Chief Financial Officer's Review

In the last six months we have seen the top-line benefit from our business customers returning to more normal operations following the lifting of COVID-19 restrictions. We have maintained positive momentum on our capital and infrastructure renewals programme; successfully managed our operational costs; and seen Business Services more than double profits for the period.

Our balance sheet continues to strengthen, with an improved pensions outlook; robust cash collection and credit management performance; and a strong funding position ready to support future growth.

Reported inflation has increased the cost of our index-linked debt, but this will be more than offset by increased revenue and RCV growth in future periods and our effective cash cost of interest remains among the lowest in the sector.

A summary of our financial performance in the period is set out below:

Group turnover was £958.2 million¹ (2020/21: £887.6 million), up 8.0%, reflecting higher consumption from non-household customers in our Regulated Water and Waste Water business and strong performance in our Operating Services business.

Group PBIT was up 13.8% to £255.6 million (2020/21: £224.6 million). In Regulated Water and Waste Water the increased revenue was partially offset by higher energy costs and higher infrastructure renewals expenditure as planned.

Higher inflation in the period increased our net finance costs to £120.8 million (2020/21: £91.1 million) and our effective interest cost to 4.2% (2020/21: 3.3%). Our effective cash cost of interest, which excludes the impact of inflation on our index-linked debt, was unchanged at 3.1%. Average net debt was broadly similar to the same period in the previous year.

In April we converted a £32.5 million loan advanced to Water Plus to equity, reinstating the investment in Water Plus on our balance sheet. As a result we have resumed recognising our share of Water Plus's post tax results. With the relaxation of COVID-19 restrictions, Water Plus's revenues and operating results have improved and our share of its loss in the period narrowed to £1.8 million (2020/21: unrecognised loss of £6.2 million).

The changes to corporation tax announced in the Chancellor's budget in March, and enacted in May, significantly impacted our tax charges. First, changes in the timing that capital expenditure is deducted from taxable profits (including the 'Super Deduction') reduced our adjusted effective tax rate for this year to nil% (2020/21: 9.1%). Second, the increase in the corporation tax rate to 25% with effect from 1 April 2023, resulted in an exceptional deferred tax charge to the income statement of £294.2 million from recalculating our opening deferred tax balances at the new rate, which is included in our reported tax charge of £326.9 million. Deferred tax is an accounting adjustment that reflects differences in timing between when profits are recorded in financial statements and when they are subject to tax. Because of the nature of our business, including our significant rolling capital programme and the long lives of our assets, these timing differences will not reverse for the foreseeable future, and may never do so.

As a result of the exceptional deferred tax charge basic loss per share was 73.0 pence (2020/21: earnings of 42.7 pence).

Our adjusted basic earnings per share were 54.4 pence (2020/21: 51.3 pence). Growth in adjusted earnings accounted for an increase of 4.9 pence per share but the higher number of shares in issue following our successful equity placement (see below) reduced our adjusted basic earnings per share by 1.8 pence.

Our cash flow and liquidity remain strong. Our undrawn committed facilities were £950 million, and our cash flow requirements are funded to July 2023.

Net cash capital expenditure was £238.0 million (2020/21: £283.5 million).

Our net pension deficit at 30 September decreased to £291.5 million, benefiting from strong asset growth of £167.1 million and planned contributions of £35.6 million, which more than offset the impact of higher expected inflation. During the period we also executed a bulk annuity buy-in for our MIPS scheme, virtually eliminating future risk in relation to this scheme. The overall funding level across all of our defined benefit schemes has improved to 90% (31 March 2021: 88%).

To fund our planned Green Recovery programme in line with our capital structure, we completed a successful equity placement in the period raising net proceeds of £245 million.

The Board continues to recognise the important role that dividends play in providing income for pensioners and other investors. Taking into account the Group's prospects; its financial position; and the interests of other stakeholders including customers, our pension scheme members, colleagues and communities, the Board determined that it remains appropriate to recommend to shareholders that the interim dividend for the year ending 31 March 2022 be increased by 0.6% to 40.86 pence in line with our policy for AMP7 to increase the dividend by CPIH.

Regulated Water and Waste Water

Turnover for the Regulated Water and Waste Water segment was £893.9 million (2020/21: £829.9 million) and PBIT was £242.4 million (2020/21: £219.6 million).

