Moodys ratings agency is warning that Ofwat is tightening the screws further on the water sector following publication by the regulator on 18 July of more draft determinations for the upcoming 2020 -25 AMP7 investment programme.

In its latest analysis, Moodys says that material differences remain between Ofwat and the companies regulator and, if not resolved by the final determinations in December, will be credit negative for the affected issuers.

According to the ratings agency, a further cut in allowed returns will intensify pressure on companies’ interest coverage ratios.

The analysis says that most companies need to find material cost efficiencies and there is still a large gap between the regulator’s view of efficient costs and the companies’ proposed spending.

 Most notable are:                      

• Anglian Water Services Ltd (Baa1 negative)
• Thames Water Utilities Ltd (Baa1 negative)
• Yorkshire Water Services Ltd (Baa2 negative).

Moodys said:

“To the extent that companies cannot reduce their costs to levels assumed by the regulator in the final determination, they will need to find other efficiency savings or suffer reduced cash flows to support their debt.”

The analysis describes the financial incentives for operational performance as “skewed to the downside”, with the potential range of financial incentives for companies’ performance against targets has shifted toward penalties being imposed rather than rewards being paid.

“Given the additional tightening in performance commitments, we believe companies are unlikely to be able to achieve similar levels of rewards as in the current period.” Moodys added:

The ratings agency has also concluded that with Ofwat proposing larger cuts in allowed returns and large gaps between companies’ plans and regulatory assumptions, the likelihood of referrals to the Competition and Markets Authority (CMA) referrals is growing. If significant differences remain at the final determination stage, the companies can choose to reject their final price determinations which would require Ofwat to refer its decision to the CMA.

Overall, the lower allowed returns will leave little room for manoeuvre to tackle potential cost overruns or performance penalties, both of which appear more likely in AMP7.

In the current period, Moodys said the companies have managed to generate modest or, in the case of Severn Trent Water Limited (A3 negative) "quite substantial performance rewards."

"However, we believe companies are unlikely to replicate this in the next period given the shift to upper-quartile performance targets," Moodys added.

Click here for more information about the analysis.