4

   Audit, risk and internal control

Code principleEvidence and outcomes
Principle M:
The board should establish formal and transparent policies and procedures to ensure the independence and effectiveness of internal and external audit functions and satisfy itself on the integrity of financial and narrative statements.
In accordance with provision 25, an explanation of how the independence and effectiveness of the external audit process can be found in the How we assess the effectiveness of the statutory audit process, and the reappointment of the statutory auditor in the Statutory auditor reappointment for the year ending 31 March 2021.
Principle N:
The board should present a fair, balanced and understandable assessment of the company's position and prospects.
Our disclosure against provision 27 can be found in the Audit committee.
Principle O:
The board should establish procedures to manage risk, oversee the internal control framework, and determine the nature and extent of the principal risks the company is willing to take in order to achieve its long-term strategic objectives.
Our risk management framework and principal risks are in Our risk management. Further information on the company's internal audit function and controls can be found in the Our risk management.

Board's approach to risk management and internal control

The board discharges its responsibility for determining the nature and extent of the risks that it is willing to take to achieve its strategic objectives through the risk appetite framework. As a key part of the risk management framework, risk appetite captures the board's desire to take and manage risk relative to the company's obligations, stakeholder interests and the capacity and capability of our key resources.

The board is also responsible for ensuring that the company's risk management and internal control systems are effectively managed across the business and that they receive an appropriate level of scrutiny and board time. The group's risks predominantly reflect those of all regulated water and wastewater companies. These generally relate to the failing of regulatory performance targets or failing to fulfil our obligations in any five-year planning cycle, potentially leading to the imposition of fines and penalties, in addition to reputational damage. Political risk is also closely monitored.

Review of the effectiveness of the risk management and internal control systems

During the year, the board reviewed the effectiveness of the risk management systems and internal control systems, including financial, operational and compliance controls. Taking into account the principal risks and uncertainties set out in Our risk management, and the ongoing work of the audit committee in monitoring the risk management and internal control systems on behalf of the board (and to whom the committee provides regular updates, see Audit committee), the board:

  • is satisfied that it has carried out a robust assessment of the emerging and principal risks facing the company, including those that would threaten its business model, future performance, solvency or liquidity; and
  • has reviewed the effectiveness of the risk management and internal control systems including all material financial, operational and compliance controls (including those relating to the financial reporting process) and no significant failings or weaknesses were identified. After review, it was concluded that through a combination of the work of the board, the audit committee and the UUW board (which has particular responsibility for operational and compliance controls), the company's risk management and internal controls were indeed effectively monitored throughout the year.

In the review of the effectiveness of risk management and internal controls systems, the board also took into account the:

Going concern and long-term viability

The following section sets out the company's compliance with part of Code provision 30 and 31.

The board, following the review by the audit committee, concluded that it was appropriate to adopt the going concern basis of accounting (see Governance structure of the board). Similarly, in accordance with the principles of the Code, the board concluded, following the recommendation from the audit committee, that it was appropriate to provide the long-term viability statement (see below). Assurance supporting these statements was provided by the review of: the group's key financial measures and contingent liabilities; the key credit financial ratios; and the group's liquidity and ongoing ability to meet its financial covenants. As part of the assurance process, the board also took into account the principal risks and uncertainties facing the company, and the actions taken to mitigate those risks, and include emerging and more topical risks.

These principal risks and uncertainties are detailed in Our risk management, as are the risk management processes and structures used to monitor and manage them. Biannually, the board receives a report detailing management's assessment of the most significant risks facing the company. The report gives an indication of the level of exposure, subject to the mitigating controls in place, for the risk profile of the group, while also highlighting the reputational and customer service impact. This provides the board with information in two categories: group-wide business risks; and wholesale operational risks. The board also receives information during the year from the treasury committee (to which the board has delegated matters of a treasury nature – see the structure diagram in the Corporate governance report) including such matters as liquidity policy, the group's capital funding requirements and interest rate management. The board believes, because of the nature of the regulatory regime of the water sector and the contribution to the longer-term planning horizon for the sector of Ofwat's business plan assessment process, under the current regulatory and statutory framework a period of seven years to assess the group's long-term viability is appropriate.

Long-term viability statement

The directors have assessed the viability of the group, taking account of the group's current position, the potential impact of the principal risks facing the business in severe but reasonable scenarios, and the effectiveness of any mitigating actions. This assessment has been performed in the context of the group's prospects as considered over the longer term. Based on this viability assessment, the directors have a reasonable expectation that the group will be able to continue in operation and meet its liabilities as they fall due over the seven year period to March 2027.

Basis of assessment

This viability statement is based on the fundamental assumption that the current regulatory and statutory framework does not substantively change. The long-term planning detailed on Long-term planning (25+ Year) assesses the group's prospects and establishes its strategy over a 25-year time horizon consistent with its rolling 25-year licence and its published long-term strategy. This provides a framework for the group's strategic planning process, and is key to achieving the group's aim of providing the best service to customers at the lowest sustainable price and in a responsible manner over the longer term, underpinning our business model set out in Our business Model.

In order to achieve this aim and promote the sustainability and resilience of the business, due consideration is given to the management of risks over the long term that could impact on the business model, future performance, credit ratings, solvency and liquidity of the group. Specifically, risks associated with the possible ongoing impact of the COVID-19 pandemic have been considered and factored into the various scenarios modelled as part of the group's assessment. An overview of our risk management approach that supports the group's long-term planning and prospects, together with the principal risks and uncertainties facing the business, can be found in Principal risks and uncertainties.