Turnover increased by £64.0 million with the main movements being:

·    A £38.9 million net increase from higher non-household consumption and lower household consumption, returning to more normal patterns following the easing of COVID-19 restrictions earlier in the year;

·  An increase of £12.9 million from the reclassification of diversions income (previously credited to infrastructure renewals expenditure as described at the previous year end);

·   An increase of £2.0 million in non-household revenue due to additional properties successfully being brought into charge under the Voids and Gaps Incentive Scheme; an offset is seen in higher operating costs (see below);

·    An increase of £3.5 million in renewable energy income in our Bioresources business; and

·    Other net increases of £6.7 million, including higher miscellaneous sales and the adjustment for inflation in the year.

Net labour costs were £6.6 million (8.6%) higher period-on-period. Gross employee costs increased by 3.6% due to the annual pay award of 2.3% and an increase in FTE due to insourcing activity. Our capitalisation of employee costs decreased by 1.2% as the focus of our technology teams switched to operational activities following the completion of major IT capital projects.

Net hired and contracted costs increased by £1.4 million (1.5%). Increases in biodiversity and catchment spend, along with additional vendor management, software maintenance, cloud storage and increased debt management costs offset the reduction achieved from insourcing activity.

Power costs were £8.2 million or 17.7% higher than the previous period, much less than the average wholesale energy prices increase of more than 200% year-on-year. We benefited from self-generation in Bioresources and internal hedges between our regulated business (a net consumer of energy) and our non-regulated business (a net generator).

Bad debt charges were £9.2 million lower than the previous period and represent 2.2% of household revenue, (2020/21 full year: 3.0%). The outlook for unemployment has improved, and we have not seen a deterioration in our collection performance. However pressure on household budgets from increasing energy costs, other inflationary impacts, the withdrawal of the £20 uplift in universal credit and the prospect of higher national insurance has led us to retain the forward-looking provision of £11.9 million taken since the start of the pandemic (of which £8.2 million was charged in the first half of 2020/21) at the balance sheet date.

Reported other costs increased by £8.9 million. Raw materials and consumables were largely unchanged as higher chemical costs were offset by a reduction in COVID-19 related consumables. We accrued £2.9 million this year for the Ofwat Innovation Fund (2020/21: nil as the mechanism for the Fund was under discussion at the reporting date last year) and the higher voids/gaps incentive payments referred to above increased costs by £1.3 million. There was an increase of £1.5 million in aborted capital expenditure and the remaining increase arose from a combination of higher pension administration costs, a resumption of employee training, and increased insurance and telecoms costs.

Reported infrastructure maintenance expenditure was £21.0 million higher in the period, reflecting £8.1 million from a planned step up in the programme and the £12.9 million reclassification to turnover referred to above.

Depreciation was £4.3 million higher period-on-period due to the growing asset base.

Business Services

Business Services turnover was £66.1 million (up 11.8%) and adjusted PBIT was £17.4 million (up 112.2%).

In our Operating Services and Other businesses, turnover and adjusted PBIT increased by £5.4 million and £1.4 million respectively. Increased activity on the 25-year MoD contract, including additional ad-hoc contract wins drove increases in the Operating Services business. Growth in the other businesses was driven by higher volumes in our property searches business.

In Green Power, turnover increased by £1.6 million and adjusted PBIT increased by £0.3 million. Higher energy prices and incentive income from increased gas generation was partially offset by lower gate fee income, primarily from local authority food waste contracts, as domestic waste volumes were higher in the previous year due to lockdown whereas volumes of commercial waste improved this year. Intra-group energy price hedges, which significantly benefited the regulated business, limited the increase in Green Power's revenue that would have been achieved if all energy had been sold at prevailing wholesale market rates.

Profits from Property Development were £7.5 million higher than the prior year, when there were no large disposals. We remain on track for our target of £100 million PBIT from Property Development over the ten years to 2027, having generated £45.3 million since setting the target in 2017.

Corporate and other

Corporate overheads were higher at £3.7 million (2020/21: £2.4 million). The main drivers of the increase were an increase in legal costs; higher insurance premiums; Board recruitment and triennial effectiveness review costs in the period.

Net finance costs

The Group's net finance costs for the six-month period were £120.8 million (2020/21: £91.1 million). Average net debt of £6,251.5 million was broadly in line with the prior year (2020/21: £6,236.1 million), however higher inflation in the period increased the interest cost on our index-linked debt by £31.1 million, and our effective interest cost to 4.2% (2020/21: 3.3%). Our effective cash cost of interest (which excludes the inflation uplift on index-linked debt) remained at 3.1% (2020/21: 3.1%). Interest capitalised of £15.2 million was broadly in line with the prior period (2020/21: £14.9 million).

