Credit ratings agency Moody's has downgraded Yorkshire Water and Southern Water’s rating from stable to negative.

The outlook change for Yorkshire Water (YWS), the fifth-largest UK water company, and Southern Water (SW) primarily reflects the company's exposure to risks associated with a potentially prolonged low-yield environment, which could significantly curtail future allowed regulatory returns and create particular challenges for companies, such as Yorkshire Water, with expensive, longer-term debt profiles.

Moody’s said a 'lower-for-longer' interest rate scenario could result in a significant reduction in allowed returns for the UK water sector from 2020 and poses particular risks for companies, including Yorkshire Water, with more expensive and longer-term debt relative to likely regulatory assumptions.

Both Southern Water's and Yorkshire Water's respective net debt was close to 80% of its regulatory capital value (RCV) as at 31 March 2016. This level of gearing is above both the sector average of around 70% and the gearing assumed by the economic regulator at previous price controls (62.5% at PR14). Consequently, Moody’s said both companies are relatively exposed to any divergence between its borrowings costs and those allowed by the regulator, while both of the utilities’ locked-in funding costs are significantly above current market rates over the long term.

The ratings agency said UK water companies would benefit from the low interest rate environment over time as they raise new debt. However, companies such as Yorkshire Water and Southern Water with debt levels beyond that assumed by the regulator, would underperform as allowed returns will converge to market rates more quickly than their embedded cost of debt.  A visible erosion of the companies’ equity value could also weaken incentives for shareholders to provide further funding. In addition, while both YWS and SW have enjoyed ready access to the capital markets, lenders may in future be less supportive of companies with high embedded debt costs and potentially limited equity value.

However, the rating agency does not expect Yorkshire Water to face significant pressures from its operations, taking into account the fact that its final price determination has been largely in line with the company's business plan submission and it has a solid operational performance track record.

The ratings agency also separately noted management actions in the previous regulatory period to protect Southern Water's credit profile, principally by retaining cash within the business rather than paying equity dividends.

Moody's further anticipates that the time available until the next price review will allow management and shareholders at both companies to consider possible changes in financial and operational policy, which may support cash flow generation and a reduction in gearing over time, thereby creating additional flexibility to mitigate lower future returns.

Commenting on Yorkshire Water, Moody’s said that given the current negative outlook, there is currently limited upgrade potential.  However, the outlook could be stabilised if Moody's concludes that the risk exposure of Yorkshire Water's capital structure remains manageable and does not adversely affect the company's financial flexibility in comparison with its industry peers, taking into account any additional measures management or shareholders may be willing to implement to mitigate the company's exposure and the timing of those.

On Southern Water's Moody's said the outlook could be stabilised if  the risk exposure of capital structure remains manageable and did not adversely affect the company's financial flexibility in comparison with its industry peers.

However, Moody’s warned that conversely, the rating for both companies could be downgraded further if the risks are not offset by mitigating measures that would address the high sensitivity to market-rate movements, or create additional financial headroom.

Other factors that could contribute to possible negative rating pressure could derive from an unexpected, severe deterioration in operating performance, a material change in the regulatory framework for the UK water sector leading to a significant increase in the utilities’ business risk or  unforeseen funding difficulties.

Commenting on both companies, Moody's said:

‘’The outlook change primarily reflects the companies' exposure to risks associated with a potentially prolonged low-yield environment, which could significantly curtail future allowed regulatory returns and create particular challenges for companies, such as Southern Water and Yorkshire Water, with expensive, longer-term debt profiles’’.