United Utilities Group PLC (OTCPK:UUGRY) Q2 2023 Earnings Conference Call November 23, 2022 4:00 AM ET
Company Participants
Steve Mogford – Chief Executive Officer
Phil Aspin – Chief Financial Officer
Conference Call Participants
Mark Freshney – Credit Suisse
James Brand – Deutsche Bank
Martin Young – Investec
Pavan Mahbubani – JPMorgan
Ahmed Farman – Jefferies
Dominic Nash – Barclays
Steve Mogford
Good morning, ladies and gentlemen and welcome to United Utilities Half Year Results Presentation for 2022-23. The UK has seen very significant political and economic turbulence this year. However, we have not allowed this to deflect us from delivering value for customers, the environment and shareholders through operational excellence and sound financial management. And in so many ways, we reflect calm confidence in the storm.
Over the last decade, we have had a clear strategy to ensure United Utilities is continuously improving and delivering better outcomes for all our stakeholders year after year. We have made significant targeted investment over that period to improve our operational performance to provide a better service for customers, to become a sector leader in the environment, and to build a business with a strong, resilient balance sheet, and this strategy has delivered real benefits and created value for all our stakeholders. Plans for AMP are also coming together and the need is becoming clear for very significant increases in capital investment for the sector over the next and subsequent AMPs to meet new and demanding environmental regulation. And whilst there’s still a lot to be done before we know what this will look like, we are supportive of the drive to go further for the benefit of all of our stakeholders and I will talk more on this later.
So here are the performance highlights at the half year, this is a tough time for customers, and we’re helping more than ever before with payment assistance schemes. Our focus on operational excellence, leveraging our systems thinking investment has again delivered year-on-year improvement in performance. This spring and summer has been particularly dry across the UK, but with effective management, supported by the investment we’ve made in our water network, we’re able to avoid the need to apply the restrictions seen elsewhere across the country.
Our improving environmental performance has again been recognized with a top 4-star rating by the environment agency. And River Health and spills into the environment are huge areas of focus for us, and we’re making good progress on our better rivers, better Northwest planned. As a result of our efficient performance and targeted investment, we are one of the top performing companies on ODI rewards and continue to target a net AMP7 ODI reward of £200 million, some 5x higher than our AMP6 reward. The government’s new Environment Act sets out an ambitious agenda for environmental improvement with the water sector required to make a major contribution. Achievement of the government’s targets will require a very significant uplift in capital investment for the sector in AMP8 and beyond. And through what has been a difficult macroeconomic environment, our financial position has been resilient.
The Northwest is home to the most socioeconomically deprived communities in the UK and the current economic climate will make life more challenging for customers. We work extremely hard to understand our customer situation and find ways to help. And we’re supporting more customers than ever before, over 200,000 households and have committed a significant package of affordability support worth around £280 million for this AMP, the largest in the sector.
Measures against a broad spectrum of companies in the UK, we have a class-leading set of tools and techniques to help customers with our most recent innovation being open banking. With the customer’s consent, we can use open banking technology to access a customer’s bank account and verify their income. And this allows us to complete all the necessary checks we need to get support in place for customers in minutes instead of days, proof if ever we needed it, that great service costs less. We have long had a strong focus on supporting customers with affordability challenges. However, we recognize there’s always more that can be done. And this is why we’re strong supporters of the national social tariff proposal put forward by the Consumer Council for Water to level up affordability support across the country. This will provide much needed help to families during these difficult times. I mentioned earlier that our determined application of systems thinking through investment in people, process and technology is paying dividends through continuously improving and sustainable operational performance. Over successive apps, we’ve seen increasing levels of customer satisfaction, environmental and operational performance, all creating shareholder value.
Water sector environmental performance is very much in the headlines and I’ve said that the Environment Agency awarded us the top 4-star rating for our environmental performance last year and for 5 of the last 7 years. This is against the backdrop of a continuously evolving and tougher assessment methodology, and we’re consistently 1 of the top performing companies in the sector.
Adding some color, with the sector’s frontier performer on pollution performance. And the investment I’ve told you about previously in Dynamic Network management is helping deliver our lowest ever levels of sewer flooding, improving our ODI performance for this metric. Our investment in River Health is helping to reduce spills from storm overflows. And I’ll talk in more detail about this shortly. We’re on track to meet our leakage target for this AMP, using latest detection techniques to find and stop leakage. And in addition, we are successfully reducing voids, finding properties using water, but not being built. I’ve mentioned previously that we’ve made additional investment in mains pipe cleaning to improve water quality through reducing discoloration that customers’ taps. And once again, this is paying off with our lowest levels of discoloration contacts from customers turning what was an ODI penalty last year into an expected ODI reward for the year.
We continue to perform well on customer satisfaction with our combined C-MeX score for the first half of the year, positioning us in the upper quartile of water and wastewater companies and the top-performing listed company. All of the above and more is serving to support our target of 200 million total net ODIs for AMP7, and we’re on track to achieve a £30 million net ODI reward this year. The dry weather this summer brought water supply resilience into sharp focus, particularly in the southern half of the UK In July and August some areas of our region received less than half of the rainfall typically expected during these months. But effective management of our real-time water production planning system enabled us to optimize abstraction to keep reservoirs as full as possible.
In addition, we are benefiting from the investment we’ve previously made in our integrated regional system. Some of you saw firsthand the work to enhance resilience of our water system in Cumbria during our Capital Markets Day earlier this year. This supports the movement of large volumes of water around our network to balance customer demand and optimize use of resources. Alongside optimizing water availability, we worked hard to deliver significant customer campaigns around water efficiency, leveraging the link to energy for water heating. And as a result, we have seen an 11% reduction in per capita consumption when we compare the first half of this year to the same period last year. And this helps to improve regional water resource resilience and ODI performance as well as helping customers to keep their bills down. As a result of these actions, we’ve not had to introduce any customer restrictions this summer. However, we’re not complacent we know that there is more to do in this area to help us become stronger and even more resilient.
I spoke to you in May about our Better Rivers program to improve river health in our region. River Health and spills into the environment is a key issue for all our stakeholders, and it’s a huge area of focus for us, too. Our original AMP7 plan provided £230 million of investment in environmental improvements. And I previously told you that we had enhanced this with a further £250 million to get a head start on requirements emerging for AMP8. This allows us to responsibly accelerate improvements, which is absolutely the right thing to do.