The Group's EBITDA interest cover was 3.9 times (2020/21: 4.8 times) and PBIT interest cover was 2.2 times (2020/21: 2.5 times). See note 18 for further details.

Net gains/(losses) on financial instruments

The Group uses financial derivatives solely to hedge risks associated with its normal business activities including:

·    Exchange rate exposure on borrowings denominated in foreign currencies;

·    Interest rate exposures on floating rate borrowings;

·    Exposures to increases in electricity prices; and

·    Changes in the regulatory model from RPI to CPIH.

The Group holds:

·    Interest rate swaps with a net notional principal of £652 million to balance our interest rate mix in line with our strategy;

·    Cross currency swaps with a sterling principal of £142 million, which economically act to hedge exchange rate risk on certain foreign currency borrowings; and

·    Inflation swaps with a notional principal of £350 million, which swap RPI linked cash flows for CPI linked cash flows.

Where hedge accounting is not applied, if the risk being hedged does not impact the income statement in the same period as the change in value of the derivative, then an accounting mismatch arises and there is a net charge or credit to the income statement. During the period there was a gain of £19.5 million (2020/21: loss of £10.0 million) in relation to these instruments.

An analysis of the amounts charged to the income statement in the period is presented in note 5 to the financial statements.

The Group has fixed around 97% of estimated wholesale energy usage for the remainder of 2021/22 through a combination of forward price contracts and financial derivatives.

Taxation

We are committed to paying the right amount of tax at the right time, and were pleased to have our Fair Tax Mark accreditation renewed for the third year.

As well as corporation tax on profits, which is included in the tax charge in our accounts, we pay a range of other taxes, charges and levies imposed by government agencies including business rates; employer's National Insurance; the Climate Change Levy; and Insurance Premium Tax. Our 2020/21 Annual Report and Accounts sets out an analysis of the taxes incurred in that year and we will set out this year's amounts in our Annual Report to be published in June 2022.

The tax charge reported in the income statement (excluding the exceptional deferred tax charge arising from the change in the corporation tax rate) is calculated at a rate of 22.3% (2020/21: 19.6%), representing the best estimate of the annual average tax rate expected for the full year, applied to the profit for the six month period. The increase in the rate arises from the deferred tax charge on current year timing differences calculated at 25%, the rate expected to be applied when the timing differences reverse (2020/21: 19%) partially offset by the impact of the 'Super Deduction', which reduced the effective rate by around 2.2 percentage points.

There was no current tax charge for the period (2020/21: £11.0 million), due to the benefit of the 'Super Deduction' and the acceleration of other capital allowances on our capital programme. Our adjusted effective current tax rate fell (in line with guidance) to nil% (2020/21: 9.1%).

The deferred tax charge was £326.9 million (2020/21: £13.8 million), including an exceptional deferred tax charge of £294.2 million.

In May 2021 the increase in corporation tax rate to 25% was substantively enacted and will take effect on 1 April 2023. We have therefore calculated the tax effect of our deferred tax timing differences at 25%, which has resulted in an exceptional charge to the income statement of £294.2 million and a credit to other comprehensive income of £8.3 million from recalculating our opening deferred tax balances at the new rate.

Because of the nature of our business, including our significant ongoing capital programme, and the long lives of our assets, these timing differences will not reverse for the foreseeable future, and may never do so.

Profit for the period and earnings per share

Reported loss for the period, after the exceptional deferred tax charge described above, was £180.0 million (2020/21: profit of £101.7 million).

Basic loss per share was 73.0 pence (2020/21: earnings of 42.7 pence). Adjusted basic earnings per share were 54.4 pence (2020/21: 51.3 pence). The increase in shares arising from the equity placing reduced adjusted basic earnings per share by 1.8 pence. For further details see note 8.

Cash flow

Six months ended 30 September

Net debt comprises:

At 30 September 2021 we held £32.2 million (31 March 2021: £44.0 million) in net cash and cash equivalents. Our average debt maturity is 13 years. Including committed facilities, of which £950 million was undrawn at the balance sheet date, the Group's cash flow requirements are funded until July 2023.

We invest cash in deposits with highly rated banks and the Board regularly reviews the list of counterparties.

Net debt at 30 September 2021 was £6,232.2 million (31 March 2021: £6,443.8 million). Balance sheet gearing (net debt/net debt plus equity) at the half year was 84.4% (31 March 2021: 84.9%). Severn Trent Water Group net debt, expressed as a percentage of estimated Regulatory Capital Value at 30 September 2021 was 60.8% (31 March 2021: 64.5%).

