Southern’s own goals have created sector’s Water-gate

Analyst Nigel Hawkins gives his view on the fallout of the Southern Water case and the parallels with a more infamous scandal.

Last week, Ofwat announced it was docking Southern £126 million – £123 million payable through customer rebates over the next five years and £3 million of fines.

In a frank assessment, Ofwat accused Southern of not operating some of its waste-water treatment plants properly ……. and found that it ‘manipulated its waste-water sampling process’ which resulted in it misreporting key performance data: these activities apparently spanned the 2010-17 period.

These are serious allegations – and the issue may eventually end up in court via the Environment Agency (EA).

Indeed, there is a whiff of the infamous 1970s Watergate scandal about the saga.

The original offence of operating spilling waste-water plants was bad enough – like the Watergate break-in – but it was compounded by the alleged seven-year cover-up of the sampling manipulation – like the Nixon White House’s infamous efforts to obstruct justice.

Ofwat’s chief executive, Rachel Fletcher, was visceral in her criticism.

“What we found in this case is shocking. In all, it shows the company was being run with scant regard for its responsibilities to society and the environment. It was not just the poor operational performance but the co-ordinated efforts to hide and deceive customers of the fact that are so troubling.”

Strong words indeed.

Given that handling wastewater from its four million plus customer base is the key activity of Southern – its clean water provision is diluted by the presence of many former statutory water companies in its wastewater area – such lapses are difficult to overlook, especially since Southern has been in the private sector for almost 30 years.

More generally, given the current political environment and the Labour Party’s radical water re-nationalisation policy, such failings will hardly help the water sector as it seeks to counter the re-nationalisation threat.

No doubt, some senior water company executives will be unimpressed by the blatant own goals conceded by Southern.

In recent months, Southern has faced other challenges, notably the on-going AMP 7 periodic review. Its business plan, along with that of the struggling Thames, was rated in the lowest ‘significant scrutiny’ category.

Only the three quoted water companies, United Utilities, Severn Trent and Pennon – the owner of South West – were rated as ‘fast-trackers’.

More seriously for Southern, its test area assessment results showed up several shortcomings, with three D ratings being recorded.

First, on ‘securing long-term resilience’ in a supply area with an expanding population and lower than average rainfall, Ofwat was far from impressed by Southern’s submission.

It concluded that Southern ‘presents a plan that falls significantly short of high quality with little and unconvincing evidence of how the company has assessed risks and consequences to its systems and services’.

Secondly, Southern’s cost efficiency record attracted further Ofwat criticism.

In particular, Ofwat noted that Southern’s ‘wholesale waste-water costs are around 26% above our view of efficient costs’. Admittedly, the cost figures on clean water were less dire.

Thirdly, under the ‘accounting for past delivery head’, Southern was criticised for its poor performance on major incidents. Four prosecutions from the EA and the Drinking Water Inspectorate (DWI) were highlighted by Ofwat.

To be fair, Southern will have responded to these – and to other – concerns expressed by Ofwat when it re-submitted its business plan. New chief executive Ian McAulay told Utility Week following Ofwat’s announcement about some of the changes that have already been made.

Furthermore, much of the criticism related to historic events; to that extent, today’s scenario may be somewhat different.

Looking forward to December 2019, Southern will eagerly await details of Ofwat’s AMP 7 draft determination covering the five-year period from April 2020.

Given Ofwat’s indicative 2.4% Weighted Average Cost of Capital (WACC) figure, financial returns will inevitably be pared back – substantial cost cutting seem probable.

Having been placed by Ofwat in the ‘significant scrutiny’ category, notwithstanding the varying mishaps it has faced in recent years, Southern can hardly expect a particularly positive final determination.

But it does have one advantage, namely the need to retain investment grade status, as prescribed by the credit rating agencies. Any credit rating beneath this coveted benchmark may lead to materially higher financial costs for the heavy investment programme.

This factor acts as a powerful financial floor for the water companies, irrespective of how dire their performance may have been.

And, rather like British Telecom’s pension deficit joker, this card can be played against the industry regulator when the going gets particularly tough.

Although Southern’s predicament may look pretty grim, it is arguably better placed than Thames, with its £11+ billion of net debt and a much-criticised water leakage record.

Indeed, with its chief executive suddenly exiting, a major responsibility falls on chairman, Ian Marchant – with his decades of utility regulation experience – to right a rocky ship.

Whilst its leakage levels are far less of an issue compared with Thames, Southern has faced major intervention from the Pensions Regulator (TPR).

Last December, TPR confirmed that Southern will pay an additional £50 million into its pension fund: its March 2016 deficit was £252 million.

TPR’s executive director of frontline regulation, Nicola Parish, pulled no punches.

“The company and trustees’ decision in 2015 to halve contributions to the pension scheme and pay them over an extended period whilst later paying substantial dividends, despite a growing scheme deficit, meant the risk to member benefits was unacceptably high. This has now been addressed.”

This ruling may have important repercussions beyond the water sector with TPR intervening more frequently – and earlier – in under-funded company pension schemes.

Clearly, Southern’s management does not lack challenges, not least the crucial final determination in the on-going periodic review. Undoubtedly, this issue has to be the highest priority McAulay, who was appointed in 2017.

And there has now been a full apology for the waste-water spills as well as agreement with Ofwat on the £126 million of penalties.

Furthermore, bad though the wastewater spills were, they do not begin to compare with the infamous Camelford pollution incident in Cornwall in 1988, whose repercussions persist to this day.

Meanwhile, Southern will no doubt hope there will be an end to the Watergate-type ‘follow-the-money’ penalties levied by critical regulators.