Viability assessment: resilience of the group

The viability assessment is based upon the group’s medium-term business planning process, which sits within the overarching strategic planning process and considers:

  • The group’s current liquidity position – with £1.2 billion of available liquidity at March 2020 providing a significant buffer to absorb short-term cash flow impacts;
  • The group’s robust capital solvency and credit rating positions – with a debt to regulatory capital value (RCV) ratio of 62 per cent, a robust pension position and current credit ratings of A3/BBB+/A- with Moody’s, S&P and Fitch respectively, this provides considerable headroom supporting access to medium-term liquidity where required;
  • The group’s expected performance, underpinned by its historical track-record; and
  • The current regulatory framework within which the group operates – which provides a high degree of cash flow certainty over the regulatory period and the broader regulatory protections outlined below.

The group has a proven track-record of being able to raise new forms of finance in most market conditions, and expects to continue to do so into the future. This is despite the group no longer having access to future EIB funding following the UK’s exit from the EU.

From a regulatory perspective, the group benefits from a rolling 25-year licence and a regulatory regime in which regulators – including the economic regulator, Ofwat – are required to have regard to the principles of best regulatory practice. These include that regulation should be carried out in a way that is transparent, accountable, proportionate, consistent and targeted. Ofwat’s primary duties provide that it should protect consumers’ interests, by promoting effective competition wherever appropriate; secure that the company properly carries out its statutory functions; secure that the company can finance the proper carrying out of these functions – in particular through securing reasonable returns on capital; and secure that water and wastewater supply systems have long-term resilience and that the company takes steps to meet long-term demands for water supplies and wastewater services.

In addition, from an economic perspective, given the market structure of water and wastewater services, threats to the group’s viability from risks such as reduced market share, substitution of services and reduced demand are low compared to those faced by many other industries.

Viability assessment: resilience to principal risks facing the business

The directors have assessed the group’s viability based on the resilience of the group and its ability to absorb a number of ‘severe but reasonable’ scenarios, derived from the principal risks facing the group, as Principal risks and uncertainties. The baseline plan against which the viability assessment has been performed reflects the estimated impact of a ‘long peak’ COVID-19 scenario on the group. This assumes restrictions and social distancing extend through the summer of 2020 resulting in a one-year GDP reduction of 8 per cent which takes 10 quarters to recover; unemployment peaking at 9 per cent; CPIH inflation reducing to zero in the year to March 2021 and averaging 1.0 per cent over the period to March 2025 before increasing back to 2.0 per cent; and non-household business revenues reduced by around 30 per cent in the year to March 2021. This baseline plan is then subject to further stress scenarios and reverse stress testing that takes into account the potential impact of the group’s principal risks. Such risks include: environmental risks such as the occurrence of extreme weather events and other impacts of climate change, further details of which are included in the group’s TCFD disclosures on Our approach to climate change (TCFD) political and regulatory risks; the risk of critical asset failure; significant cyber security breaches; longer term, economic impacts resulting from COVID-19, including unemployment and corporate failures affecting debt collection and lower inflation affecting revenues, financing costs and RCV; and the potential for a restriction to the availability of financing resulting from a capital markets crisis. While a scenario in which no trade deal is reached ahead of the conclusion of the transition period following the UK’s withdrawal from the EU may have adverse operational and financial impacts on the group, this is not considered to represent a significant risk to the group’s ongoing viability.

The scenarios considered are underpinned by the group’s established risk management processes, taking into account those risks with a greater than 10 per cent (1 in 10) cumulative likelihood of occurrence. In addressing the risks associated with COVID-19 the further downside scenario considered is one in which the pandemic gives rise to a potential depression with persisting levels of high unemployment and short-term deflation, followed by medium term low inflation. This is assumed to result in elevated levels of bad debt, increased totex costs, outcome delivery incentive penalties and lower CPIH inflation, in each case, across the whole viability period.

The assessment has considered the impact of these scenarios on the group’s business model, future performance, credit ratings, solvency and liquidity over the course of the viability assessment period. This assessment has demonstrated the group’s ability to absorb the impact of all severe but reasonable scenarios modelled, without the need to rely on the key mitigating actions detailed below.

As part of the assessment, reverse stress tests of extreme theoretical scenarios have been performed to understand the headroom in the group’s ability to absorb all severe but reasonable scenarios.

Viability assessment: key mitigating actions

In the event of more extreme but low likelihood scenarios occurring, there are a number of key mitigations available to the group, the effectiveness of which are underpinned by the strength of the group’s capital solvency position.

As well as the protections that exist from the regulatory environment within which the group operates, a number of actions are available to mitigate more severe scenarios, which include: the raising of new finance; capital programme deferral; the closeout of derivative asset positions; the restriction of dividend payments; and access to additional equity.

Governance:

The analysis underpinning this assessment has been through a robust internal review process, which has included scrutiny and challenge from the audit committee and board, and has been reviewed by the group’s external auditor, KPMG, as part of their normal audit procedures.

Going concern:

The directors also considered it appropriate to prepare the financial statements on the going concern basis, as explained in the basis of preparation note to the accounts.