Have the drivers of value in the water sector changed? – Blog by Paul Horton and Richard Laikin

Have the drivers of value in the water sector changed? What will “business as usual” look like as we move beyond the immediate lockdown?

Over the last few months, there has been a focus on the impacts of COVID-19 on companies’ programmes of work, on their costs, on whether they can meet their regulatory obligations, and so on. Most of the public commentary has been about negative impacts and challenges, so it was interesting to see Severn Trent saying in their recent annual results presentation that “our operations teams have been able to complete work ahead of schedule, reducing work in progress thanks to the significant reduction in road traffic” and “we have brought forward projects scheduled for later in the year to minimise public disruption – for example, renewing parts of our network in Derby, providing additional resilience for customers, several months early”.

Overall, Severn Trent said that there has been “no material step up in operating costs as a result of COVID-19 to date” and that while there might be lower revenue in the short term (because of lower water consumption by businesses which is only partially offset by higher household consumption) “the Ofwat regulatory model allows us to recover this revenue in two years”. Are there other similar stories across the sector?

In a recent update on infrastructure valuations, PwC, the professional services firm, noted that share prices of listed UK regulated utilities have reduced by only c.2% on average since the start of the year, compared to c.24% for the FTSE all share index, and that “the COVID-19 outbreak appears to have impacted regulated utilities [such as UK water companies] less severely than the broader market given the essential nature of the businesses and the stable revenue and regulated earnings generated by these assets, largely isolating them from the economic downturn.”

The ratings agency, Moody’s, also believes that “the UK regulated water sector faces low overall coronavirus exposure risk given regulatory protections and solid liquidity.”

Although many water companies have been more reticent at predicting the financial impacts of the pandemic at this stage, and while there might be some longer term scarring effects depending on the nature and shape of the economic recovery, it’s important to remind ourselves that water is a long term business. We are at the beginning of a new five-year regulatory period, and there are more significant drivers of value beyond the immediate crisis. These include delivering on the aspirations and commitments set out in the companies’ five year business plans, meeting (and outperforming on) the targets set by Ofwat in the PR19 final determinations, and addressing the longer term challenges of resilience and climate change.

Moody’s recently said that, as a result of the PR19 determinations, its outlook for the sector remains negative. They cited a number of factors: an “unprecedented cut in returns…[that] will pose particular problems for companies with expensive long-dated debt”; “material cuts in [allowed] enhancement spending”; and “tough performance targets for most companies”. Moody’s estimates that the sector “could still rack up stiff penalties of £150m-£350m in aggregate over the five years when performing in line with their business plans or latest performance levels”.

In summary Moody’s suggests that “financial flexibility will be eroded across the sector, with particular pressure on interest coverage, and companies will have limited room to offset unforeseen challenges”. During AMP6, for example, there were regional flooding and drought events, the “Beast from the East”, and company-specific failures, all of which challenged companies in different ways. AMP7 is unlikely to be different – indeed climate change may exacerbate these trends.

There has been a wide range of responses from companies as they have got ready for the start of the AMP. For example, Thames Water said in its letter to Ofwat accepting the final determination that “we must be transparent with you about the scale of challenge that the package sets for us…we do not necessarily expect to be able to operate within the cost and service thresholds set out in the FD. Our central expectation is that we will incur net overspends and net penalties.” Southern Water also highlighted similar themes in their acceptance: “….the very challenging PR19 financial determination by Ofwat, in particular the level of the allowed cost of capital and a punitive Outcomes Delivery Incentive (ODI) regime…. As such, Ofwat’s quite stringent determination adds to the increased overall balance of risk that the business faces over the next 5 years…”.

But at the other end of the spectrum, some companies are already publicly targeting AMP7 outperformance on costs and outcomes, including the 3 “fast track” companies (Severn Trent, South West Water and United Utilities).

The industry will need to step up to the challenges set by the regulator for improved service quality and cost efficiency in this AMP and into the next. This includes meeting the demands of the new C-MeX and D-MeX measures of customer experience, which challenge the companies to go even further than before in delivering excellent experiences for end user customers and developer customers respectively.

In parallel, there is a healthy debate already underway about where next for regulation of the water sector and the role of water companies within that as the longer term challenges take centre stage. There needs to be the right framework to support this transition. Can regulators and Government, through policy development and implementation, reflect back customers’ desires for change? Can water utilities position themselves as custodians of water and environmental management, more directly serving local and regional community needs? With the sector aiming for net carbon zero by 2030, and the ongoing joint approach to agreeing a sector innovation strategy, the water industry could be at the forefront of supporting the green/infrastructure-led ‘revolution’.

  • So a couple of concluding thoughts for supply chain partners:
    Take time to understand the drivers of water companies’ operational and financial success in this period and how they have changed from AMP6, and in particular the financial and reputational targets and incentives that they face in your specific area of business;
  • Understand how your products and service offerings can contribute to companies meeting and beating these targets and expectations more efficiently, more effectively, and within the required timeframes;
  • Understand how your service or product offering can be integrated into wider delivery plans with other partners, vendors, and suppliers… as so many of the more innovative and transformational solutions will be multi-vendor/ multi-stakeholder; and
  • Contribute ideas through the many technical and policy networks that are springing up around innovation and policy development in the sector and more widely on “building back better” – make your voice heard and build relationships with water companies and others in the supply chain.

We remain confident that the sector, working with its supply chain partners, will be able to step up and respond as it has done in previous AMPs. There is a buzz around transformation and, in particular, the role that specialists and SMEs can play in a more agile, innovation driven, sector.

                                                               
Richard Laikin                                                                                     Paul Horton
Director, RL Strategy Consulting Limited                                    CEO, Future Water Association
Email: richard@rlstrategyconsulting.com                                    Email: paul@futurewaterassociation.com

17 June 2020