Over the last year, there has been coverage in the media about Severn Trent Trimpley. In the interests of being open and transparent, we’d like to share our responses to requests for information that we’ve received.

This has included a letter from MPs which you can read here.

A letter to the EFRA committee that you can find here.

The Financial Reporting Council will publish a summary of their findings  in relation to the financial statements of Severn Trent Water Limited (STW), Severn Trent Draycote Limited (Draycote) and Severn Trent Trimpley Limited (Trimpley) later this month. 

Here is a summary of our response and the key explanation of the structure.

Transactions involving Severn Trent Draycote Limited, Severn Trent Trimpley Limited and Severn Trent Water Limited

Severn Trent Trimpley Limited (“Trimpley”), was incorporated on 24 March 2017 as a wholly owned subsidiary of Severn Trent Draycote Limited (“Draycote”). Trimpley issued shares to the value of £3 billion to Draycote with the consideration for the shares being recorded as an intercompany receivable by Trimpley, and that Draycote recorded an increase in its fixed asset investments of £3 billion with a corresponding increase in borrowings. On 31 March 2017, Trimpley undertook a capital reduction which resulted in the £3 billion of share capital and share premium that had been recognised being credited to a distributable reserve.

On 24 March 2017 Severn Trent Water Limited acquired a 49% holding in Trimpley from Draycote for consideration of £1.47 billion settled by Severn Trent Water Limited issuing additional shares to Draycote. Severn Trent Water Limited subsequently undertook a capital reduction to create additional distributable reserves of £1.57 billion.

·         the intercompany balance between Draycote and Trimpley bears interest;

·         the interest payable (and receivable) is being added to the intercompany balance and has not been settled in cash; and

·         the terms of the intercompany amount have been amended over the period since origination resulting in the interest rate being rebased and the term of the arrangement being extended.

·         the fair value of Severn Trent Water’s investment in Trimpley increases by its proportionate share of Trimpley’s increase in net assets in the year. Since Trimpley has never paid a dividend, this is equivalent to the share of profit after tax and in essence the financial outcome has been the same, but the fair value assessment is based on the value of the underlying net assets in Trimpley’s draft accounts.

To be helpful in this area to a user of the financial statements, an additional disclosure, included below will be shared in the financial statements for the year ended 31 March 2025, which will be published in July.

 

The purpose of the series of transactions as referenced above is as follows:

During the financial year ended 31 March 2017 falling interest rates that were driven by the outcome of the Brexit referendum had substantially increased the pension deficit recorded in Severn Trent Water’s balance sheet and depleted its distributable reserves.   

The underlying value of Severn Trent Water was undiminished, demonstrated by its Regulatory Capital Value (RCV), which is the base that Ofwat, the economic regulator of the water industry in England and Wales, uses to calculate the allowed return for water companies, and is therefore a key metric in determining the value of a water company. Regulated water businesses in England and Wales are valued based on a multiple of RCV, (typically ranging between 1.1 – 1.4 times) in market transactions.

Severn Trent Water’s RCV at 31 March 2017 was £8.2 billion, an increase of 5.3% over the previous year. The market capitalisation of Severn Trent Plc is a market based indicator of the value of Severn Trent Water, as Severn Trent Water is by far the most significant driver of value for Severn Trent Plc.

At 31 March 2017 Severn Trent Plc’s market capitalisation was £5.1 billion, which was 98% of its value a year earlier. Severn Trent Water’s full value, demonstrated by its RCV and Severn Trent Plc’s market capitalisation, was not recognised in the financial statements prepared under IFRS and was not reflected in the carrying value of Draycote’s investment in Severn Trent Water.

The Board resolved to put in place the series of steps described above to replenish Severn Trent Water’s distributable reserves.  This was not the only approach that we could have taken. For example, instead we had an option to increase customer bills based on regulatory rewards for the outperformance of operational metrics that had been agreed by Ofwat. However, we chose to smooth these increases to customers rather than go down this route.

When Trimpley’s £3 billion loan to Draycote was initiated, it was supported by Draycote’s investment in Severn Trent Water, which was included in Draycote’s balance sheet at its historical cost of £3.5 billion. The fair value of Draycote’s investment in Severn Trent Water was estimated at the time to be more than £5 billion. This investment gave Draycote access to a future dividend stream capable of servicing the interest and capital payments on the loan. Thus, Trimpley’s loan to Draycote would be recoverable.

The investments in Trimpley held by Draycote and Severn Trent Water are recoverable on the basis that Trimpley can recover its loan to Draycote. This loan is recoverable because Draycote can service it, using dividend payments from Severn Trent Water.

