Analyst’s view: Affinity Water

Shortly before water privatisation in 1989, three French companies – CGE, Suez and SAUR – launched bids for several Statutory Water Companies, which had never been state-owned.

CGE’s acquisitions, boosted by subsequent takeovers, form the core business of the Hatfield-based, Affinity Water, which is setting high standards in the UK water sector.

In fact, Affinity’s water supply area resembles a patchwork quilt.

Most of its activities are on the edge of the North and West London suburbs, including the Colne and Lee Valleys and the town of Rickmansworth – Affinity’s predecessor, The Three Valleys business, was built around these areas.

In addition, Affinity has water supply operations in North Surrey and parts of East Kent, centring on Folkestone and Dover.

In total, Affinity owns a 16,500 kilometres network of mains water pipes and supplies 3.6 million people. But it is not involved in the sewerage sector, unlike the 10 large privatised water companies.  

In recent years, the key event for Affinity has been the 2014/15 periodic review, for which it was awarded the coveted ‘enhanced status’ by Ofwat.

As a result, it received a better overall deal than all other water companies, bar South West, which was also granted ‘enhanced status’.

Ofwat has confirmed that this status ‘means that the company produced a high-quality business plan that stood apart from the other companies’.   

Importantly, Affinity has been allocated a Weighted Average Cost of Capital (WACC) for its wholesale water business of 3.7% – 0.1% above the WACC of non-enhanced water companies.

Ofwat has confirmed that this higher WACC assumption is worth around £5 million. Furthermore, Affinity is protected – under the ‘do no harm’ principle – against various regulatory downsides prior to April 2020. 

For the five years until 2019/20, Ofwat has agreed wholesale water revenues of an average £249 million: for last year, the out-turn was £268 million.   

On its web-site, Affinity has listed several unequivocal pledges; they include a 14% reduction in water leakage by 2020 – a policy that Ofwat, which has been persistently criticised for its lacklustre approach to cutting water leakage, will surely welcome.

Higher quality water, a more environmentally-orientated abstraction policy, an extended metering programme, a community-focussed approach and a concerted ‘value for money’ priority are also emphasised – all are grist to Ofwat’s regulatory mill.  

In terms of Affinity’s water charges, these are set to fall from £165 in 2014/15 to £156 in 2019/20, a cut of just over 1% per year.

To achieve these cuts and to protect the profit line, Affinity will have to deliver much of its planned £106 million five-year efficiency savings. 

Importantly, there are key personnel at Affinity, who know how Ofwat is programmed and how to press the right buttons, especially on leakage.

Chairman, Dr Phil Nolan, is a veteran of the epic 1990s Battle of Transco between the former British Gas and Ofgas (now Ofgem), whilst Chris Bolt, a serial utility regulator, is a Non-Executive Director.   

In terms of its finances, Affinity reported revenues of £291 million for 2014/15, an identical number to the preceding year.

Operating profits were £93 million, compared with £84 million in 2013/14, as the already healthy margins were widened.

Given its water-only status, comparisons with Bristol Water are inevitable, even though the latter’s annual revenues are just under half those of Affinity.

The very different outcomes to their respective periodic reviews merit comment.

Bristol chose to appeal to the Competition and Markets Authority (CMA), whose eventual judgment fell well short of its optimistic expectations; furthermore, its current relationship with Ofwat can be described as strained – at best.   

Affinity, by contrast, sailed through the periodic review, on the basis of being a ‘fast-tracker’.  

Such a scenario must have pleased Affinity’s owners, who are a financial consortium, in which Morgan Stanley – through North Haven Infrastructure Partners – plays the lead role, with a 40% shareholding.

The other key shareholder, with a 35% stake, is Infracapital Partners II: M and G Investment, a Prudential subsidiary, is the key backer.

Two 10% stakes are held, by Veolia UK – a residual share-holding – and by a Chinese-backed investment business. 

Given the post-periodic review rumours about sector consolidation, there is bound to be speculation about an eventual sale of Affinity, especially if the three major shareholders seek to release some of the accrued £1 billion + Regulatory Asset Value (RAV).

Of course, like every company, Affinity does face risks. Problems on the operating front could materialise, as United Utilities experienced last year with its cryptosporidium outbreak.

Water shortages could also materialise, although this winter’s heavy rains suggest this is an unlikely scenario for 2016. Later on in the regulatory cycle, drought conditions should not be ruled out.

Financial setbacks are also possible, especially if there were materially adverse tax changes or interest rates rose substantially: Affinity’s net debt is almost £800 million.

And regulatory changes, often driven by short-term political considerations, are risks that every utility has to accept, although Affinity is afforded real protection through the ‘do no harm’ criteria.  

For now, though, Affinity is very well-placed. After all, for a regulated business, it never hurts to be, like Jose Mourinho, the ‘special one’. 

Nigel Hawkins (nigelhawkins1010@aol.com) is a Director of Nigel Hawkins Associates which undertakes investment and policy research