S&P Global Ratings has lowered its credit ratings on Northumbrian Water Limited (NWL) and parent holding company, Northumbrian Water Group Ltd. (NWG) to 'BBB' from 'BBB+', due to pressure on NWL's operating and financing costs due to rising inflation and heavier than anticipated capital expenditure (capex).

The group's capex profile is now heavily backloaded and will significantly accelerate in the last two years of AMP7 - capex averaging about £360 million annually in financial year 2024 and financial year 2025, from about £230 million for the first three years of AMP7).

S & P said:

“Both of these factors add to the already challenging operating conditions for the current regulatory period (AMP7) and therefore weigh on the group's credit metrics.”

Significantly higher inflation than in S & P’s previous base case pressured both operating and financing costs which will pressure the group's credit metrics until the end of the regulatory period, the ratings agency says – pushing up operational costs while high energy prices aggravated by the Russia-Ukraine conflict are pressuring margins.

According to S & P, inflation typically benefits regulated water companies like NWL - however, the spike in energy prices recorded in the last quarter of 2021 and since then aggravated by the Russia-Ukraine conflict has led to energy prices rising significantly above average inflation levels.

In the agency’s view, this is pressuring margins in light of the group's hedging profile with approximately 20% of power demand currently unhedged for financial year 2023 and 50% for financial year 2024.

According to the ratings agency, operating conditions are proving to be much tougher compared with the previous AMP6 regulatory period. Notably, NWL recorded the largest decline (13.2% in real terms) in the industry's combined water and wastewater bill at the start of the current regulatory period.

Storm Arwen in 2021 also weighed on the group's operational performance for the 2022 financial year. NWL received a large penalty as a result, which more than offset the financial reward earned over financial year 2022, with NWL recording a £20 million net penalty position. The ratings agency commented:

“We understand that the representations NWL made to Ofwat to remove the effect of Storm Arwen on its performance commitments were unsuccessful. We otherwise see NWL as an efficient water company with a track-record of robust operational performance.”

Although S & P notes that the pressure will ease and credit metrics gradually recover by the end of AMP7 in March 2025, the ratings agency now expects that NWL and parent holding company NWG will continue to operate below its 'BBB+' rating threshold until the end of March 2025. It also expects high inflation to push up other operational costs such as labour and chemicals.

However, according to S & P, NWL is relatively less exposed to rising financing costs due to inflation than peers, given its lower proportion of inflation-linked financing in its capital structure-about 40% compared to about 50% for other water and wastewater companies.

Given NWL's large investment program and projected cash flow generation, S&P is now forecasting that dividend distributions, averaging about £100 million per year, would either have to be entirely debt-funded during the rest of AMP7 or come at the expense of some discretionary capex.

The group has yet to refinance its biggest debt maturity for AMP7 - a £350 million Eurobond due February 2023 - S&P could take a negative rating action by the end of this year if it observesm that the group is yet to refinance the Eurobond.

The group’s ultimate parent company is CK Hutchison Holdings Ltd., a diversified conglomerate based in Hong Kong. On 14 July 2022, Nimbus U.K. Bidco Ltd entered into an agreement to purchase 25% of the entire issued share capital of NWG.

S&P maintains its stable outlook for the company – based on the expectation the group's adjusted funds from operations to debt will remain within 6%-9%, and that its debt to EBITDA remains 8x-10x throughout the rest of the regulatory period.