Combined storm overflows or CSOs, are very much in the headlines with the government setting ambitious targets to reduce spill frequency across the country. And we’re fully engaged with this ambition and have already made great progress delivering a 29% reduction in the number of reported spills last year compared with our 2020 baseline. We had targeted a 33% reduction between 2020 and 2025, but our great progress so far suggests that will beat this ambition. This targeted action and investment is enhancing our environmental performance and delivering sustainable performance of our wastewater networks against a backdrop of increasing regulatory standards. In addition, last week, we hosted the region’s first Future Rivers Forum, bringing together several organizations to collaborate to improve the quality of our rivers. These activities are helping us deliver on our four-step plan to improve River Health.
The government’s Environment Act 2021 sets out an ambitious program of environmental improvements. The most high-profile component which has received much of the public attention is the ambition to reduce spill frequency from storm overflows. These are so assist and pressure relief valves, and we have over 2,000 of them across our network. Estimates prepared for government point to around 60% of the sector investment necessary to meet their targets needing to be made in the north. And this is a reflection of the nature of the long industrial legacy and higher rainfall in the region. This is only part of the story.
Another driver is the desire to further reduce phosphate release into the environment from wastewater treatment works by 80% across the country by deploying the best technology currently available. And in addition, there is several areas across the country where further development is prohibited unless neutrally imbalance can be corrected in which the water sector can play a part in the solution. There are other less significant drivers that combined to produce a patch work of statutory requirements, we’re required to satisfy.
Our Better Rivers program was our first step in making an early start on these requirements. But the government has asked us to go faster, and we’ve responded by identifying additional investment that could be accelerated as transitional investment from AMP8 into AMP7. We’re still early in the process of scoping and costing the environmental program for AMP8, but early indications are that we may need to invest significantly more than the average over the last two AMP periods. And this is only AMP8 but it’s clear that AMP9 and beyond could present similar opportunities.
Affordability and deliverability of a program of this size are important considerations and we’re therefore, in discussion with regulators on the pace of the investment. We’re unlikely to know the actual size of the program until much later in the AMP8 process. But early indications are that we are facing a period of significant growth in capital investment and with that, much higher RCV growth.
I will now hand you over to Phil to take you through the financials.
Phil Aspin
Thanks, Steve and good morning everyone. This year has seen both a continuation of a challenging macroeconomic environment, but also the realization of significant inflation alongside higher interest rates. While both of these factors have a material impact on our reported and underlying results, the economic performance of the business, reflecting a regulatory model remains robust with the company on track to deliver an improved rate of return on equity or ROE this year.
In today’s presentation, I will focus on how we’re managing our cost base, our strong balance sheet and our resilient pensions position. And to finish, I’ll provide some updated guidance for the full year to March ‘23. Here are the key financial highlights for the half year. Revenue is down 1% at £919 million as a result of consumption being lower than expected. Household bad debt has remained stable at 1.8% of regulated revenue. Underlying operating profit of £259 million has been impacted primarily by inflationary increases on core costs. As a result of higher inflation and in particular, its impact on finance expense, we have a small underlying net loss for the first half of the year and an EPS of minus 1.8p per share.
In contrast, our reported EPS is 51.8 per share, reflecting the significant fair value gains arising from higher interest rates. The interim dividend per share is 15.17p, in line with our policy. Inflation on core cost is being actively managed, and we are well positioned with a current pay deal agreed at 4.75%, virtually all our base capital program on contract and 96% of power costs fixed for the year. We continue to have one of the strongest balance sheets in the sector with RCV gearing of 60% and a pension scheme, which is fully funded on a low dependency basis, and which has been resilient to the recent market challenges. And finally, we have a strong liquidity position, having raised debt early in the AMP at attractive rates. I’ll now consider these points in further detail.
So, let’s look first at our household cash collection and bad debt performance. We are driving continued growth in customers on direct debit. This provides us with a strong starting position for our collections activity, which has continued to be robust in the first half of the year. At 81%, we have 1 of the highest proportions of customers on direct debit over payment plans within the sector, providing a high level of collection certainty for a significant proportion of our revenue. We’re very conscious of the difficult times that customers may face over this winter and are utilizing data and technology efficiently, allowing us to act early and swift way to support customers. Good examples of this are our nudge activity of customer behavior changes and open banking, which helps customers to efficiently access support tariffs and reduces our cost to serve for these customers. This all supports our lowest ever level but household bad debt at 1.8% of regulated revenue.
Underlying operating profit of £259 million is down £74 million, this principally reflects the decrease in revenue, inflationary increases in our core costs, investments in driving ODI performance and costs associated with incidents resulting from dry weather over the summer. Revenue is £13 million lower than the first half of last year. Over-recovery in the prior half year broadly offsets the allowed inflationary increases in the current half year. The remaining reduction in revenue is driven by lower consumption as we focus on reducing per capita consumption, which supports our water resilience position and benefits our PCC ODI. The £19 million impact of lower consumption in the first half of the year will be recovered in revenue in the financial year ending March 25.
We are not immune to the global inflationary pressures, and as a result, we have experienced inflationary pressures on input costs with the largest impact to power and chemical costs, resulting in a £36 million increase in the first half of the year. We have invested an additional £9 million in infrastructure renewals expenditure associated with dynamic network management and water quality and which is targeted at improving ODI performance. And during the exceptionally dry summer, we experienced three a typically large burst in our water network, resulting in around £8 million of cost associated with network repairs, customer support and compensation. As these were core operational incidents, they have not been excluded as adjusted items in our underlying measure of performance. As we noted at the full year, the accounting change towards the end of last year in respect to Software as a Service, now results in cost of £3 million being treated as OpEx rather than CapEx. So we’re very focused on the actions we can take to mitigate the impact of higher inflation. And while we’re not immune to the macroeconomic challenges we all face, we are well positioned.
Let’s first look at how we are managing the near-term impact of inflation. We agreed our pay deal for the current year at 4.75%. Our decision to accelerate AMP7 investment means our base capital program is already 98% let under target pricing arrangements, providing confidence of supply chain resource in a challenging environment and incentivizing efficient and effective cost management. We’ve already delivered around 65% of the program only halfway through the AMP, giving an increased level of certainty on costs.
