Fitch Ratings has affirmed Kemble Water (a holding company of Thames Water) Utilities Issuer Default Rating (IDR) at 'BB-' with a Stable Outlook and senior secured rating at 'BB'.

The agency has also affirmed Thames Water (Kemble) Finance PLC's £400 million senior secured bond issue at 'BB', which is guaranteed by Kemble Water.

The ratings also reflect Thames Water's operating and regulatory performance. Fitch said the company has scope to improve customer service, reduce sewer flooding incidents, move asset serviceability for sewerage infrastructure back to stable and become more efficient in terms of operating expenditure.

The affirmation takes into account the pressure on credit metrics stemming from water industry regulator Ofwat's risk and reward guidance for the price review covering April 2015 to March 2020.

The regulator has guided towards a cost of capital of 3.85% for the regulated companies, lower than Fitch expected. The ratings agency said that Ofwat appears to have done “a lot of modelling2regarding the hypothetically possible return on regulatory equity for the regulated companies, but has put limited emphasis on the timing and visibility of these returns.

As the price control process moves forward, Fitch will re-assess companies' scope to outperform, consider funding mechanisms associated with incentives and establish forecasts with detailed sensitivities.

To establish is rating case forecast for Kemble Fitch used the cost of capital of 3.85%, factored in the revenue adjustments related to the last price control period included in Thames Water's business plan and no outperformance. The forecast credit metrics continue to be in line with guidance for Kemble Water's 'BB-' rating.

Upstream cash flow tightens

The £750 million of incremental debt at the holding company level represents around 5% of Regulatory Asset Value and incurs an annual finance charge of around £60 million. Fitch said the re-based dividend stream from Thames Water expected for the next price control period will still allow servicing of the debt - based on the assumption that Thames Water will maintain its current financial structure.

However, Fitch warned thaf management decided to reduce gearing at Thames Water by retaining dividends, this would likely have a negative impact on Kemble Water's ratings. Similarly, if Fitch concluded after the price control process that business risk in the sector had increased or Thames Water was expected to underperform price control assumptions, a downgrade of Kemble Water would be likely considering that currently forecasted dividend cover only has little headroom in comparison with the established guideline.

Meeting regulatory targets

In the financial year to March 2013 (FY13) Thames Water reported marginal asset serviceability for sewerage infrastructure and the number of sewer flooding incidents exceeded the target. The company met leakage targets for the seventh consecutive year.

Customer satisfaction lagging behind

In terms of the service incentive mechanism, which measures customer satisfaction in the water sector, the company scored 63 points out of 100 for FY13, ranking low compared with peers. In comparison, peers made some progress in improving scores during FY13. The bad debt charge remained at a high level. Fitch said there is more work to be done to improve these factors.

Future developments unlikely to lead to positive rating action

Fitch has concluded that any future developments that could lead to positive rating action are unlikely at this stage due to the challenges posed by the upcoming price control.

Future developments that could lead to negative rating action include:

• Decrease of dividend cover at Kemble Water below 2x, increase of gearing above 95% and/or decrease of post-maintenance and post-tax interest cover below 1.05x (as per Fitch's forecasts).
• Possibility of a dividend lock-up at Thames Water.
• Deterioration of operational and regulatory performance at Thames Water.
• Increasing business risk in the sector following conclusion of the price control process.
• Retention of dividends at the Thames Water level in order to reduce leverage.