What is wrong with South East Water?

Many readers may have limited interest in the performance of a medium-sized water company in the South of England. However, bear with me. The story that I tell treats South East Water as the canary in the mine whose fate warns of dangers that may be hidden from immediate view. It illustrates the dangers of relying upon technocratic regulation to fudge crucial choices about how to fund investment in network infrastructure and improvements in service quality.

For those who follow the news in the UK, there have been numerous articles about the performance of South East Water (SEW), the company responsible for water – but not wastewater – services in large parts of the historic counties of Kent and Sussex as well as in a separate area covering parts of Berkshire and Hampshire. As a result of operational failures and bad weather, in the last three months the company has had to cut off water supplies for periods of up to a week to various towns and villages in Kent and Sussex, most notably Tunbridge Wells.[1]

The question that I will address is whether what has happened at SEW is what physicians call “idiopathic”, i.e. the consequence of random company-specific circumstances, or is symptomatic of wider problems in the UK’s water industry. Though there are clearly idiopathic elements, I will argue that SEW’s travails reflect wider issues that are not understood by focusing on the company’s dire communications and operational performance.

There have been three major factors contributing to the water interruptions in Kent and Sussex.

1. There was an incident at the water treatment plant serving Tunbridge Wells. The company’s description of the incident was incoherent. The core claim was that they had been supplied with treatment chemicals that were not to specification. For whatever reason, the treatment plant had to be stopped, it and parts of the network had to be flushed, and then the treatment plant restarted with different network zones being monitored and, in some cases, flushed again. Reading between the lines, it seems that SEW could not meet very strict drinking water standards imposed by the regulator – the Drinking Water Inspectorate – and the regulator would not issue a waiver even though the water supplied was safe for human consumption. SEW also pointed out that it did not have the reservoir and network capacity to supply Tunbridge Wells from other treatment plants.

2. A storm resulted in the loss of power to a pumping station, which did not have a backup generator. Consequently, water pressure could not be maintained in parts of SEW’s network, which led to some supply zones being cut off.

3. Severe frosts (by the standards of Kent and Sussex) led to burst water mains and loss of water pressure in other supply zones. This is a routine problem in milder parts of the UK where water pipes have not been buried sufficiently deep to be immune to freezing conditions. Often, the problem cannot be blamed on the water supplier because the fault may lie with supply pipes from the water main to houses that were not in the past the responsibility of the water supplier.

All these incidents are, or should be, regarded as routine components of the contingency planning that any water company should undertake. So, one way of looking at what has happened over the last three months is to blame SEW for a failure to put in place proper plans to deal with events that were certainly not unforeseeable. However, there is an alternative way of looking at the underlying pattern. The incidents reflect the systematic consequence of a reluctance of all water companies, not only SEW, to invest in providing higher levels of asset backup and network resilience.

Some parts of this failure are due to the large costs of and public resistance to increasing reservoir capacity in the South of England. Without properly located reservoirs, companies like SEW rely on pumping from underground water resources. These are easily depleted in periods of dry weather. Equally, in principle the public approve of measures to reduce leakage and improve network connections, but in practice they object to the disruption that is caused by undertaking such projects. There is a widespread myth that problems of water scarcity can be solved by using water resources better with minimal disruption and no requirement to use more land in the process.

In the last 15 years these attitudes have been reinforced by a political reluctance to countenance real increases in water charges. The pressure on economic regulators – Ofwat in England and Wales – has been to push water companies to achieve higher levels of drinking water and environmental quality, while holding revenues constant in real terms. Ofwat has encouraged water companies to run their network assets “hot” while minimising the costs incurred for backup and resilience.

Of course, Ofwat would claim that no such explicit trade-off was made, but any economist and regulatory insider knows that this was the inevitable consequence of the assumptions made by the regulator. Investments in network resilience had to compete with funding for serving new customers and improvements in water quality. Inevitably, network resilience had lower priority than more visible indicators of performance. At least this was the case until things went wrong, at which point the regulator would blame company managements for the foreseeable consequences of regulatory incentives.

The incentive to sweat network assets is especially large for water companies in SE England because unit operating costs are higher than in the rest of the UK while population growth has pushed up spending per customer on expanding network capacity. Ofwat’s efficiency comparisons and financial modelling should take such factors into account. However, the indicators are crude while the pressure to avoid significant regional differences in water charges are great. So, operators in the South have usually been under greater financial pressure to meet performance targets than those operating in the rest of the country.

As is usually the case, media reports of SEW’s problems have focused on the salary paid to the company’s Chief Executive.[2] Others can reach their own conclusion about whether a base salary of just over £300,000 per year is reasonable for the CEO of a company with revenues of about £300 million per year and an asset base of nearly £5 billion at replacement cost. My view is that his pay is not particularly generous, even though his public presence is inept. In any case, the amount paid to the CEO and other Executive Directors is irrelevant to the financial situation of the company.

SEW is a company with serious financial problems. Its 2024-25 accounts up to March 2025 show that SEW made an accounting loss before taxes of about £56 million on actual revenues of £586 million in the two years 2023-24 and 2024-25.[3] That translates to a cumulative loss of nearly 10% of revenues over two years.