On power, we are in a strong position, having increased our hedge to 96% for the current year. And as we look forward, we continue to focus on tightly controlling our cost base, although it’s also important to understand how the regulatory mechanisms mitigate this impact. We expect a higher non-cash indexation charge in our inflation-linked debt this year. Inflation-linked debt equates to around 30% of our RCV, with a full RCV benefit, therefore, being around 3x the non-cash indexation charge although, as you know, the RCV benefit is not reflected in the income statement. The regulatory contract also allows for inflation indexation of a totex allowance, providing mitigation to inflation on core costs. Each 1% increase in CPIH over the AMP will result in around £600 million increase to the RCV and around £150 million increase in the totex allowance.
At our full year results in May, I gave a lot of detail on our power position and hedging policy. We came into the year in a strong position and now have 96% of our consumption locked in on contracted rates for the current year. This has helped us control power cost at an average rate of £85 per megawatt hour, which compares favorably to the energy price cap of £211 per megawatt hour through the second half of the year.
Our hedging policy has created significant value as we have the benefit of the hedge, our power cost would have been around £75 million higher for the full year. As a result of our hedging strategy, we’re also focused on driving energy efficiency across the organization, minimizing usage and maximizing benefits from time of usage. We continue to benefit from 25% of our power needs being sourced from self-generation and long-term power purchase agreements. The sale of our Energy business, which completed in September, has unlocked capital, but we will recycle back into projects to support our journey towards net zero. At the same time, we have locked in the price of the energy from those assets sold through long-term power purchase agreements, or PPAs. Lastly, our long-term power hedging policy is demonstrating its effectiveness. We’re in a strong position for the rest of the AMP and have locked in a large proportion of our energy needs at favorable prices.
So let’s now focus on finance expense. Our underlying net finance expense for the first half of the year is £267 million. This is £132 million increase from the prior half year, largely reflecting a significantly higher inflation applied to a non-cash indexation of our index-linked debt. Our reported net finance income includes a significant fair value gain of £403 million. This reflects the benefit we will receive in our underlying cash interest expense in future periods from having fixed rates on our nominal debt.
Turning to our forecast for FY ‘23, we now expect underlying net finance expense to be around £165 million higher than the previous year. This increase relates to the non-cash indexation on our index linked debt due to the higher inflation. But importantly, our cash interest for FY ‘23 is expected to be broadly the same as FY ‘22. We have provided our current forecast along with the main components of our finance expense for FY ‘22 and the first half of FY ‘23 in the appendix to this presentation.
Let’s now look at how well we are positioned on financing. First, we are ahead of where we need to be, having raised a significant financing in the first half of the AMP. We have a strong liquidity position with over £1 billion of liquidity, enough to take us through to almost the end of the AMP7 period. This means we have flexibility to choose when and how we issue to maximize best value. Second, we have a strong track record of outperforming the debt index for new debt, typically by between 50 and 100 basis points as illustrated on the chart in the appendix. This, together with the acceleration of our financing means we benefit from the debt indexation mechanism in a rising interest rate environment. Third, we are also benefiting from having issued debt early in the AMP, which locked in historically low long-term yields, all of which puts us in a robust position from which to navigate the second half of the AMP.
Now turning to our strong balance sheet. To the left of this slide, we have a bridge of our net debt position from March 22 to September 22. Net debt of £7.8 billion has increased by £259 million since March 22, with the usual underlying movement shown in the bridge. High levels of inflation have impacted both net debt and our RCV and therefore, RCV gearing has reduced slightly to 60%.
At the full year, I provided a view of how the investments we’re making in AMP7 together with the expectations of inflation, we’re expected to drive higher RCV growth through this 5-year period. So right of this slide, I’ve provided an update to this reflecting our current expectations of inflation, our nominal RCV growth over the 5-year period is now anticipated to be 27.5%. This means we expect to exit AMP7 with an RCV of £15.1 billion and gearing trending towards the lower end of our 55% to 65% target range, which comfortably supports a stable A3 credit rating with Moody’s.
Now to touch on pensions as it’s been a challenging time for many pension schemes over the last few months. As of September 22, we had an IFRS pension surplus of £824 million and remain fully funded on a low dependency basis, with no ongoing pension scheme deficit contributions payable. Our clear and effective risk management policies enabled our schemes to successfully navigate the recent challenging market conditions.
And as I mentioned at the full year, we are now exploring with our trustees further derisking options, and this process remains ongoing. This slide sets out our update for the outlook for the year to March 23. We expect revenue to be around 1% lower year-on-year with consumption trends we’ve seen in the first half of the year expected to continue into the second half. The £34 million expected impact from lower consumption will be recovered through increased revenue in FY ‘25.
Underlying operating costs are expected to increase by around £130 million around £80 million reflects inflationary pressures on operating costs, principally power, chemicals, labor and other contract costs. Around £30 million reflects the increased scope and includes the FY ‘23 element of incremental infrastructure renewals expenditure in relation to the investment we previously announced. The remaining £20 million reflects typical costs, including the dry weather costs incurred in the first half.
As I’ve already mentioned, higher inflation materially impacts our index-linked debt. And as a consequence, we expect our underlying finance expense to be around £165 million higher. Further details of the assumptions are set out in the appendix to this presentation. And we expect an underlying tax charge of between £5 million and £10 million for the full year as we continue to optimize capital on super deductions and efficiently manage the group’s tax position.
CapEx for the year is expected to be in the range of £660 million to £750 million, a small increase on the guidance given in May as a result of revised phasing. And this includes the FY ‘23 elements of incremental CapEx in relation to the additional £765 million investment we previously announced. We’re targeting a customer ODI reward of around £30 million, consistent with our investment plans and our AMP7 guidance on ODIs and with higher expected financing performance alongside our improved ODI performance this year, ROE is expected to be higher than the 7.9% reported last year.
Finally, our dividend policy remains unchanged, and we expect dividends in FY ‘23 to be in line with our AMP7 dividend policy of growth year-on-year by CPIH. And so to conclude, we’re in a robust financial position. We are actively managing the near-term impact of inflation driven by wider macroeconomic challenges and we benefit from higher totex allowances and RCV growth. Despite the cost of living challenges, our focus on supporting customers and our approach to debt management means that household cash collection has remained robust with our bad debt position stable at 1.8%. And finally, we have a strong balance sheet with a sustainable level of gearing and a leading pension position enabling us to capture the opportunities for future investment.
So thank you and I’ll now hand back to Steve.
