Moody's Investors Service has today changed its outlook on Thames Water’ s Baa1 corporate family rating from stable to negative. The ratings agency is also warning  that the firm is “exposed to reputational and financial challenges that other companies in the sector do not face.”

The ratings agency has changed to negative from stable the outlook on the Baa1 corporate family rating (CFR) of Thames Water Utilities Limited, the A3 ratings on the senior secured Class A notes and the Baa3 rating on the subordinated Class B notes, issued under the £10 billion medium-term note programme by Thames Water's finance subsidiaries, Thames Water UtilitiesFinance Limited and Thames Water Utilities Cayman Finance Limited, and guaranteed by Thames Water.

Today's outlook change follows Thames Water's announcement yesterday that it would launch a consent solicitation process to obtain senior lenders' approval for certain technical amendments to its finance documentation to facilitate the preferred delivery solution for the Thames Tideway Tunnel (TTT) project, the sewerage interceptor tunnel to be built underneath the river Thames.

Moody's said the outlook change reflects the risk that the company may not be able to exhibit sufficient headroom within its financial profile to absorb the risk, albeit limited, that is posed by its involvement in the TTT project.

 The announced consent solicitation will allow Thames Water to avoid unintended technical accounting consequences on the calculation of its financial covenants. If the consent solicitation is approved by senior creditors, Moody's expects that the UK government will formally conclude on the specification of the TTT project under the Specified Infrastructure Projects Regulations introduced in summer 2013.

This will pave the way for Thames Water to enter into the preferred delivery model in relation to the development of the TTT project, which will involve the procurement of a special purpose company that will be responsible for delivering and financing the main tunnel construction works.

Thames exposed to reputational and financial challenges other water companies do not face

 However, even though the development of the TTT project through a specified infrastructure provider will ring-fence Thames Water from the main construction risk, a credit positive, Moody's still believes that the company is exposed to reputational and financial challenges that other companies in the sector do not face.

Thames Water will not only be involved in the procurement of the specified infrastructure provider, it will also be responsible for enabling and interface work in relation to the project and, importantly, collect the infrastructure provider's revenues as part of its own customer bills.

Given such incremental risks, which are unique to Thames Water, Moody's expects the company to require solid financial headroom to maintain its current ratings, with net debt/RCV in the low 80ies or lower and an adjusted interest coverage ratio around 1.4x or higher. Thames Water's historical performance has been in line or better than this guidance but headroom will reduce over AMP6.

This new guidance is slightly more demanding than for its highly leveraged peers, such as Anglian Water Services Limited (Baa1 stable) or Yorkshire Water Services Limited (Baa1 stable), whose minimum guidance is leverage of up to 85% and adjusted interest coverage at least 1.2x.

 This is particularly relevant in the context of already lower cash flows envisaged for the next regulatory period commencing on 1 April 2015, as indicated by Ofwat’s  January 2014 guidance paper, which would see the allowed return reduce to3.85% compared with 5.1% in the current regulatory period.

In its recent special comment on the UK Water Sector, published in February 2014, Moody's said the reduction in the allowed return will reduce the financial flexibility for all water companies.

However, highly-leveraged companies, including Thames Water, will be most exposed. While Thames Water historically benefited from financial outperformance as evidenced by solid headroom against key financial metrics, Moody's expects this to reduce significantly over the next regulatory period.

Stefanie Voelz, Vice President - Senior Analyst, Moody's commented:

“Given the company's reduced financial flexibility, any additional risk factor, such as in relation to Thames Water's involvement in the development of the TTT project, may create additional pressure that the company will have limited headroom to absorb.”

“The negative rating outlook reflects Moody's expectation that the TTT project will go ahead as planned and that Thames Water's involvement in this project will create incremental risk for the company's credit quality that is unique to Thames Water. Given the expected reduction in cash flows for the next regulatory period, Thames Water may have limited flexibility to absorb the incremental risk associated with its involvement in the TTT project.”