Changes in the way that Ofwat sets tariffs for water companies in England and Wales in PR14 could weaken financial covenants that protect creditors, says Moody's Investors Service in a report published today.

"Highly-leveraged financing structures in the UK water sector incorporate a range of creditor protections, including financial covenants that lock up cash if breached," says Stefanie Voelz, a Moody's Vice President -- Senior Analyst and author of the report. "If these covenants are not adapted to the new regulatory revenue building blocks, they could overstate cash flows for debt interest service. As a result, the financial covenant package would be less effective and reduce the credit quality of affected UK water companies."

Moody's expects that the affected companies, which include Anglian Water Services Ltd (Baa1 stable), Thames Water Utilities Ltd (Baa1 negative) and Yorkshire Water Services Limited (Baa1 stable), will aim to preserve the value of their financing structures and hence their credit quality by adding an additional covenant, following the regulator’s ongoing review to set prices for the five years from April 2015.

Moody's also notes that following the regulatory changes, it may be difficult to estimate a company's performance from its statutory financial statements. Accordingly, investors would require additional information to assess company performance against regulatory targets.