Since the structure was established:

·           Severn Trent Water has paid £1.8 billion in dividends to Draycote.

·           The retained earnings created from the capital reductions were intended to provide a buffer to absorb short-term earnings fluctuations and were not intended to provide an additional source from which to pay dividends. These earnings have never been used to support dividend payments either on a short-term or permanent basis.

·           Draycote has invested a further £850 million in equity in Severn Trent Water, which was raised by Severn Trent Plc.

·           Severn Trent Water’s RCV has increased to more than £13 billion.

·           Severn Trent Water has paid contributions to its main defined benefit scheme amounting to £478 million, reducing the deficit and mitigating the risk of future impacts to distributable reserves.

An extract from the minutes of Severn Trent Water’s Board meeting of 24 March 2017 is set out below. This records the decision making process applied by the Board in implementing these transactions and their purpose:

The impact of falling interest rates on the pension deficit in the run up to the half year had resulted in a depletion of the company’s distributable reserves.  Therefore a plan had been developed in conjunction with PwC to create approximately £1.6 billion of additional distributable reserves with no adverse impact on earnings, cash or tax.  The plan would involve a reduction in share capital without court approval and would require a solvency statement from each of the Directors to the effect that the company could pay its debts as they fell due for the next 12 months.  The paper set out the reasonable grounds on which the Directors could rely on making the statement.

Whilst this was normal practice and it would be clearly shown in the year end accounts, the Board was concerned to make sure that this was not in breach of any regulatory requirements or would be perceived negatively by Ofwat.  It was agreed that the proposal should therefore be confirmed with Ofwat outside the meeting.

On this basis, and noting the advice from PwC on the company’s financial position and Herbert Smith Freehills on the legal requirements and duties of directors, the Board APPROVED:-

i.               The proposed capital reduction and Solvency Statement.

ii.              The proposed acquisition of 49,000 ordinary shares of £1.00 each of the share capital of Severn Trent Trimpley Limited, the payment to be satisfied by allotting and issuing to Severn Trent Draycote Limited up to 100,000 Ordinary shares of £0.10 each in the share capital of the Company, at a premium of £14,699.900016 per share (the “Transaction”), pursuant to an Intra Group Share Purchase Agreement between the Company and Severn Trent Draycote Limited (the “SPA”).

iii.            The SPA and authorised any Director to execute the SPA on behalf of the Company, subject to such amendment and modifications that Director in his absolute discretion may think fit.

iv.            Any Director to do all other acts or things as might be necessary to give effect to the Transaction or which might otherwise be desirable in connection therewith.

v.              Conditional upon the execution of the Transaction, a reduction of capital of the Company by cancelling the whole of the Company’s share premium account and re-denominating the Company’s issued ordinary share capital from Ordinary shares of £0.10 each to Ordinary shares of £0.001 each, thereby creating £1,569 million of distributable reserves.

vi.            The Written Resolution in respect of the reduction of capital to be sent all eligible members of the Company for the reduction of capital.

vii.          For the signing and dating by each director of a solvency statement (the "Solvency Statement") pursuant to section 642 of the Companies Act 2006 (the "2006 Act").

viii.         For the signing and dating by each director of a Directors’ Statement pursuant to section 644(5) of the 2006 Act confirming compliance with the statutory requirement.

ix.            One director to sign and date a statement of capital (form SH19) to comply with section 644(2) of the 2006 Act.

x.              The filing, within 15 days of the Written Resolution being passed, of a copy of the resolution, a signed Solvency Statement, Form SH19 and a statement of compliance by the directors confirming that the Solvency Statement was made not more than 15 days before the date on which the resolution was passed and was provided to the members in accordance with section 642(2) of the 2006 Act.

 

The Board received accounting and tax advice from PricewaterhouseCoopers and legal advice from Herbert Smith Freehills in connection with the transactions to ensure that they were in compliance with all applicable accounting, tax and legal requirements/standards.

In line with the Board’s request, the CEO wrote to Ofwat’s Chief Executive Officer on 13 April 2017 to set out and explain the series of transactions that had been undertaken.

The transactions were not intended to and did not:

·                Result in any tax advantage to the group.

·                Improve Severn Trent Water’s financial resilience under Ofwat’s metrics.

·                Enhance the credit rating of any of the companies involved or related companies.
 

