Moody's ratings agency has today downgraded to Baa2 from Baa1 the backed senior secured debt rating of Bristol Water plc - the outlook is negative.
The rating action follows Bristol Water's announcement, on 13 February 2020 that it will not accept Ofwat’s final determination for the five-year AMP7) regulatory period starting in April 2020. As a result, the water sector regulator will now refer the determination to the Competition and Markets Authority (CMA), which will set its own re-determination within the next six months, extendable to up to 12 months.
Moody’s said the rating action takes into account the current determination, which exposes Bristol Water to a significant cut in allowed wholesale returns, a reduction in total expenditure allowances compared with its requests and challenging performance targets, as well as the company's decision to reject the regulator's determination and ask for a CMA review.
Specifically, the downgrade to Baa2 reflects Moody's view that Bristol Water will be unable to maintain financial ratios in line with guidance for the previous Baa1 rating.
Whilst the CMA appeal may result in a more favourable settlement, Ofwat's final determination presents a range of challenges and the rating agency does not expect any increase in allowances will be enough to restore Bristol Water's credit quality.
In addition, the negative outlook considers the uncertainty and delay associated with the appeal and risk that absent material outperformance, a better re-determination and/or balance-sheet strengthening measures, financial metrics could also fall outside of the boundaries for the Baa2 rating.
Moody's estimates that Bristol Water will have an average allowed cash return of around 2.5% over AMP7. On an Retail Prices Index-stripped basis, for comparison with the current period, allowed returns will fall to 1.92% (1.96% including retail margin) from 3.6% (3.74% including the retail margin), a nearly 50% cut.
The ratings agency said the low returns put particular pressure on companies, including Bristol Water, which have expensive existing debt, and whose smaller size means that they access financial markets less frequently and are therefore not able to benefit fully from lower interest rates today.
In previous CMA referrals, the company was able to secure a small company premium within its allowed return, which -- if achieved again -- could reduce the pressure on the water company’s finances.
While Bristol Water's modest gearing of around 60%-65% of net debt to regulatory capital value (RCV) at the start of the new regulatory may help offset some of the pressure, Moody's expects gearing to increase over the period, in particular due to the cost challenges presented by the final determination.
Ofwat's allowances for base operating and maintenance expenditure, excluding enhancement projects but including retail costs, were £432 million, roughly £27 million (or 5.9%) below what the company requested, even after the company had reduced its requested cost by £15 million in its response to the draft determination.
Commenting on operational performance commitments, Moody’s said Bristol Water has faced difficulty in meeting some of its targets under the Outcome Delivery Incentives (ODIs) mechanism for the current period. Ofwat's final determination includes a penalty of £7.1 million associated with the company's AMP6 ODI performance, which will reduce AMP7 revenues, while a further £0.8 million of penalties will be applied as an adjustment to the company's RCV (all in 2017/18 prices).
Bristol Water's rating continues to be constrained by the company's small size and relatively inflexible financing structure, which increases risk exposure in an environment of falling returns, somewhat offset by the structural enhancements included in the company's bond covenant and security package.
Rating outlook could be further downgraded
The negative outlook reflects that Bristol Water will not have certainty over its revenues and investment programme for a further six to 12 months and that the eventual determination, if not materially improved from Ofwat's final determination, may lead to credit metrics that -- absent significant outperformance -- are weakly positioned for the assigned rating.
Given the negative outlook and the reduced financial flexibility in AMP7, Moody's currently does not envisage any upward rating pressure.
The rating could also be downgraded further if the CMA's re-determination provides for a lower allowed return, lower cost allowances or greater operational penalties that are not adequately mitigated by management action.