Fitch ratings agency has confirmed that the proposed change to Welsh Water’s Dwr Cymru's structure will not result in a change to the debt ratings

Welsh Water wants to add a new holding company (holdco) above the current holdco, Glas Cymru Cyfyngedig, which sits within the ring-fenced group.

The new holdco will be a company limited by guarantee, but sit outside the ring-fenced group. The STID proposal also allows the ring-fenced group to pay out dividends totalling only £ 100 million, which Fitch said is “easily absorbed within the current rating guidance.”

Fitch Ratings has affirmed Dwr Cymru (Financing) Ltd's senior secured class A debt and class B debt rating at 'A' and its class C debt at 'BBB+'. Dwr Financing is the debt-raising vehicle of Dwr Cymru Welsh Water, one of the 10 appointed water and sewerage companies in England and Wales.

The affirmation takes into account Dwr Cymru's Security Trust and Intercreditor Deed (STID) proposal, establishing a new holding company above Dwr Cymru's secured borrowing structure, in order to invest in related commercial activities not allowed within the regulated entity.

Fitch commented:

“The affirmation reflects our expectation that Dwr Cymru will maintain adequate financial metrics for the ratings, despite the material reduction of earnings for the current regulatory period from April 2015 to March 2020 (asset management plan 6; AMP6). While interest cover is under pressure, Fitch notes that the group has substantial financial flexibility in terms of gearing and robust cash flow characteristics.”

Dwr Cymru must improve regulatory performance in order to meet current top quartile levels by 2020

Commenting on Welsh Water’s regulatory performance Fitch said it perceives the utility as a middle-ranking company in the industry in terms of regulatory and operational performance. Fitch is expecting the efficiency targets for total expenditure in the wholesale price controls to leave the company with some room for outperformance, whereas allowances for the retail price controls are challenging and may offset some or all of the savings from the wholesale business.

Dwr Cymru will need to improve its regulatory performance to ensure it will meeting current top quartile levels by the end of the current regulatory period in March 2020, the ratings agency said.

Providing further perspective on credit metrics, Fitch has noted that Dwr Cymru's board of directors opted to pursue capital schemes over and above the regulator's funded baseline in the period to March 2015 in order to support asset resilience and sustainability of operations.

This investment is treated as overspend under the Capital Incentive Scheme (CIS), leading to a material log up of RAV in March 2015 and around £50 million revenue penalty for AMP6.

Removing the penalty from revenue allowance for AMP6 would have resulted in regulatory gearing around 60% and PMICR above 1.5x, in which case both metrics meet the rating guidelines.

Fitch's key assumptions for the rating case for Dwr Cymru Welsh Water include:

• Regulated revenues in line with the final determination of tariffs for April 2015 to March 2020, i.e. assuming no material over- or under- recoveries.
• No totex out- or underperformance over the five year price control.
• Retail price inflation of 0.75% for FY15, 1% for FY16, 2% for FY17 and 2.5% thereafter.
• No impact on cash flow generation from outcome delivery incentives, given that financial rewards and penalties will all be taken into account as part of the next price review

Business risk in the sector has increased for AMP6

However, Fitch added that it believes that business risk in the water sector has increased for AMP6, and is now more closely aligned with regulated UK gas and electricity network businesses.

In addition to a significant reduction in the cost of capital, total expenditure will be benchmarked to the top quartile by 2020, representing a more demanding target for capital expenditure. Ofwat is pursuing progressive targets for the retail price controls, eliminating protection from inflation and implementing catch-up efficiency targets using an average cost to serve, which does not fully reflect each company's operating cost base, according to the ratings agency.