Macquarie bets on Southern

Macquarie has signaled its determination to plough capital into the water sector's whipping boy Southern Water as it continues its struggle to "become brilliant at the basics". Industry analyst Nigel Hawkins examines the bid and its background.

In February 2020, Southern Water stated its intention of becoming “brilliant at the basics”. Eighteen months on, that ambition has been severely tarnished and brings back memories of the Major government in the 1990s, which went “back to basics” with disastrous political consequences.

In recent years, Southern has become the whipping boy of the water sector. But, for various reasons, it has just attracted a new investor, the well-known Australian fund Macquarie, which has promised over £1 billion of new equity investment.

With net debt now exceeding £5 billion, it is much-needed because Southern’s investment strategy and operational capabilities have attracted trenchant criticism.

Recently, Southern was fined £90 million for dumping raw sewage at sea. Mr Justice Johnson concluded that “each of 51 offences seen in isolation shows a shocking and wholesale disregard for the environment”.

Neither was former Ofwat chief executive Rachel Fletcher overly impressed when Southern was fined £126 million in 2019 for misreporting the performance of its wastewater treatment works. She stated: “What we found in this case is shocking.”

And The Pensions Regulator (TPR) was also on Southern’s trail. TPR executive Nicola Parish concluded that “in our view, the pension scheme was not being treated fairly”. Southern was required to contribute £50 million to make up the shortfall.

These issues took place against the background of a far tougher water sector periodic review, covering the April 2020 to March 2025 quinquennium. Unlike some water companies, Southern did not appeal its final determination to the Competition and Markets Authority (CMA).

Given the latter’s quixotic rulings regarding Ofwat’s pivotal WACC (weighted average cost of capital) assumptions, which would have incensed Ofwat’s senior executives, Southern’s board may rue this decision.

Indeed, in accepting its final determination, Southern highlighted Ofwat’s punitive Outcome Delivery Incentive (ODI) regime.

Macquarie will aim to turn round the Southern business. It can point to undoubted success as a global infrastructure player, earning good returns for its investors. However, in the UK water sector, its reputation is more tainted, especially through its heavy – and controversial – investment in Thames Water, as a recent coruscating article in the Daily Telegraph highlighted.

As a key investor for a decade in the consortium, Macquarie presided over a massive increase in Thames’ net debt – to over £10 billion – while dividends of over £1.5 billion were paid. Corporation tax payments were minimal.

Importantly, Macquarie has access to funds that should now enable Southern’s five-year investment programme to be delivered.

In its PR19 final determination, Southern was allocated a wholesale totex figure of over £3.6 billion between 2020/21 and 2024/25: around 60 per cent of this figure was earmarked for its sewerage operations. Seemingly, Southern needs to spend more than this figure.

Having been privatised in 1989, it is not clear why, over 30 years later, it finds itself in such a mess. After all, Severn Trent, for example, is thriving as a publicly quoted company, with a valuation of over £7 billion.

Unlike Severn Trent, Southern is disproportionately dependent upon its sewerage business, partly for historical reasons since many water-only businesses (formerly statutory water companies) are based on its patch.

Many of Southern’s treatment works were built pre-war, whereas South West, another water company with many bathing beaches in its region, invested heavily in new sewerage infrastructure from the mid-1990s.

Southern’s case was not helped by several items being disallowed by Ofwat during PR19. A proposal to invest £33.1 million to tackle excess leakage levels was struck out – rightly or wrongly – by Ofwat. Macquarie has now pledged extra expenditure to reduce leakage.

For Southern’s customers, Ofwat’s PR19 prescribed real price cuts until 2025. Average bills, prior to inflation, were due to fall from £420 in 2019/20 to just £343 by 2024/25.

Macquarie, though, has simply promised to “ensure that average water and wastewater customer bills, in aggregate, do not rise by more than inflation”.

In seeking to turn round Southern, Macquarie recognises that the process will take time. The one certainty is that Macquarie seems set to pursue a rather different path from that adopted during its period as a lead shareholder of Thames.

Ofwat itself has emphasised the priority it accords to both operating and financial resilience – neither of which Southern has offered of late. More generally, the Southern saga – and its lengthy charge sheet – has been a lousy advert for the benefits of utility privatisation, as many other water company executives privately concede.

And, in Southern’s case, in its core activity of running a regulated sewerage business – it has certainly not been “brilliant at the basics”.