Steve Mogford
Thanks very much, Phil. So to summarize, we see the huge challenges that many of our customers are facing as a result of cost of living increases and are supporting more customers than ever through our sector-leading package of support. Our investment in Systems Thinking is delivering sustainable improvements in operational performance and is helping us to deliver one of the best ODI positions in the sector and continue to target an ODI reward for AMP7 of around £200 million.
Effective management supported by previous investment has helped us deliver a reliable and resilient water supply throughout the dry spring and summer. We’re improving river health and reducing spills into the environment through our Better Rivers and better Northwest plan. And our focus on tight cost control is helping us to navigate the current macroeconomic challenges and with a robust regulatory model with a strong economic position. And looking to the future, the government’s Environment Act creates significant drivers for increased investment in AMP8 and beyond. We’re supportive of the drive to go further to deliver a better environmental outcomes for the benefit of all of our stakeholders.
So thanks very much for listening, and we will now take questions.
Question-and-Answer Session
A – Steve Mogford
So the first question we’ve got is from Mark Freshney, Credit Suisse. Mark, can I – can you hear? Mark, you’re on mute. Okay. We’re struggling to hook up with Mark. Should we try James, who is also there? So, if we can get to James and we will come back to Mark, if we can connect. James? Can’t hear you.
Mark Freshney
[indiscernible]
Phil Aspin
That’s Mark Freshney.
Steve Mogford
That was Mark Freshney we had there. Yes. No, we will go back to Mark excuse for a second, Mark. So – but James, we can hear you now.
James Brand
Okay. Great. Fine. So look, two questions, one for Steve, one for Phil. For Steve, you mentioned in the environmental rules driving kind of stronger ramp growth, is there any more detail you can give on that? What kind of projects you think you might be doing in the next regulatory period, big projects that will be driving CapEx? And is there any kind of quantum you can share with us for what that might look like you do in terms of millions of CapEx spend a year or ramp growth coming through? And the second question for Phil, the fixed rate debt in a declining kind of balance hedging. Could you – firstly, could you confirm that’s roughly linear as we go through the next 10 years because that would imply that you’d hedged more than half of your fixed rate debt for the first year of the next regulatory period, which I think would be quite reassuring. Thank you very much.
Steve Mogford
Okay. I’ll pick up the first question, James. Thanks. Yes, the – as I mentioned before, there are a number of drivers. One is the overall driver to reduce essentially the number of times that CSOs operate. And that essentially will require either significant reconfiguration of our systems, which might be, for example, construction of storage so that we can hold more storm water, most of which is surface water at the time that we get storms or it may look at natural solutions as to whether we can convert what those pressure relief valves into more natural solutions, red beds and others where stuff is being released before it gets into rivers. And then I mentioned also that with an 80% phosphate reduction, there is quite a lot of work on our wastewater treatment works to effectively implement the latest technology that does that. I think at the moment, we’re seeing – if you look for a strict interpretation of the current requirements, we’re seeing a huge program for AMP8, which is several multiples of what we would spend literally high single-digit multiples of what we would spend in conventionally in an AMP period. I don’t – and I think there are two components to that. One is the issue of affordability, what that would do to customer bills at a time that’s difficult. The other is when you are working on your system, so extensively, how do you maintain current levels of performance whilst you’re actually taking stuff out. So the government has essentially asked for us to put forward a fairly straightforward expose of all of that in terms of what that means. And then I think we will be getting into a conversation about pace as to at what rate should be meeting those requirements. I think just to sort of put a little bit of color on it. I mentioned that in the north, the requirements are particularly large for northern companies and principally us and Yorkshire. I think there is also something of a high driver in Wessex Waters area.
But just between us and the North, we account for something over 60% of the total investment needed just in CSOs alone. And therefore, the challenge for the rest of the country in terms of size of program is relatively small once you’ve divided that up amongst all the other companies. So I think the issue there for us and the conversation with government to arrive at what that final program size would be will be very much driven by, a, what do we want to see on customer bills during the period? And then just generally, how much can you do over a 5-year period. So we are looking at resources, we look understanding how we deliver a large program. But I think whatever you do, it would require government to essentially adjust the pace of delivery in order for the bill impact and the total amount of work to reduce during AMP8. So there is a conversation to be had there. And I think our business plan will reflect whatever that conversation arises. But whichever way you look at this, it’s a very significant increase on the capital expenditure. And obviously, from a – the opportunity for us is huge interventions to improve our wastewater system or performance, but also RCV growth that would go with it. So, yes more to say on this as we go through those conversations and we will probably have an update when we get to full year as to where those conversations have taken us. Phil?
Phil Aspin
Okay. Good morning, James. The short answer is you’re quite correct, sort of building on that a little bit further. I think there is probably four key points I’ll pull out. Firstly, our hedging policies are very clearly and transparently set out in our annual reporting accounts. So it is a very clear sort of position articulated there. So secondly, I think in the context of nominal debt, we have that 10-year reducing balance approach to hedging. So effectively, we do hedge out into the next AMP period. And the reason we do that and the approach we take is very much mirrored towards trying to best reflect the economic model that the regulator follows in terms of the cost of debt allowances. So that’s what we’re trying to sort of always manage and match off the cost of debt towards. So I think that positions us very, very favorably. And finally, sort of fourth point, I guess some of the impact of that you’ve seen in the reported results today because effectively the reported results had that large fair value gain on some of the interest rate derivatives that are hedging forward interest rate cost. And as I said in the presentation, that will unwind through the underlying interest position over future years, and that’s how that benefit will support the operating result going forward.
Steve Mogford
Thanks, Phil. Okay. Thanks, James. Can I – can we move to Mark now, please? I think we’ve got you now, Mark. Yes.
Mark Freshney
Perfect. Can you hear me, okay?
Steve Mogford
Yes, we can. Thank you.
Mark Freshney
Perfect. Thank you. So Steve, you mentioned bringing some spend from AMP8 into AMP7. Can you talk about the regulatory mechanism because the government may want you to do the work, but you’re kind of stuck between governments and people who stipulate what the CapEx should be and regulators. So can you talk about how that would come through an extra allowance rather than totex sharing? And if you could also talk about these large numbers, I think the point that you didn’t mention was local supply chain, mobilizing labor to do some of these works is it’s a massive process. Could you also talk about ramping up the supply chain for this? Phil, inflation, can you let us know what RPI assumptions you’re running for December to get to the guidance? And also to get to the £15.1 billion RAB and could you also talk about the – I think it’s £4.2 billion of inflation-linked bonds or RPI-linked bonds. I believe that hardly any of them have clauses in preventing the principal going down in a period of deflation, which is a valuable risk here given what’s happening to natural gas in Europe. So if you could talk about those things that would be great? Thank you.
