Moody's Investors Service is warning that Ofwat’s proposed changes in its approach to the upcoming PR19 Price Review  - Water 2020 - would, if implemented,  be "credit negative" for the water sector.

"Individually, the proposals would be unlikely to have a significant negative impact over the medium term", said Stefanie Voelz, Moody's Vice President and Senior Analyst. "However, we believe that, taken together, the proposed changes would decrease the stability and predictability of cash flows for the water and sewerage companies over the medium to long-term, which will be credit negative", added Ms Voelz.

Moody’s says the regulator's proposals have come at a time of heightened political scrutiny, referring to the plans announced by the UK government In December 2015 to extend retail competition to household customers, subject to an assessment to be carried out by Ofwat. Moody’s has also separately flagged up yesterday’s  report by the House of Commons Public Accounts Committee which concludes that Ofwat had consistently overestimated water companies' financing and tax costs when setting price limits and calls for the regulator 'to secure a better deal for customers'.

Smaller water-only firms have most to lose from retail competition

However, Moody’s acknowledges that while the proposed changes are credit negative for the sector overall, companies' individual exposure varies - reforms relating to sludge treatment and disposal, for example, will only affect the larger companies. The smaller water-only companies are more exposed to the move towards CPI indexation of revenues and regulatory capital value (RCV), or a new approach to setting the cost of debt allowance. They also have most to lose from the introduction of retail competition.

Potential for full competition from 2025 is a further credit negative

The analyst says that proposals to set tariffs for sludge under a separate price control, and on the basis of a price rather than a revenue cap, from 2020 will expose sewerage companies to volume risk. There is also potential for full competition from 2025 - a further credit negative.

Moody’s is also warning that while any expenditure added to the RCV through 2020 will be 'protected', this may not be the case for all subsequent maintenance investments for those assets. As a consequence, in the long run companies will be exposed to the risk of asset stranding.

On Ofwat’s aim of encouraging third party provision of new water resources, Moody’s says that while existing water resource assets will not face direct competition, companies with a higher proportion of assets or costs allocated to resources activities face greater exposure to potential efficiency challenges. The regulatory approach to assessing efficient costs will likely become more challenging, increasing the risk of inadequate cost recovery.

Ofwat plans to replace RPI with CPI could pressure returns

Commenting on Ofwat’s proposals to replace Retail Prices Index (RPI) inflation with the lower Consumer Prices Index (CPI) measure of inflation as the benchmark for tariff increases and to use an average of the two indices for RCV growth from 2020, Moody’s says this could pressure returns.

It could also lead to changes in the timing of cost recovery if bill increases are to be avoided and create a mismatch between growth in regulatory assets and RPI-linked debt.

Ofwat is currently consulting on its plans to phase out the Retail Prices Index (RPI) which has been used to adjust revenues for UK water and energy networks since privatisation 25 years ago RPI in favour of the structurally-lower Consumer Prices Index (CPI) starting in 2020.

Transition to CPI creates risks for both water and energy sectors

Describing the RPI as “deeply entrenched” in the Regulated Asset Base (RAB) and in the industry’s capital structure, Moodys says the transition to CPI creates particular risks and challenges for both water and energy networks.

The ratings agency acknowledges that higher current returns could be credit positive. By increasing the proportion of returns which are recovered through revenues today, rather than through RAB growth, the use of CPI will boost funds from operations and interest coverage ratios unless offset by other changes. This could be credit positive, if the additional cash flows are used to reduce indebtedness.

Returns could fall if regulators underestimate CPI-RPI differential or balk at resulting bill increase

However, Moody’s is warning that total returns could fall if regulators underestimate the CPI-RPI differential or balk at the resulting increase in customer bills, a credit negative for the sector.

Moody's also says that the use of regulatory levers to offset bill increases could erode confidence in the regulatory framework, pointing out that by permanently capitalising a larger share of total expenditure, it is possible to protect customers from bill increases. However, the ratings agency commented:

“If revenue deferrals are imposed on companies such that the “allowed” return can never be realised, our current view of the regulatory framework could be weakened.”

Ofwat’s view of “willingness to pay”: firms found flexibility to use regulatory levers “severely limited” in PR14

According to Moodys, in theory, the water companies have significant discretion in using the regulatory levers - the analyst says it therefore regards them as pure “speed of money” adjustments that shift cash flows between periods without affecting underlying credit quality.

However, water companies found that their practical flexibility to use the levers was severely limited in the last price review by Ofwat’s view of customers’ “willingness to pay”, Moodys says.

CPI-RPI underestimates could “significantly undermine the value of regulated companies”

The consultation launched by Ofwat in December 2015 has proposed that the allowed return for 2020-25 should use an equally-weighted average of CPI and RPI  to derive the allowed return and to inflate the RAB.  The regulator has also proposed a “true-up” mechanism to correct for any difference between the actual and expected RPI-CPI differential,  described by Ofwat as “a transition mechanism” toward full CPI indexation in an unspecified future period.  Moody’s said Ofwat’s phased approach would “change the route but not the destination.”

Outlining ways in which an under-estimate by the regulator could plausibly occur, Moodys says “such systematic errors could significantly undermine the value of regulated companies and, absent drastic dividend reductions, impair credit quality.”

In the ratings agency’s opinon, Ofwat’s transitional phase-in arrangement, which is intended “to provide time for existing RPI linked debt to unwind”, will only delay, not resolve, the mismatch. Moodys says that by 2025 only 9% of RPI-linked bonds issued by water companies will have matured, and a material portion of debt will be outstanding into the 2050s.

Potential for full competition from 2025 is a further credit negative

The analyst says that proposals to set tariffs for sludge under a separate price control, and on the basis of a price rather than a revenue cap, from 2020 will expose sewerage companies to volume risk. There is also potential for full competition from 2025 - a further credit negative according to Moody's.

Moody’s is also warning that while any expenditure added to the RCV through 2020 will be 'protected', this may not be the case for all subsequent maintenance investments for those assets. As a consequence, in the long run companies will be exposed to the risk of asset stranding.

Commenting on Ofwat’s aim to encourage third party provision of new water resources, Moody’s says that while existing water resource assets will not face direct competition, companies with a higher proportion of assets or costs allocated to resources activities face greater exposure to potential efficiency challenges. The regulatory approach to assessing efficient costs will likely become more challenging, increasing the risk of inadequate cost recovery.

Ofwat intends to set out its final proposals for PR19 in May 2016. Based on these, the regulator expects to consult with companies on licence changes to implement its proposals during the second half of 2016 and before finalising framework and approach for PR19 in autumn/winter 2017.

Ofwat also has to provide its assessment to the government on the costs and benefits of extending retail competition to household customers in England by summer 2016.

Moody's commented:

 “If implemented, retail competition could (1) increase cash flow volatility and, where revenue losses cannot be offset by cost savings, pressure earnings; and (2) potentially increase counterparty risk exposure towards small and less well-capitalised new entrants.”

Moody's report "UK Water Sector: 'Water 2020' Proposals Are Credit Negative" is now available on www.moodys.com. Click here to order the report.