Credit ratings agency Moody's has downgraded the holding companies of both Thames Water and Anglian Water from a stable to negative outlook as a result of the current PR14 Price Review.

Moody's said the negative outlook reflects the risk that the ongoing price review for the UK water industry, which will set tariffs for the five-year period commencing 1 April 2015 (AMP6), will result in reduced financial flexibility and capacity to meet debt service obligations for the water companies.

The ratings agency said that guidance issued by Ofwat on 27 January  suggests that allowed returns for the UK water sector and, therefore, Thames Water and Anglian Water is likely to fall from the current 5.1% to 3.85% from the start of the next five year regulatory period in April 2015. The outlook change reflects the increased likelihood that cash flow generation at both companies will be curtailed by a challenging regulatory price review, which Moody's expects to significantly reduce the amount of dividends being upstreamed to the holding companies’ level.

Although Moody's expects the holding companies to remain in a position to meet their debt service payments,  the assigned negative outlook reflects the increased risk exposure to cash flow shortages in the event that Thames and Anglian are faced with additional pressures, such as low inflation, operational underperformance or cost overruns in their capex programmes.

No upgrade potential for either company

Moody's said that given the current negative outlook, there is no upgrade potential which would see an upward adjustment of the revised ratings. However, the outlook could be stabilised, if it became clear by the time of the final price determination in December 2014, that neither Anglian nor Thames Water were likely to be materially constrained in their ability to upstream sufficient dividend payments to cover their respective holding companies (Osprey and Kemble Finance) debt service requirements.

Moody's said that the credit profile of Thames Water (and hence Kemble) was also likely to be strained if the utility were required to deliver the main construction works associated with the Thames Tideway Tunnel at an estimated construction cost of £4.1 billion. The rating agency believes that this scenario is unlikely due to the UK government's ongoing consultation for appointing a specified infrastructure provider.

Ofwat - "3.85% is a genuine, forward-looking cost of capital...credit rating is not the be all and end all"

In a recent conference call with investors on Ofwat's risk and reward guidance, Sonia Brown, Chief Regulation Officer at Ofwat reiterated that the allowed 3.85% return  was “a genuine, forward-looking cost of capital”  and that Ofwat did not anticipate changing that view ahead of the final determination unless there were “ a substantial shift in capital markets or unexpected events” that meant it was reasonable for the regulator to revisit the issue.

Commenting on Ofwat’s view of credit ratings, Ofwat’s City Adviser Graham Taylor told investors:

“….we aren't defining financeability in terms of credit ratings as such. We're trying to avoid defining it even in terms of specific ratios.”…..

“ We certainly take the view of the agencies very seriously. We maintain a very regular dialog with them. While we're saying that the rating agency credit rating is not the be all and end all in terms of the definition of financeability, it has a very significant impact on the borrowing costs of the industry, and so we're very conscious of that. Beyond that, though, it really is a matter for the agencies, and for the companies, as it would be in any other industry.”

Keith Mason, Ofwat’s Senior Director of Finance went on to clarify Ofwat’s view on ratings in response to a question from  Andrew Moulder of CreditSights who asked:

“You said that the credit rating is not the be all and end all. You said that it's up to companies to decide where they want to pitch their credit ratings. It is a bit different from what you said before in terms of – before, you said companies should have a comfortable investment-grade rating. It doesn't sound like that's what you're saying anymore. I just wanted to be clear on that, that you're now saying, if a company wants to be BBB-, that's fine, or even if they want to be sub-investment grade, that's fine, as long as they can finance themselves. I just want to know how that also fits into your thinking on the cost of debt assumption.”

Keith Mason replied:

“The key thing to say is that although we're not going to be specifying the particular credit rating range, most of the companies – and we would like all of the companies to – have a licence condition about maintaining an investment-grade credit rating. So when you talked…. about whether they could target sub-investment grade, I think the answer to that is probably not.”

Keith Mason disputed Andrew Moulder’s further comment that the licence condition about investment-grade rating was a best-endeavours basis, meaning that the water companies could argue that with the price control being set by Ofwat , it was not within their power to maintain an investment-grade rating and therefore the licence condition was meaningless.

Mason said that the best endeavours clause was put in because it was a legal document. However, in the general, overall, day-to-day running of the business, including dealing with price reviews, having the investment-grade rating was “part and parcel of having the licence.”