The initial values of the transactions were based on the surplus of Severn Trent Water’s fair value over its carrying value in Draycote’s financial statements before the transactions were implemented. Draycote accounted for the transfer of 49% of its shareholding in Trimpley to Severn Trent Water as an increase in its investment in Severn Trent Water. It was necessary to demonstrate that this increased carrying value was not greater than Severn Trent Water’s fair value less costs to sell, to confirm that there was not an immediate impairment on implementation of the transactions. The increased carrying value was £5.0 billion and Severn Trent Water’s fair value less costs to sell at 31 March 2017 was assessed to be £5.1 billion.

 

At 31 March 2024  how is Draycote assessed for its investment in Trimpley for impairment?

 

Trimpley is classified as a subsidiary company in Draycote’s financial statements. Draycote’s accounting policy for investments in subsidiaries, as disclosed in note 1(g) of its financial statements for the year ended 31 March 2024, is as follows:

Investments in subsidiaries are stated at cost less, where appropriate, provisions for impairment. Investments in subsidiaries are reviewed for impairment in line with note 1f) when indicators of impairment have been identified.

Note 1f) sets out Draycote’s accounting policy for impairment of non-current assets, including investments in subsidiaries as follows:

If the recoverable amount of a non-current asset is estimated to be less than its carrying amount, the carrying amount of the asset is reduced to its recoverable amount. Where the asset does not generate cash flows that are independent from other assets, the Company estimates the recoverable amount of the cash-generating unit to which the asset belongs. Recoverable amount is the higher of fair value less costs to sell or estimated value in use at the date the impairment review is undertaken. Fair value less costs to sell represents the amount obtainable from the sale of the asset in an arm’s length transaction between knowledgeable and willing third parties, less costs of disposal. Value in use represents the present value of future cash flows expected to be derived from a cash-generating unit, discounted using a pre-tax discount rate that reflects current market assessments of the cost of capital of the cash-generating unit or asset. 

The discount rate used is based on the estimated cost of capital adjusted for the risk profiles of the business. 

Impairment reviews are also carried out if there is an indication that an impairment may have occurred, or, where otherwise required, to ensure that non-current assets are not carried above their estimated recoverable amounts. 

Impairments are recognised in the income statement.

As set out above, Draycote’s investment in Trimpley is supported by the value of Trimpley’s loan receivable. Trimpley can recover its loan if Draycote has the ability to repay it. Draycote’s ability to repay the loan primarily derives from its investment in Severn Trent Water and the dividend stream that flows from that.

In determining whether there was any indicator of impairment, Draycote considered the factors identified in paragraph 12 of IAS 36 and concluded that none were present in this case. In accordance with paragraph 13 of IAS 36 Draycote also considered whether there were any other indicators that its investment in Trimpley might be impaired and none were noted. Draycote also considered the factors from internal reporting set out in paragraph 14 of IAS 36 and noted no evidence of impairment.

The key factor in determining whether there was an indicator of impairment was that Draycote would be able to service the loan note through its access to dividends received from Severn Trent Water. Since the loan note was established, Draycote had received £1.8 billion in dividends from Severn Trent Water and this dividend flow was expected to continue into the foreseeable future. 

In making its assessment Draycote considered the nature of its investment in Trimpley and whether there had been any reduction in the value of Trimpley’s underlying assets. At 31 March 2024, Trimpley’s assets comprised:

·                a loan note receivable of £3 billion due from Draycote. The loan note bears interest at the Bank of England Base Rate plus a margin of 1.375%. This is considered to be in line with the market rate of interest.

·                accumulated unpaid interest amounting to £462.8 million, also bearing interest.

·                corporation tax payable of £69 million, representing the tax payable from the two most recent financial years.

 

Trimpley had assessed its loan note receivable for impairment in accordance with paragraph 5.5.1 of IFRS 9. We set out the results of this assessment below in our response to question 1.6 (b) ii. below.
 

How at 31 March 2024 is Trimpley assessed its receivable due from Draycote for impairment?

 

The loan receivable is held to collect contractual cash flows that are solely payments of principal and interest and is classified under IFRS 9 paragraph 4.1.2 as measured at amortised cost. The loan is measured for impairment under the expected credit loss model set out in Chapter 5 of IFRS 9 as described below.

The original loan has been refinanced since its inception, most recently on 22 March 2024. The key terms were:

Facility amount: £3,500,000

Amount drawn: £3,000,000

Maturity date: 22 March 2026

Interest period: 6 months

Basis: Bank of England base rate

Margin: 1.375% 

 

These terms were not materially different from the original loan and this was not considered to be derecognition of the old asset and recognition of a new asset. On 22 March 2024 Trimpley and Draycote considered that these terms were based on market conditions and that the margin reflected an appropriate return for the credit risk, based on our Group Treasury Department’s assessment of market transactions.