Steve Mogford
Okay. Thanks, Mark. I’ll pick up the first couple of questions then. Yes, the – I mentioned that the government is quite keen that we don’t wait until AMP8 to start the delivery of the – their ambition on the environmental improvements. So what they have done is they have come out to industry with regulator engagement and support to say what would you do in the last couple of years of the AMP that essentially would give us an early start. Now bear in mind, we’re already doing – and I mentioned we’ve got £250 million of work that we’re already doing on Better Rivers. But we’ve gone back with a program of a total program, which is around £300 million as a number of work that if it was approved, we could effectively deliver during that period. Whether we get all of that Mark, I suspect we may not. And therefore, it’s not something to bake into numbers at the moment, but essentially, that’s what we’ve done. The mechanism is what we call transition investment. A number of years ago, we talked to the regulator to say that doing work in 5-year chunks is not necessarily an efficient way of doing things, be great if we could essentially start work on the next AMP at the end of the current one, but that would essentially be considered AMP8 expenditure. And so it’s – what we’re looking at now is this as an extension of that principle for transition investment. But rather than simply being applicable for the last year of the AMP, it would now be applicable from approval of that investment. So let’s say, over the last 2 years of the AMP. And the way that, that would effectively operate or certainly what we proposed is that it would be an AMP8 expenditure, but it may well be essentially logged up as a midnight adjustment at the end of AMP7. So – and mostly go to RCV. So essentially, that is the proposal. We haven’t – we’ve had quite a lot of dialogue as have others with it – with regulators and with government about company proposals. We think that we might know something by the time we get to Christmas in terms of what is likely to be approved. So a fairly significant package of work. We may not have everything approved as you saw in green recovery. There were choices exercised about what we do. But essentially, that’s the mechanism.
I think in terms of labor mobilization, it’s quite true that because our program is very significant potentially in the Environment Act requirements. And as I said, we, in the north between us and Yorkshire are sort of over 60% just of the CSO program. We are now working to look at supply chain arrangements both how one would mobilize additional supply chain resources to be able to deliver a more intense program but also our own resources in terms of program managing that. So quite advanced in those – in that thinking in those conversations. But you’re absolutely right. We would normally be delivering a program of what, 600 million, 700 million over the period, an environmental improvement we’re now talking of potentially multiples of that, and that will require us to enhance the supply chain. I think one of the issues to consider here is, of course, at the moment, infrastructure investment is really quite heated. We have the advantage of, as Phil said, of having about 98% of our capital program committed. That doesn’t just bring pricing advantage, but it also brings resource availability because we’ve locked in those programs with our suppliers. It’s very difficult at the moment. If you haven’t got work committed to get it committed and to get it committed at a price that’s acceptable, but I think as we start to move into AMP8, the macroeconomic impact will be resources will become available because we are seeing certainly in terms of areas of private investment and that’s being held back at the moment. So I think we may well see resource picture improve as we roll into AMP8, but certainly a lot of planning on our part as to how we deliver a much larger program. Phil?
Phil Aspin
Okay. Good morning, Mark. Two questions, inflation and then the inflation-linked bonds. In terms of the forecast in the appendix to the presentation, there is a sort of detailed slide that has the assumptions on for the inflation numbers for January, which is what will drive the inflation-linked debt, indexation charge for the full year. So in some respects, really helpful guidance for analysts because – if you have your own views of what inflation is going to be, you’ll be able to substitute that and update guidance real time effectively as we go through the next few months, recognizing that the inflation environment remains very volatile. And then your second question was on the sort of £4.2 billion of index-linked debt and sort of what happens if rates – if inflation goes negative, clearly, the position there is very much set out in the trustee. So that’s a matter of public record. And I would encourage people to go and have a look if they really wanted to rely on the answer. But my understanding, Mark, is that effectively. If inflation goes negative, I think we will see the benefit of that for our index-linked debt position as well. And that’s always been one of the big benefits of our index-linked hedging policy is a reflection of we’re not trying to call the market. We’re not trying to call what the future views of inflation will be. And the debt is there to sort of provide mitigation for sort of downside inflation sort of as well. So a very valuable point to be aware of going forward, I suppose.
Steve Mogford
Okay. Thanks very much, Phil. Thanks for that, Mark. We’ve now got Martin Young, Investec. Good morning, Martin.
Martin Young
Yes. Good morning to everybody. I hope you’re well. A couple of questions please. Getting back to the cost of the CSO investment and how this is skewed to the north of the country, any conversations going on about some kind of smearing of the cost across the whole of the country? I’m conscious that there are mechanisms that provide help to water customers in the Southwest of England and there are mechanisms that provide help to customers in electricity in the north of Scotland. So there are some precedents where this kind of sharing does go on. And then the second question that comes off the back of everything you’re saying about potential significant uplifts in spend in AMP8. I would say in the past that the stance taken by the regulator is to have squeezed on totex and arguably squeezed on returns. Maybe you could just share some thoughts as to where you feel the regulatory mindset is changing to be one of allowing more investments and arguably allowing a fair return on that investments? And then if I can squeeze 1 very small one. And I missed the number that you were giving in respect of transition expenditure that you were hoping to get approved in AMP7. So if you could just refresh mine nor do that one, please?
Steve Mogford
Okay. Alright. Thank you. I think certainly, when it comes to the CSO investment, the concept of smearing. I think when this was first considered by government, and they conducted their own review of what the potential cost of this program might be. When you looked at it as an average across the country, it was actually relatively small. By memory, it was mid £60 on customer bills. And I think at that point, when those – that program was being considered. I don’t think we’ve had the localized implications of some of the changes fully understood. I mean that is effectively now emerging. I think it will be difficult to see a smearing as you called it, of the investment across all customer bills. I think that might well be seen as being unfair for those customers where, for example, they don’t have the same levels of combined sewers. We have, in the Northwest, something like 57%, something like that 56%, 57% of our sewer system is combined, which basically means you’re getting surface water and fall water mixed in the sewer systems. And that’s how they were constructed. It’s a legacy of the Industrial Revolution. It’s a legacy of urbanization. It’s a design choice that was made well before privatization. And the average across the country is below 30%. It’s sort of 26%, 27%, something like that.
