost allowance per person was over 30 per cent lower than the average.¹³ This is in spite of regional factors that drive a higher cost base in the Company’s catchment area, such as a largely coastal population and relatively high wages. The Company has asked Ofwat to address this disparity in the 2025-30 regulatory period.
• Additional investment made in this regulatory period: The Company is forecast to invest more than £1 billion over and above the amount funded via bills in this regulatory period. Under the regulatory framework, only 34 per cent of this additional investment is recovered from customers via future bills, with the remaining 66 per cent paid for through a reduction in shareholder returns.
• Step-change in future investment: Southern Water has proposed the highest percentage increase in investment levels on the water side of its business, given it must replace a third of its current water supply by 2050 to prepare for climate change, population growth and a material reduction in abstraction from protected chalk-streams. Southern Water has also proposed a significant increase in investment on the waste-water side of its business.

Although Southern Water’s proposed bill increase represents the largest requested in percentage terms across the industry, these changes are needed to ensure the Company can respond to various challenges unique to its catchment area and continue to provide reliable and high-quality water and wastewater treatment services in the years ahead.

In recognition of the challenging cost of living environment, Southern Water increased the discount available to customers on its financial assistance schemes to 45 per cent of their bill during this regulatory period. Any future bill increases will be spread across a five-year period, with Southern Water also indicating that its social tariff, hardship fund, and Priority Services Register will be significantly expanded if its business plan is approved by Ofwat.

Improve customer service

Providing a better customer experience is a core component of Southern Water’s Turnaround Plan. The company continues to progress a series of initiatives to meet Macquarie’s ambition for it to move from being ranked 16^th (of 17) in the industry on customer service, to an average performer by the next regulatory period.¹⁴

During the period, Southern Water launched a new website so customers can more easily find information and access enhanced digital resources to assist with remote and self-servicing. The Company redesigned its complaints process and job management system so customers can more quickly raise their concerns, while improving the way in which its teams log customer issues, schedule repairs, deliver follow-up actions, and ensure customers remain informed at every stage of the process. These steps, amongst others, helped reduce customer complaints by 59 per cent in the period.

In addition to the above, Southern Water has launched regular community engagement forums, providing an opportunity for customers across the region it serves to learn more about its operations, ask questions, and raise concerns in-person.  

As noted in our previous update, we believe that a key component of better customer service is improving the underlying operational performance of the network. This remains on-track following the changes implemented over the past year, however, the pace at which this will be reflected in the regulator’s assessment of customer service remains uncertain.

Adopt a sustainable financing strategy and conservative distribution policy during transformation 

No distributions have been paid to shareholders since 2017, with £1.6 billion of equity instead injected by shareholders into the Southern Water group since September 2021.

As noted in our previous update, 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.

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.

Yours sincerely,

Martin Bradley
Head of Infrastructure EMEA, Macquarie Asset Management
On behalf of the Fund

¹ Statistics with an asterisk (*) can also be found in the Southern Water Annual Report for the year to 31 March 2024, Southern Water, 2024

² In line with the Ofwat regulatory methodology, the real price reduction is calculated using RPI inflation for the period from March 2015 to March 2020 and then a 50:50 average of RPI and CPI inflation for the period from March 2020 to March 2024

³ Southern Water Annual Report for 2023/24, Southern Water, 2024

⁴ Defined as Category 1 and 2 incidents, Review of activities by the Environment Agency, Environment Agency, 2022

⁵ Water and sewerage companies in England: Environmental Performance Report 2022, Environment Agency (Link)

⁶ Since privatisation, steady investment from water companies has improved water quality in the UK, Southern Water, 2023

⁷ Storm overflows discharge reduction plan, Department for Environment, Food and Rural Affairs, 2023

⁸ Clean Rivers and Seas Task Force – Isle of Wight, Southern Water, 2024 

⁹ Our business plan, Southern Water 2023

¹⁰ In line with the Ofwat regulatory methodology, the real price reduction is calculated using RPI inflation for the period from March 2015 to March 2020 and then a 50:50 average of RPI and CPI inflation for the period from March 2020 to March 2024

¹¹ Average combined energy bill was £1,344 in 2014 and £1,928 as at March 2024.  Domestic energy bills in 2014 and New energy price cap starts today, Ofgem, 2014 and 2024

¹² Average Band D council tax was £1,456 for 2013/14 and £2,065 for 2023/24. Council tax levels set by local authorities in England 2013-14 and Council tax levels set by local authorities in England 2023-24, Department for Communities and Local Government, 2013 and 2023

¹³ Southern Water analysis

¹⁴ C-Mex and D-Mex 2022/23 Results, Ofwat, 2023