 

Trimpley assessed that at 31 March 2024, there had not been a significant increase in credit risk on the loan receivable since its initial measurement on 24 March 2017. This assessment was based on the following:

·                There had been no material adverse change in the circumstances of any of the parties from inception on 24 March 2017 and the measurement date, 31 March 2024.

·                Draycote was the beneficiary of a statutory guarantee from its parent company Severn Trent Plc, which had investment grade credit ratings of BBB with Standard and Poor’s and Fitch and Baa2 with Moody’s

·                Draycote had benefited from a regular flow of dividends from Severn Trent Water. In the seven years following establishment of the original loan note, Draycote had received over £1.8 billion in cash dividends from Severn Trent Water.

·                The Regulatory Capital Value (‘RCV’) of Severn Trent Water, Draycote’s principal investment and asset, had increased by 44% to £11.4 billion since the inception of the loan in 2017. Regulated water businesses in England and Wales are valued at a multiple of RCV in market transactions and RCV is therefore a key metric in determining the value of a water company. This indicates that Draycote’s main asset was significantly more valuable at 31 March 2024 than it had been on 24 March 2017 when the original loan was established. 

·                The practical operation of the loan had been agreed between the parties, in particular that interest may be ‘rolled up’ rather than settled in cash. The rolled up interest accrues further interest at the same rate as the principal, hence the present value of the interest payments at any point is the same irrespective of when they are actually settled.

 

In determining whether there had been an increase in credit risk, Trimpley considered the fact that the interest due on the loan had not been settled in cash. Trimpley noted that this was an informal variation of the terms of the loan, agreed between itself and Draycote. In each year since inception of the loan, Draycote had received cash dividends from Severn Trent Water greater than the interest amounts due on the loan and had therefore been capable of settling the interest payments on the due dates. However, the parties had agreed to roll over the interest as a matter of administrative convenience. When the loan was established the accounting advice noted that the structure did not require actual cash to flow.

Since there had not been a significant increase in credit risk since initial recognition, under paragraph 5.5.5 of IFRS 9 Trimpley measured its loss allowance for the loan at its 12-month expected credit losses. In estimating the 12-month expected credit losses Trimpley took into account that:

·                The loan bears interest at a market rate.

·                Any late payments of interest bear interest at the same market rate.

·                Draycote is a solvent, well-capitalised company, backed by a guarantee from its parent that holds investment grade credit ratings from three ratings agencies, and owning a profitable regulated water company that has a track record of paying regular cash dividends.

 

Trimpley assessed the expected credit loss in accordance with paragraph B5.5.29 of Appendix B to IFRS 9 as the present value of the difference between:

a.             the contractual cash flows that are due to Trimpley under the contract; and

b.             the cash flows that the Trimpley expects to receive.

At 31 March 2024 Trimpley expected to collect all cash flows due under the contract, including a market rate of interest on any late payments and therefore assessed the expected credit loss to be de minimis.

We set out in our response to question 1.6 (c) how we expect that Draycote will settle its obligations under the loan. 

How, at 31 March 2024 is Severn Trent Water Limited assessed its investment in Trimpley for impairment?

 

Severn Trent Water’s investment in Trimpley is classified as an ‘other investment’ at fair value through profit and loss. Its accounting policy for other investments is set out in note 2 m) to the financial statements as follows:

Other investments are initially recognised and subsequently measured at fair value. Changes in fair value are recognised in profit or loss.

As such the investment is not subject to the impairment approach set out in Chapter 5 of IFRS 9 because the investment is measured at fair value and gains and losses are taken through profit and loss.

We set out below under our response to question 1.7 how the fair value of the investment has been determined.

 

How do we envisage Draycote will repay the borrowings when the intercompany arrangement matures?

 

We envisage that the borrowings will be repaid from dividends that Draycote receives from Severn Trent Water and from equity contributions that will be received from Severn Trent Plc. We anticipate establishing a formal repayment schedule using these mechanisms at the next review date for the loan.  

As an illustration of how this would be possible, we noted above that, up to 31 March 2024 since the borrowings were put in place, Draycote had received more than £1.8 billion in cash dividends from Severn Trent Water. In the year ended 31 March 2024, Draycote also received £600 million from Severn Trent Plc, which was part of the proceeds of an equity placing of £1 billion undertaken by Severn Trent Plc, which it used to make an equity investment in Severn Trent Water (included in the investment value above). Severn Trent Plc will invest the remaining £400 million raised in the equity placing as an equity investment into Draycote as and when Severn Trent Water requires the funds for its capital programme. In September 2021 Severn Trent Plc undertook an equity placing for £250 million which was passed to Draycote to make an equity investment in Severn Trent Water to fund additional capital investment in the current regulatory period as part of Ofwat’s Green Recovery programme.