The primary reason for these losses is that at the end of 2024-25 the company had debts of nearly £1.4 billion or about 4.8 times its annual revenues. The average interest rate on this debt in 2024-45 was nearly 6% and even higher in 2023-24. About 36% of the company’s debt is index-linked, so the sharp acceleration in inflation after the pandemic pushed up the interest cost of such borrowing as recorded in the company’s accounts.

On the asset side of the balance sheet the company has fixed assets of about £1.9 billion valued at historic cost after depreciation. The net value of shareholder equity at the end of 2024-25 was about £290 million or about 17% of the combined total of debt and shareholder equity. In very round terms, the company had debts that were close to 5 times its shareholder equity. This is an extremely fragile financial structure which, as the accounts show, is highly vulnerable to major changes in interest rates and financial conditions.

While many readers may have little interest in the details of water company accounts, these figures highlight the choices made by Ofwat and water companies that lead to the lack of resilience revealed by SEW’s recent performance. Over five years from March 2020 to March 2025, SEW’s assets at historic cost grew from £1.9 billion to £2.4 billion (28%) while its actual revenues increased from £252 million to £296 million (17%). Its long-term debt increased from £1.0 billion to £1.3 billion (30%) over the same period, while its shareholder equity fell from £540 million to £288 million (a decline of 53%).

Everything about this is wrong. No network company can survive in the long term under a regime in which revenues increase much less than its network assets, especially when interest rates have risen greatly. In the case of SEW, the increase in assets and the decline in its operating margin have been financed by taking on more debt and reducing shareholder equity. This is a death spiral that can only end with the company being taken into public ownership. Still, it is a choice that appears to have been made by the regulator, no doubt under political pressure.

The key regulatory strategy over the period since 2010 has been to increase capital spending on water quality and network expansion while holding water charges constant in real terms. This was achieved by a large reduction in the average rate of return on assets that companies were allowed to earn. This fell from about 4.8% in real terms for 2010-15 to about 2.0% for 2020-25.[4]

The idea that assets with long lives such as water pipes, reservoirs, and treatment plants could be financed at a cost of barely 2% per year after allowing for inflation was as a product of the extraordinary – and patently unsustainable – financial conditions which prevailed during the 2010s. As an illustration, the yield on 10-year UK gilts fell from an average of 4.6% for the decade 2000-09 to 0.9% for 2019. Something close to sanity returned to financial markets after the pandemic, so that the average yield on 10-year UK gilts was 4.3% for the period 2023-25.[5]

Notwithstanding the reversion of bond yields to a level matching those in the 2000s, Ofwat fixed the allowed nominal rate of return for water companies at about 6% for the period 2025-30. Two decades earlier, the comparable rate of return allowed for 2005-10 was about 8%.

The return on capital that water companies can earn has been considerably reduced. That has prompted most of the companies to rely much more heavily on debt finance to maintain their return on equity. In turn, financial structures with high levels of debt left the companies extremely vulnerable when nominal interest rates rose rapidly after the pandemic.

The larger point here is that over the period from 2010 to now water customers have had a “free” ride. They have benefited from regulatory decisions to squeeze the allowed return on capital below any reasonable view of its long-term value. The response of water companies has been to reduce capital spending wherever it is not directly mandated by the regulator. Specifically, this includes spending on network resilience, which, inevitably, involves some degree of redundancy for as long as equipment breakdowns and other bad things don’t happen.

It is not an accident that the most troubled water companies over the last 15 years – SEW, Southern Water, Thames Water - are in SE England. They face the most difficult and expensive operating conditions as well as being required to expand their networks to handle significant population growth. Strong public opposition to some of their projects means that the average costs of network expansion tend to be much higher than in other parts of the UK.

Thus, the recent travails of South East Water reflect a combination of complacent technocratic regulation and a political reluctance to accept that providing reliable water services in a densely settled and water scarce region of the UK is expensive and getting more so over time. Naturally, Ofwat and the government will claim they did not intend that what has happened in Kent and Sussex to occur. They are right: they did not think beyond what was convenient in the short term.

This is not a lesson for the UK’s water industry alone. It is easy to identify multiple examples in other infrastructure sectors for which short-term technocratic decisions designed to avoid difficult economic and political choices lead to unwanted and poor outcomes. This is one of the saddest and most damaging manifestations of the UK’s decline over the last two decades.

[1] As full disclosure, a part of my extended family live in Tunbridge Wells, which adds colour to SEW’s performance but does not alter my conclusions which are based on my experience in regulating water companies as well as detailed financial information from SEW’s recent annual accounts.

[2] As usual the press reports are rather misleading, since journalists rarely look beyond headline numbers presented in company accounts. The CEO’s base salary in 2024-25 was about £307,000 which was supplemented by pension contributions, an annual bonus, and small payments in kind of about £150,000. The annual bonus was spread over 3 years from 2025 to 2027. The calculation of pension contributions is fiction, reflecting the way in which defined benefit pensions are treated in company accounts.

[3] I have excluded bad debts from the calculation of actual revenues.

[4] For the period 2020-25 the allowed nominal rate of return was about 5%. These figures are the typical values of what Ofwat refers to as the “vanilla” pre-tax weighted average cost of capital (WACC) in real terms using the RPI as the inflation indicator.

[5] While dressed up in elaborate economic and financial mumbo-jumbo, the methods used by regulators such as Ofwat mean that the vanilla pre-tax WACC is closely linked to the average cost of government borrowing.