So I think we – whether from a regulatory standpoint and just the context of fairness, you’d see that spreading. I think that it is more likely that we would see the program being spread over time. I mean on CSOs, the objective is to get to 10 pills by 2050. As I said earlier, we have a patchwork of requirements that drives very early investment in AMP8 and AMP9 to meet the current targets. Clearly, that’s an area to be discussed as to whether we need to go quite as fast. I think there are areas – you’re absolutely right. If you’re thinking there are precedents in the water sector, Southwest Water, I think, still receives an assistance or Southwest Water customers receive a £50 contribution to their bill from government, which I believe comes straight from treasury to recognize the burden that Southwest customers have from their systems getting strained by tourism, etcetera, very rural community. So I think there are some precedents there. Again, one of the future options is that something that we should be considering for Northern customers – excuse me. I think the other element that we see as really important is the national social tariff conversation because at the moment, the social tariff that customers get around the country is something of a postcode lottery. If you live in a reasonably affluent area, customers are prepared to contribute more to help their neighbors than you find, say, in our area. And the degree of that tariff, which is actually then needed and used to help customers you have choices over whether all that money actually is needed. And I think what the Consumer Council for water are doing is saying, well, actually, we ought to take away this postcode lottery and we ought to make sure that essentially, we collect that money, and then we distribute according to need so that it’s not where you live and how wealthy your neighbors are that determines whether you get any help or not.
So we see that as a huge opportunity to level up, particularly for those parts of the country where customers don’t get as much help as others. And that also in itself will help particularly in the north on higher bills. So I think as you pointed, you’ve highlighted, there is one lever there. There is another lever that we’re discussing, which could help. So I do think that there are opportunities here to both look at the pace of investment, to look at, as you say, whether there are subsidies that can be provided to help. And also, we’ve got our own self-help that we can do through national social tariff and I’m very much hoping that that’s approved. I think on the regulatory attitude, certainly, our regulators have been deeply involved in all of the issues that we’ve discussed this morning. I do think that we’re seeing a recognition that climate change is a very significant issue.
And so there is a huge focus, very, very – a very engaged conversation with regulators around what we do nationally around water resources. I think you know we have a scheme that we’ve combined with 7x and 10x to come up with what we call the 7x transfer scheme where that is being worked as an option for the opportunity to get water from the north to the south, principally the Southeast and London. And that’s quite advanced his thinking and development. I like that scheme because it means that the North becomes much more relevant to the South. And we will need to be more resilient to ensure that we can help the South. So, there is very much mutual benefit in that scheme. We are seeing considerations of reservoir development, other transfers, etcetera. So, I do think that the mindset is saying we have got real challenges with climate change. We have got real challenges with water resources. And there is active collaboration between regulators and industry. I think the whole issue of investment in things like mains renewal. For many years, the industry has complained about the rate of renewal of its asset base and the average age of assets is increasing. I think that’s an area where I think there is some recognition. We will see what happens in AMP8 as we go through. So, yes, I do think that there is a broad recognition amongst us that we have to invest for future challenge. And of course, much of that will drive OpEx. A lot of the solutions that we would have to drive to meet the new environmental schemes will drive OpEx. They will drive more chemicals, more energy. And all of that will need to then be supported and maintained. So, yes, I think the challenges are out there. We have got to really work our way through how fast we address them and how we best address them, how we most sufficiently address them. Okay. So I think with that, that all for you, Martin, I think I covered the points. Pavan, JPMorgan. Good morning.
Pavan Mahbubani
Hi guys. Good morning. Thank you for the presentation and for taking my questions. So, firstly on my end, I just wanted to know how your discussions with the regulator have been when thinking of the impacts of inflation. And I ask that in the context of GM potentially looking into the impact of inflation on returns whether they should be sharing with customers or any other sort of mechanisms. Have you been having these discussions? And then my other question is on – you mentioned fill gearing gliding down to 55% by the end of AMP7, which is in line with the notional gearing that at least the regulator seems to be minded to do based on the drop determination. So, my question is, if that’s the notional gearing level set by the regulator, is it your intention to stay in line with that level for AMP8? Thank you.
Steve Mogford
Okay. Thanks. Thanks Pavan. Just before I answer that, Martin did ask the question, which was what have we submitted to the regulator as the transition investment. And I said it’s around £300 million. We are in discussion as to whether all of that would be funded. So, I don’t think you should presume that, that will be what gets approved. It would be great if it does, experience as it doesn’t always get approved and it wouldn’t be accelerated. But Martin, sorry, I didn’t actually close with the answer to that question. Pavan, picking up on your point, thanks. I think yes, certainly, it’s been our attitude to this is that – and we have seen that over a number of years is that where we are seeing outperformance, we have reinvested that outperformance for the benefit of the business and the consequences that then delivers in terms of better performance for customers, better performance for the environment, better sustainable performance, which then reflects through into ODIs, and we are seeing that here. And you will be aware that we have made significant additional investment over and above our determination, FD allowance through the £765 million in order to drive a number of features of both customer and environmental performance. So, I think we believe that we are acting responsibly in an environment where we are seeing the benefits of outperformance, both operationally, but also financially through financing. So, I think in – in that sense, we believe we are responding, and we are responding ahead of any call from regulators. And I think it’s fair to say across the sector, outperformance is very, very mixed. I mean we are one of the two or three companies that are actually making positive ODI returns and obviously, not all companies will be benefiting from financing outperformance. So, I think to that extent, it’s a very mixed picture in the sector, but we are certainly doing what we think is the right thing, the responsible thing to do in terms of reinvestment. On pricing, I think you are right, Pavan, next year, as we start to see the regulatory mechanism rolling for pricing and price rises as we go into ‘23, ‘24, it is something that we and the regulator Ofwat is alert to. Companies are in conversation with regulators about next year. We are in a situation where we think we are going to be looking at below inflation increases through the way that the regulatory mechanism works with CPIH adjustment, with ODI impact, with the revenue recovery mechanism. When you put all that together, we think we will be below inflation impact price rise next year. So, I think which is a positive, it’s a good place to be in the current environment. So, I think in that sense, that’s the key points from us, notional gearing.