It is within Draycote’s control to use the investment received from Severn Trent Plc and dividends received from Severn Trent Water to pay down its loan due to Trimpley. Had it chosen to do so at the time, a total of £2.65 billion would have been paid down and the outstanding balance of capital and interest at 31 March 2024 would have been £812.8 million, with £400 million available at Severn Trent Plc that could be used to repay the debt further.

The dividends received from Severn Trent Water and the funds invested from Severn Trent Plc are from external sources – Severn Trent Water’s retained profits, and equity raised by Severn Trent Plc. We anticipate that Severn Trent Water’s profits and dividends will grow over the course of the current regulatory period. Investment in water infrastructure is expected to continue to grow beyond the current regulatory period, which could be met by further equity raising by Severn Trent Plc. As set out above, the dividends paid to Draycote from Severn Trent Water and equity investment from Severn Trent Plc will provide a mechanism to pay down the loan due to Trimpley.

How is the fair value of the investment in Trimpley been determined by reference to the requirements of IFRS 13, ‘Fair Value Measurement’ which defines fair value, in paragraph 9, as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date?

 

Given the nature of Trimpley’s assets, we have assessed that a market participant would take an asset based approach to valuation of Trimpley. Severn Trent Water’s investment in Trimpley represents a 49% share in Trimpley’s net assets. At 31 March 2024, these net assets comprised entirely monetary assets and liabilities being:

·                The loan due from Draycote.

·                The accrued interest on the loan

·                The related tax liability to the extent not already settled.

 

A market participant assessing the fair value of the 49% shareholding in Trimpley would base their valuation on the fair values of the underlying assets and liabilities. The fair value of these assets and liabilities may be determined using a present value measurement as set out in Appendix B to IFRS 13.

A market participant would calculate the present value of the loan due from Draycote by discounting the contractual cash flows using a risk-adjusted discount rate. This is the same approach that was used to assess the arms-length interest rate to be applied to the loan when it was renegotiated as at 22 March 2024. Therefore, the discount rate to be applied would be the interest rate on the loan and the present value of the loan would be the amount advanced.

A similar approach would be applied to the accrued interest on the loan. Since interest is added to any unpaid amount at the risk adjusted rate, the present value of the accrued interest is its carrying amount.

The tax liability, which was assessed at its expected value at 31 March 2024, would be expected to be settled within a year of the balance sheet date. The fair value of this amount would not be materially different to the carrying amount.

The assessment of the fair values of Trimpley’s underlying assets and liabilities supported the assessment of the fair value of Severn Trent Water’s 49% holding in Trimpley.

Appendix

 

Pro forma disclosure for the judgment relating to the assessment of the fair value of Severn Trent Water’s investment in Severn Trent Trimpley Limited

 

Critical accounting judgments and sources of estimation uncertainty

 

In the process of applying the Group and Company accounting policies, the Group and Company are required to make certain judgments, estimates and assumptions that they believe are reasonable based on the information available. Although these estimates are based on management’s best knowledge of the amount, event or actions, actual results may ultimately differ from those estimates.

Assessment of fair value of the investment in Severn Trent Trimpley Limited

The Company holds 49% of the equity share capital of Severn Trent Trimpley Limited. The majority 51% share is held by the Company’s holding company, Severn Trent Draycote Limited. The investment is classified as a financial asset measured at fair value through profit and loss because the investment does not give rise to cash flows that are solely payments of principal and interest. Therefore the investment is measured at fair value through profit or loss in accordance with Chapter 4 of IFRS 9.

Assessing the fair value of the investment requires judgment about the methodology that a market participant would adopt to determine the price that would be expected to be received to sell the asset in an orderly transaction.

The investment represents a 49% stake in a company that holds a single asset, a loan note receivable bearing a market rate of interest. Interest receivable from the loan note and tax payable thereon are the only other transactions that the investment incurs.

Because the investment has a single asset and no trade, we consider that a market participant would adopt an asset-based approach to determine the fair value of this investment by determining the fair values of the underlying assets and liabilities at the measurement date. This approach involves estimating the present values of the expected cash flows from the underlying assets and liabilities.

We will also be making additional disclosures in our next Severn Trent Water Annual Report to be published in July, and a link will be provided once this report is issued.