Stock story: Severn Trent

By delivering improved water services and a cleaner environment, the UK utility’s investors enjoy outsized returns.

Stock story: Severn Trent

Severn Trent is one of the largest regulated water and sewerage companies in the UK, supplying 2.0 billion litres of drinking water and treating 3.2 billion litres of wastewater each day for its 4.6 million customers in the English Midlands and Wales.

The company operates within a transparent and prescriptive regulatory regime, where tariffs are set by the Office of Water Services Regulatory Authority for five-year periods. In accordance with precedent, the regulator fixes tariffs in a manner that allows a standard utility to recover its efficient costs of operations. At the same time, the regulator must ensure that water and sewerage companies can finance their activities; in particular, by securing reasonable returns on their invested capital.

At the review finalised in 2019, the regulator’s assessment of a reasonable return on equity for water and sewerage companies was approximately 3.2% p.a., expressed in real (inflation-adjusted) terms – a meagre return, even accounting for the benign risk profile of a utility supplying the most basic of human needs.

Yet closer examination reveals that the regulatory regime can support returns well above what is allowed. For the five years to March 2020 (when the reasonable allowed return was 5.6% p.a.), Severn Trent achieved an average real return on regulatory equity of 8.5% p.a., 2.9% ahead of the regulator’s ‘baseline’ allowance. This outsized return represents the reward for exceptional efficiency and operating performance.

Under the UK’s model of incentive regulation, water and sewerage companies can generate excess returns in three ways. The first is by delivering their investment and service package at a lower total cost than the regulator’s assessment of what it would cost a notional, efficient utility. The second way is by raising debt at levels below the notional allowance determined by the regulator. The third is by delivering service and environmental improvements under the regulator’s ‘outcome delivery incentive’ framework.

Severn Trent generated excess returns on these parameters during the most recent five-year regulatory period, but it was on the final lever, outcome delivery incentives, that the company excelled.

Through targeted investments in its infrastructure, Severn Trent reduced external sewer flooding events by 48%, cut sewer flooding incidents occurring inside customer homes by 20%, and delivered a 21% reduction in the discharge of pollutants from its treatment plants, securing the company a net reward of 174 million pounds for the five years. In addition to providing a better experience for the Severn Trent customers, these achievements contributed to restoring the environment, improving the quality of rivers spanning 1,600 kilometres, and enhancing the biodiversity of 244 hectares of land.

With the first year of the current five-year regulatory control period having recently ended, Severn Trent appears poised to again reward investors by delivering improved customer service and a cleaner environment.

In its fiscal third-quarter trading update, the utility noted that it has reduced sewer blockages by 25%, cut pollution incidents by a further 15%, and delivered over 2,200 hectares of enhanced natural environment through its biodiversity program during the year to date. These results prompted management to inform investors to expect net rewards of at least 50 million pounds when the company reports its full-year 2020-2021 results in May.

Sources: Company filings.

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