In almost two months final business plans for 2015-20 are due in to Ofwat. Consultation on Southern Water’s draft has recently closed. The £3 billion plan contains a number of bold ambitions (see table).
In line with a growing trend in the industry, Southern is proposing to deliver all this while capping price rises at the rate of inflation. Pre-inflation, its average water and sewerage bill will be the same in 2020 as in 2015 at £449; with inflation added, the average customer will pay £535 by the end of the period. This contrasts with an inflation+7 per cent price hike in the 2009 price review.
Chief executive Matthew Wright brushes off the suggestion that capping prices at inflation is designed to keep on the right side of Ofwat and avoid the full strength of its glare when business plans are graded. Thames Water’s recent rebuke over its interim determination would suggest this isn’t an entirely unreasonable idea. Instead Wright explains: “A lot of things are driving it. There is concern about affordability and customer ability to pay… Our strong sense is that as a package, in most walks of life, for most companies, customers would like more for less or more for the same, so we have been very conscious about the overall effect on prices. The general economy is such that above inflation increases would attract some interest, if not criticism.
“But there ’s another reason. We’ve done the bottom-up as well so we’ve got a very detailed plan that sits behind that… So it’s not that we started with the bills rising by no more than inflation and worked backwards. We’ve worked both ways and we’re confident we can deliver the improvements our customers want to see within an affordability envelope that sees bills rise by no more than inflation.”
Wright stresses that where customers have expressed a greater willingness to pay for a specific item – for example, more resilient water resources – Southern will prioritise and resource it, within the wider inflation-capped plan. He says: “What we’ve done is look at all the things customers have said are a priority and where they might pay more for those in individual components. But in the round they might also want us to either do less in some areas or become more efficient, so that by the time it feeds through into prices they are, at a component level, paying more for resilience but actually it’s being offset by efficiencies or something else.”
Southern factored efficiency savings worth £180 million into its draft plan: £150 million of capital savings and £30 million of operational savings. Wright says additional help for those who particularly struggle to pay their bills should be in place for the start of the sixth asset management plan (AMP6) period, in the form of a social tariff. Preliminary research suggests customers would be willing to pay a cross-subsidy to the tune of up to £6 a year, though Wright notes that it’s a difficult sell in practice. “Whether that’s where we end up ; I think we have to go through various other phases to get there.” Wessex Water, a social tariff pioneer, has kicked off with a cross-subsidy of just 50p.
So, of all the business plan elements, what are Southern’s priorities? Wright doesn’t hesitate in listing first an improvement in customer service. He is refreshingly frank about the company’s recent poor performance: “We are not contented in any sense with our customer service performance historically – it’s been an area of particular weakness for us.” He includes as reasons poor processes, under resourcing at peak times, and a culture not focused on the customer.
Extensive improvement programmes are going on already and will continue into AMP6. Says Wright: “Sitting rather uncomfortably towards the bottom of the league table on the SIM is not a good place to be in terms of the legitimacy agenda. That’s why we’ve made such strong commitments in our business plan around the level of improvement, which we’re starting to deliver now rather than waiting for AMP6.”
The other priorities Wright lists are: bathing water quality improvement; reducing the number of properties subject to flooding; and achieving a bold per capita consumption target, set on the back of a 90 per cent metered customer base by 2015. To put its money where its mouth is, Southern is voluntarily introducing “outcome delivery incentives” for outcomes customers have identified as especially important. In a nutshell, the company will pay a penalty if it fails to meet a set target – say, the number of properties suffering flooding. If it meets the target there will be neither penalty nor reward. If it exceeds the target it will get a reward.
I ask if the company will be incentivised, then, to prioritise delivering the targets where there are potential rewards, possibly to the detriment of other outcomes? Wright replies honestly: “Yes, but only because those are the areas customers have told us are important… So it’s not a question of us focusing on the things that will get us a reward. It’s almost the reverse, which is that we will be focusing on things they want to see improvement in and we will pay a penalty if we don’t.” He adds “the downside will be bigger than the reward – in aggregate”.
The focus on customer priorities in the draft plan and on dealing with customers equitably is crucial to the entire price review process this time around. According to Wright: “I can’t stress highly enough this reorientation away from a regulatory process and ticking the boxes for the regulator, 180 degrees towards what our customers are telling us. It’s actually been an incredibly profound change for the industry.”
He is full of praise for Southern’s Customer Challenge Group, chaired by Anna Bradley, whom he describes as “a top-drawer customer advocate; tremendous”. He elaborates: “Hand on heart, we would not be in the position we are in without the help of the challenge group. It wouldn’t be as good.” The plan is certainly clear, accessible and unambiguous.
What of other aspects of the process of PR14? Eyebrows have been raised at the sheer amount of reform the regulator has packed in, not to mention key Ofwat personnel changes at such a critical time; outsourcing some of the process; and a £10 million levy on companies to make ends meet.
Wright is firmly in the camp that welcomes the lack of prescription from the regulator on business planning. “I think that’s been tremendously liberating and I think you will see a lot of variability as a result of that, but surely that’s a strength? The diversity of approach, that’s where innovation comes from; that’s where ideas come from. So I think it’s been an entirely positive thing.”
He adds: “Would we like to understand exactly how the menu works and how the cost comparisons and all that is going to work? Well, yes we would, but we’ll get that in the fullness of time.”
More broadly, he says: “Ultimately I’m pretty confident that get it right, because they have to. And if they need more time and more resource to do that, I’m not going to be critical of that because it’s in our interest that that’s what they do.
“I think the transition between Regina Finn , while not ideally timed, is good in one sense because it’s Cathryn, and Cathryn’s been there before and was there at the beginning of this sea change in the way in which Ofwat has sought to regulate the industry, so she’s philosophically aligned with Regina’s direction… We’ve embraced the new approach, we’re supportive of it, we expect that to continue.”
On the crucial issue of cost of capital, Wright acknowledges that the macroeconomics – particularly the cost of debt – have changed since PR09, so he considers it “reasonable” to expect a lower weighted average cost of capital (Wacc). However, he cautions even if the cost of debt is lower, Ofwat needs to judge whether it will remain low over the next five years.
Ratings agency Moody’s has warned that Southern would be one of the water companies most exposed by a lower Wacc or demanding efficiencies at PR14 because of its high embedded cost of index-linked debt. Wright acknowledges that it used to be the most highly leveraged company in the sector, but now it is only number three on the list.
Southern Water is owned by Greensands Investments, a consortium of pension and infrastructure funds. As a privately-owned company, you might expect Southern to be in the front line of recent criticism about opaque ownership structures, reporting and governance, but Wright is unconcerned. He says his company has responded to requests for more financial disclosure willingly, and has four independent non-executive directors plus an independent chair at the operating company board level, when only three are required.
He is robust, too, on the issue of corporation tax, saying he understands concerns but as the industry is capital-intensive and debt-loaded, little will change unless the tax rules are altered – and there’s no quick fix there. “UK plc will continue to need to invest in infrastructure. It will need to continue to attract debt and equity and it will need a certain form of incentive – through the return or whatever – to allow that money to be provided. So it’s a difficult one to say. I think a lot of the angst and uncertainty around this issue would be mitigated by greater transparency. That’s what we’re being encouraged to do and we are doing and we think that’s right.”