Credit ratings agency Moody's says that today's announcement by the Secretary of State for the Environment, Food and Rural Affairs that the Thames Tideway Tunnel project is being specified under the Water Industry(Specified Infrastructure Projects) (English Undertakers) Regulations 2013 is a key step towards implementation of the project.

Moody's were expecting the Government to specify the TTT project, following Thames Water's successful consent solicitation process in May 2014.

The specification notice prohibits Thames Water from conducting the main tunnel construction works, and requires the company to tender the project through a competitive procurement process for a separate Infrastructure Provider (IP).

According to the Government's specification notice, the IP will finance, design, construct, operate, maintain and own the tunnel assets. Thames Water will remain responsible for preparatory works of a nature similar to the company's investment programme as part of its ordinary business.

Moody’s says the move has no immediate rating implications for Thames Water Utilities Limited (Thames Water, Baa1 negative) and its financing subsidiaries, Thames Water Utilities Cayman Finance Limited (A3/Baa3 negative) and Thames Water Utilities Finance Limited (A3 negative).

Moody's believes that the proposed arrangements will largely ring-fence Thames Water from the risks associated with the construction of what would be a sizeable asset compared with its existing asset base, and removes the risk of a significant shift in the company's business risk profile.

Project creates incremental risk for Thames Water

However, the agency is warning that involvement in the project creates incremental risk for Thames.

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

“As outlined in previous company-specific research, we remain of the view 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 allowed returns and, consequently, 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. This incremental risk exposure is reflected in the current negative outlook on the companies' ratings.”

In May Moody's separately published a Credit Focus Report addressing how the project creates incremental credit risk for the utility.

As part of its announcement, the Government also confirmed that it would provide a support package to the TTT project to enable it to attract sufficient private sector funding at reasonable cost to customers. The Government support package is designed to mitigate against some low probability but high impact events, including:

• insurance cover of last resort;
• short-term liquidity in the event of financial market disruption;
• additional equity contribution in the event of significant construction cost overruns and after other sources have been exhausted.

The Government support package will also provide compensation to debt and equity investors into the IP, if the project is discontinued, e.g., in a scenario where the Government has decided not to provide additional equity upon request.

Finally, if the IP were to go into special administration at any point during the TTT project construction phase and remained there for more than 18 months, the Government will be required to either make an offer to purchase the IP; or discontinue the project, thereby triggering the above compensation mechanism for investors.

The support package remains subject to state aid approval from the EU Commission.

The Government's announcement is confirmation of its support for the proposed 25km tunnel to be constructed underneath the river Thames to collect excess sewer discharge and storm water in London. Main benefits of the specification solution expressed by government are:

i. ring-fencing the risk of major projects from the existing activities of companies;

ii. providing competition on the delivery of the project to ensure best value for money outcome for customers; and

iii. market-testing finance as well as construction costs.

The specification follows Thames Water's successful consent solicitation process with its senior lenders during May 2014, which paved the way for certain amendments to the company's financial documentation that were necessary to accommodate the proposed IP structure.

Thames Water will now initiate the procurement process for the IP. Procurement for the three main construction contracts for the TTT project are already underway.

Following the procurement process, the Secretary of State for the Environment, Food and Rural Affairs wil then designate the winning bidder as an IP, while water industry economic regulator Ofwat will also need to award a licence to the IP. The licensed IP would then become subject to a modified regulatory framework, building on the established principles of regulation which currently applies to the UK water sector.