The estimated fair value of debt at 30 September 2021 was £1,597.5 million higher than book value (31 March 2021: £1,454.9 million higher). The increase in the difference to book value is largely due to higher market expectations for inflation in the long-term.

Pensions

We have three defined benefit pensions arrangements, two for Severn Trent and one for Dee Valley Water. The two Severn Trent schemes closed to future accrual on 31 March 2015.

Formal three-yearly actuarial valuations were completed at 31 March 2019 for the Severn Trent schemes and at 31 March 2020 for the Dee Valley Water scheme.

Under the 2019 valuation, the future funding plan for the Severn Trent Pension Scheme ('STPS'), which is by far the largest, includes:

·   Inflation-linked payments of £15.0 million per annum through an asset-backed funding arrangement, potentially continuing to 31 March 2031, although these contributions will cease earlier should a subsequent valuation of the STPS show that these contributions are no longer needed;

·    Payments under another asset-backed funding arrangement of £8.2 million per annum to 31 March 2032; and

·    Deficit reduction payments totalling £32.4 million increasing in line with inflation through to 31 March 2027.

On an IAS 19 basis, the estimated net position (before deferred tax) of all of the Group's defined benefit pension schemes at 30 September 2021 was a deficit of £291.5 million (31 March 2021: £367.7 million). Defined benefit obligations increased due to the impact of the higher long-term inflation assumption on the schemes' liabilities and inflation in the period higher than the previous assumption. However, strong asset performance more than compensated for these and, together with the employer's contribution of £35.6 million in the period, led to the reduction in the deficit.

During the period we executed a bulk annuity buy-in for the MIPS scheme, which represents around 4% of the Group's defined benefit liabilities. Under the buy-in, the liabilities of this scheme are met by an insurance policy and as a result the Group's risk is substantially reduced. See notes 2 and 12 for further details.

The movements in the net deficit during the period were as follows:

On an IAS 19 basis, the funding level is 90% (31 March 2021: 88%).

Dividends

The Board has declared an interim ordinary dividend of 40.86p per share (2020/21: 40.63p per share), which will be paid on 7 January 2022 to shareholders on the register at 3 December 2021.

Principal risks and uncertainties

The Board considers the principal risks and uncertainties affecting the business activities of the Group for the remainder of the financial year to be those detailed below. Details of how the Group mitigates and manages these risks are set out in the Annual Report.

Cyber Security and Technology Resilience:

·    Cyber threats cause damage to key infrastructure assets, interruptions to core systems or data loss resulting in a negative impact on our reputation, operations, regulatory (including GDPR) compliance or finances.

Service Failure and Asset Resilience:

·    We fail to provide a safe and secure supply of drinking water to our customers and there is reduced public confidence in water supply.

·    We fail to effectively transport and treat wastewater and there is reduced public confidence in our wastewater system.

Financial Liabilities:

·    We fail to fund the Severn Trent defined benefit ('DB') pension scheme sustainably.

·    We are unable to secure sufficient liquidity to meet our funding requirements.

Capital Project Delivery and Scheme Resilience:

·    We fail to design or deliver to time and cost capital projects that ensure the resilience of our operations and safety of our assets.

Political, Legal and Regulatory:

·    Accelerating changes in the political, legal environment and environmental obligations increase our risk of non-compliance.

Climate Change, Environment and Biodiversity:

·    Our climate change strategy does not enable us to respond to the shifting natural climatic environment and maintain our essential services.

·    We fail to positively influence natural capital in our region.

Health and Safety:

·    Due to the nature of our operations, we could endanger the health and safety of our people, contractors and members of the public.

COVID-19:

·    Whilst global pandemics have not previously been noted as a principal risk, they do feature on our horizon scanning and many of the associated risks are captured within our Enterprise Risk Management framework. We have a well-rehearsed approach to incident management and while COVID-19 presented many unique challenges, the governance structure we implemented in response to the COVID-19 pandemic provided a stable foundation from which we could respond to the changing situation.

·    COVID-19 assumptions are built into our budget and business plan process. Our priority remains the health and safety of our people and customers, and we are taking all possible actions to support them whilst continuing to deliver our essential services. The Board continues to receive regular updates on the Group's COVID-19 response in order to assess, monitor and respond to the evolving impact of COVID-19 on our operations and business, including impacts for all of our stakeholders.