Moody's ratings agency has changed the outlook on the ratings of four UK-based regulated water companies and one high-yield holding company to negative.

The move follows proposals by the Water Services Regulation Authority (Ofwat) that would give it greater influence over the water companies' capital structures and dividends. At the same time, the rating agency has affirmed the ratings. 

Ofwat has proposed that in future the regulator should assess companies' dividend policies, and indicated that dividend yields above the level it regards as "reasonable" would not be acceptable in the absence of outperformance or explicit customer support.

According to the ratings agency, Ofwat's long-standing position has been that companies are responsible for determining their capital structure and that they carry any associated risks. However, while maintaining that this view still holds, in Moody's view the changes represent a clear departure from previous practice and a reaction to mounting political (and public) pressure.

Heightened risk of future political interference

"We see moves by Ofwat to discourage gearing above the regulator's notional capital structure and the proposed further oversight of equity distributions as departures from long-standing regulatory practice", says Stefanie Voelz, a VP-Senior Credit Officer at Moody's.

"We also see heightened risk of future political interference in the design of the regulatory framework and are changing our assessment of the stability and predictability of the UK water regulatory regime under our methodology to Aa from Aaa. To reflect the increasing business risk we have also tightened our generic ratio guidance for the sector,"

Moody's said rating actions take into account:

• The companies' exposure to a likely significant cut in allowed returns from 2020 and more challenging performance targets, as guided by the regulator in its final PR19 methodology published in December 2017;
• The regulator's proposed financing cost sharing requirements, intended to reduce the earnings of companies benefitting from a highly leveraged capital structure;
• Moody's revised and slightly more demanding financial ratio guidance for the sector, which has been recalibrated to reflect the rating agency's perception of increased regulatory risk.

Specifically, the negative outlooks reflect Moody's expectation that a reduction in allowed returns from 2020 will weigh on companies' financial metrics and, in the absence of measures to strengthen companies' balance sheets and/or significant outperformance, there is an increased risk of key ratios falling below Moody's guidance for current rating categories.

In December 2017 Moody's also changed the outlook on five other water companies and one holding company to negative. The ratings agency now holds a negative outlook on 60% of the rated water companies as well as the sector as a whole.