Phil Aspin
Yes. On the gearing point, I mean you are right, sort of – our target range for gearing is 55% to 65%. And as I said, through the AMP, we see that trending down towards the 55% level from where we are today at 60%. I think it’s probably fair to say that that is the Board’s policy on gearing and capital structure. Clearly, as we head into AMP8, there is still quite a lot of uncertainties at this point in terms of scale and size of the investment program, etcetera. I think having a gearing position at that level really sort of positions us well to be able to respond to that investment challenge. And so we will have to weigh up what all that means in terms of gearing for AMP8 when we get there.
Steve Mogford
Okay. Thanks very much, Pavan. Ahmed Farman of Jefferies. Good morning.
Ahmed Farman
Good morning and thank you for taking my questions. A few from my side. Just firstly, I was – you have given us some very helpful granularity on the financial outlook for this year and quite specific comments on tax. I was just hoping to get some commentary on how do you think about that tax expense normalizing over the coming years? Then a very sort of quick follow-up to the comments you have just made about – I think you said something that you expect bill increases or tariff increases to be below inflation, I just wanted to confirm you are sort of referring to the November EPI at inflation there? And then finally, just sort of a broader question. You outlined quite interesting opportunities ahead for the sector in terms of big investment spends in AMP8 as all the sort of inflation of the RCV that needs to be recovered as well. I just wonder how – when you looked at through these scenarios, what does that mean for the build profile of the end customer because it seems to me that a number of these things could potentially be quite expensive. And how this translates into the build profile amidst an affordability prices in mid-media, some media continue of the sector is going to be critical for the overall sort of stability of the regulatory framework. So, any comments that you have there would be very helpful. Thank you.
Steve Mogford
Okay. Do you want to deal with tax, and I will pick on the other?
Phil Aspin
Yes. So, we have provided some quite good guidance for this year. And clearly, looking to sort of maximize the sort of tax position as we step into next year with a 25% sort of corporation tax rate. I think it’s quite hard at this stage to sort of call guidance for next year, and I will be giving an update on that in May. But one thing to bear in mind is clearly about the high sort of inflation index cost on our index-linked debt actually flows through into our tax position. So, that inflation volatility will play quite a part in terms of driving what the tax forecast is for FY ‘24. And I will say I will update on that in May.
Steve Mogford
Okay. I think picking up on price increases. Yes, I mean you are right that essentially, the price is struck from the November CPIH as we roll forward. So, that effectively provides the baseline inflation level. I think as I have said, as we look at all of the adjustments that you then apply to that, we think we are going to be below inflation by 1%, perhaps 1.5% in terms of where we think that sort of current – where the current direction is taking us. So, we do think that we will be below inflation, but it will be against whatever the number is in November. I think in terms of bill impact, it’s clearly, I think for all companies, but particularly when you are serving the community that we do, we are very, very conscious of bill impact. And that’s one of the reasons why we want to get into conversation with regulators about how this can best be managed. Clearly, we have got a very strong environmental ambition coming through from government. We share that. We are talking mostly about capital investment. And therefore, it’s a pretty slow bleed when it comes to impact on pricing, because you are looking at depreciation impact over a very long period. So, I think in that sense, it’s not an immediate impact on bills. But – we are in an environment where bill increases are difficult and popular. So, I think we are all very alert to that. The regulators, government are very alert to it. And that’s really part of the conversation. I think as companies are now putting in numbers to define how big this program is nationally, then we will start looking at what do we do about it. How do we manage the ambition both on pace, are there ideas that can help as far as customers are concerned. What are we – what could – are other things that we can do. So, for example, we have had tremendous progress this year reducing per capita consumption. Not only is that reducing customer bills because they are using less water, it actually helps us in the sense that it costs us less to produce. So, I think the more we can do to effectively drive efficiency, but also understand those areas where we can help customers. And then we can look to mitigate some of this. But yes, it will raise bills. Doing this environmental ambition will increase bills, and we need to understand how we best manage that. Okay. Dominic. Dominic Nash, Barclays. Good morning Dominic. What a lovely smile on this morning.
Dominic Nash
Yes. A couple of questions for me, please. Firstly, on the dreaded RoRE number, you have obviously given us guidance that RoRE this year is going to be higher than last year and that 7.9% real. You have quite a lot of movements in your totex numbers with headline totex being – headline totex including your stock you are being both the accruing the improvement spend, the green deal, etcetera, etcetera, etcetera. Does that 7.9% – is that a headline totex number after all totex underperforms, or are you going to be stripping out your totex underperformance against that to give us sort of like an underlying number? And secondly, I think Jonson Cox was on record recently saying that he would like to see water company licenses being – the potential to remove those being reduced from 25 years down to 5 years to sort of keep us that way. Let us use in the industry alive and in participants honest, what are your thoughts about that? And where do you think the legitimacy of the industry debate is going? Thank you.
Steve Mogford
Thanks Dominic. Phil, do you want to pick up the RoRE?
Phil Aspin
Yes. So, 7.9% reported last year, Dominic was including the impact of all the extra totex investments. So, it wasn’t flattered by sort of stripping those amounts out. I think we are relatively clear about the sort of extra investment spend that’s been hard. So, we can put that out going forward. But as I say, it’s a reported number at 7.9% that actually takes into account the cost of those extra investments.
Steve Mogford
Okay. Thanks, Phil. Yes, Dominic, I heard about Jonson talking about licenses at a recent conference. Interestingly, Jonson said it wasn’t his idea, but he said that people have mentioned it to him. And so – and therefore, he felt that he wanted to talk about what people had said. I think it’s interesting. I mean the government actually changed the license position back in the early – I think it was 2000, principally because they wanted to give investors confidence in investing particularly debt investors in investing in the sector and having the confidence of returns. So – and I think we had somebody in the audience who sort of picked up with Jonson this, and there was a bit of a conversation about it. And I think taking – reducing the license period, back to and Jonson was saying, should it be 5 years, should it be 10 years. I think reducing that period would obviously have an impact there and sort of be reversing back out of that position. And I think it’s interesting, actually. I mean we have recently had exposure to the labor, the shadow cabinet their view of the sector and going forward. Obviously, we are heading into a general election. And what we are actually seeing there is that this concept that we had a few years ago of renationalizing the sector, or introducing very different terms for the sector is something that they are not wedded to. I think it’s something where they have looked at policy and actually felt that there is so much investment needed in the water sector as we go forward that actually continuing to access private markets for that funding is the right thing to do. So, I think as Johnson was obviously flying that particular kite, but we have no evidence elsewhere that, that’s a sentiment that either government is considering or regulators are considering at this point in time. For the very reasons that they put the licenses to 25 years to ensure that they could continue to attract investors. And certainly, government sentiment at the moment, and we have sort of tested the thing with treasury as well. Government sentiment is the moment is they are going to need to keep that investment interest in the sector. So, yes.
Phil Aspin
I think just if I could just add, perhaps, Steve, just to build on that. I think in the context of sort of resilience of the sector clearly, the 25-year license is really important to the financial resilience longer term, as Steve said, that was the reason it was extended to that position in the first place. And I think understanding that point, probably sort of Jonson has been a big proponent of the sector, putting itself into a stronger resilient position going forward. And I think understanding that is probably quite key.
Steve Mogford
Okay.
Dominic Nash
Thanks Steve. Sorry, could you just follow-up on the RoRE number though, but if we sort of plug in what the drag on your totex of everything you are putting through is in the order of 1.5% to 2%. Is that sort of sound about right…?
Phil Aspin
It sounds a reasonable guesstimate sort of Dominic, yes.
Dominic Nash
Okay. Thank you.
Steve Mogford
Alright. Mark, have we got you back with more questions. Mark Freshney.
Mark Freshney
Unfortunately, yes, you have me back. So, following from Dominic’s question, so like top level, the debates or the focus of regulators over the last 5 years or 6 years has been on value for money. And I don’t want to use the word nickel and dime, but they have really driven your returns and cost allowances down to low levels. And the RoRE is very low and there has been a huge focus on customer bills. But going the other way, I mean you guys deliver a lot of stuff. You use mostly domestic content in regions away from the Southeast and with a huge multiplier on the local economy. And it seems that you guys – with a very good record on delivery, unlike things like civil nuclear, for instance, you guys have a very strong track record of delivering. And you have your assets and areas, you have some red wall seats in your area, some swing seats, should we say. So, against that backdrop, when you speak to politicians, the EA, cabinet office, do you – do they get it that actually going forward, giving you a little bit of extra money, aiming up, for instance, and a big totex allowance would actually be a positive thing for the country. When you enter that debate with them, do they actually get it?
Steve Mogford
I think the – there are different components to that, Mark. Sorry, I was trying to structure my thoughts in a way that would give you a thoughtful response to that. I do think there will always be an obligation on regulators to ensure that whatever is done is done efficiently. And I think we have seen over the years a continual pressure on operating costs to drive levels of efficiency. And I have to say, I have been in the sector 12 years. I came into the sector and was quite surprised at what I found in the context of how companies operated, use of technology, better situational awareness. And you have seen us drive a program of operational improvement. And I think we are one of the few companies in the sector that’s gone from being one of the worst performers to one of the best over the last 10 years through that determined application of operational improvement. And I think – so I think in some ways, the regulator is right in saying that you could be more efficient than you are. And I think that’s one element. And of course, in any commercial market, you are constantly searching for more efficiency for improving margins. And I think that is something that the regulator is right to keep the pressure on. And we need to use as much innovation as much of the new technologies and opportunities available to us because at the end of the day, we have got customers out there that are paying the bill and they don’t have a choice. So, I think I do feel that, that duty is exercised, whether you think it’s exercised over zealously or not, you will get different views across the sector. I do though believe that there is a recognition. And it really has to start in government, because government has to give regulators strategic direction. I do think there is a growing recognition in government. This summer has been a great example because I think for a long time, we haven’t had major water restrictions in the South of England, but we have seen it across so many parts of England and Wales, where we have seen water restrictions as a consequence of a year of our summer, spring, summer of bad weather, that causes people to say, what have we got to do to make sure that this doesn’t happen frequently. And of course, during climate change, it will. We see in sort of perhaps said, and this is coming out of COP27 that is 1.5 going to be achievable, or are we actually now talking 2.5. And in those sorts of environment, water resilience in the UK is a huge issue, and I think it’s recognized. That’s why we have got a thing called RAPID, which the regulators informed to work with industry on more of a national scheme. I think the area that probably is beginning to be recognized. And certainly, if you talk to the chair of Ofwat, you will hear this. But I think you will also hear it when you talk to other regulators is the whole issue of the state of our asset base, the average age of our asset base and are we replacing sufficiently at a rate per AMP per 5-year cycle, which essentially maintains the levels of performance that we need to achieve. And that I think as we go into AMP8 is going to be – that’s going to be a test for all of us as to whether we really do recognize that and go forward. So, yes, I think it – I think we are seeing recognition. I don’t think we will ever see, Mark, the foot coming off the gas pedal on efficiency. It’s the regulator’s duty. It’s what they should do, it’s what we should all do because our customers don’t have a choice and we have an obligation and moral obligation to do the best we can for them. But I do think we are climate change, the whole question of environment, is recognizably driving both government and regulator ambition. And that will come through, I believe in the determinations that we see in AMP8 and I think beyond that. Okay. Thanks Mark. Thanks for that question.
A bit philosophical at the end there. I think as we finish, we have got no more questions coming through. I just wanted to say that this is my last results presentation. The next one will be done by the new team of Louise Beardmore and Phil. And I just wanted to say thanks to everybody for the support that we have had over the years, for the questions, for the interest in the business. I am sure I am going to miss it. But I do know that I am handing the batton to a fantastic team. I couldn’t be more delighted that Louis is taking over from me. I have worked with us for many years. She is an absolute force of nature. When people told me when I first joined United Utilities, they have said UU is a sleeping giant. You have got – it’s a big company, one of the biggest in the sector. It’s got great people and it has, but it’s a sleep and it’s happy to be mediocre or worst in the sector. Well, I think 12 years later, that giant is standing tall amongst its peer group and one of the great performers. And we have got some huge opportunities coming forward and we are well positioned to take them. Phil as puts us in a great position.
Looking at the next half of this AMP, with where we are on the capital program, so much of it left on terms and with resources. We are in a situation where we have raised sufficient finance that we don’t need – actually need to do any more of this AMP if we don’t have to, we will, but we will do it on the terms that are attractive to us at the time that those terms become available. And operationally, we are as good as any in terms of how we perform. So, a great baseline, and I know that Louis and Phil will take this business forward and will deliver even more because I just understand the energy that comes with that new team.
So, I will be sat there with you as a customer and a shareholder and want to observe their success. But thanks so much for the interest and support we have had and I wish you all the best for the future. Thank you.
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