Ofwat’s final price determinations package announced on 16 December 2019 for UK water companies offers an improvement on the draft determinations but the ratings remain under pressure, according to Fitch Ratings.

The ratings agency has estimated that the impact from lower performance-related penalties and better total expenditure (totex) performance will more than offset the financial impact of lower weighted average cost of capital (WACC).

However, the ratings for UK water companies remain under pressure which is reflected in the Negative Outlooks and Rating Watches, Fitch said.

Ultimately, the impact varies widely across companies, depending on the remaining totex gap and estimated financial impact of specific performance commitments.

Major changes in Ofwat’s Final Determinations (FD) compared to the Draft Determinations (DD) for the 2020-25 five-year price control starting in April 2020 included:

• a £1.5 billion increase in totex allowances (in 17/18 prices, including a £0.5 billion contingent allowance for Thames Water)
• less demanding performance commitment targets
• reducing the negative skew in the outcome delivery incentives (ODIs).

The remaining totex gap is 5% versus 11% at DD stage due to higher totex allowances and lower costs requested by companies at their representations.

According to Fitch, the potential financial impact of ODI rewards / penalties measured as a percentage of regulatory equity is now more symmetrical: it has shifted to 1.3%/-1.9% at FD from 0.6%/-2.6% at DD.

Overall, cost of equity is down by 30 basis points (bp) for a notional company, while the range of ODI penalties / rewards in terms of return on regulated equity (RoRE) improves by around 70bp.

Additionally, cost allowances also increased, reducing the negative RoRE impact related to totex.

Fitch has concluded that the negative financial profile impact from the next price control is likely to be less severe than what it had assumed at the DD stage.

The ratings agency added that while the impact of an all-time low allowed WACC on cash flows and post-maintenance interest cover ratios (PMICRs) will keep the pressure on ratings, strong operational performance resulting in limited penalties or significant rewards could help some companies maintain their ratings.

The ratings of Yorkshire Water Services (YWS), Southern Water Services (SWS) and Dwr Cymru (Dwr) are currently on Negative Outlooks as the companies' forecast financial profiles are borderline and depend on regulatory performance during financial years to 31 March 2021 - 2025, including ODIs and totex. Fitch expects pressure on both adjusted gearing and post-maintenance and post-tax interest cover (PMICR) for YWS and SWS and believes that significant PMICR pressure on Dwr could be offset by significant gearing headroom.

The rating of Wessex Water is also on Negative Outlook, mostly on risks around its gearing and financial policy. The ratings agency expects to have more clarity around the company's dividend and financial policy later in 2020.

The ratings of Kemble Water, holding company of Thames Water, have remained on Rating Watch Negative (RWN) since December 2019, with a strong probability of a downgrade unless the company appeals to the Competition Markets Authority and obtains a more favourable FD settlement or unless any balance-sheet strengthening is proposed.

Following an analysis which worked through the FD financial models published by Ofwat for the Fitch-rated universe of water companies , the agency took a number of urgent rating actions which were announced on 23 December 2019. These included:

• placing Anglian Water Services' senior secured class A and class B debt and holding company Osprey Acquisitions Limited's Long-Term Issuer Default Rating (IDR) of 'BB' and senior secured debt rating of 'BB+' on RWN;
• downgrading Kelda Finance (No.2) Ltd's IDR to 'BB-' from 'BB' and senior secured debt rating to 'BB-' from 'BB+' and placing both these ratings on RWN;
• downgrading Greensands UK Ltd's senior secured rating to 'C' from 'CC' and withdrawing the rating for commercial reasons.

Commenting on their actions to date, Fitch said:

“We did not take any other rating actions as we believe that the existing ratings and Outlooks for the rest of the rated universe still hold. All Fitch-rated UK water operating and holding companies currently have Negative Outlooks or are placed on RWN except for United Utilities, which we believe has sufficient financial profile headroom to maintain its 'BBB+' IDR.

“Our decision to keep the Negative Outlooks is underpinned by the longer-term nature of key rating drivers, which in most cases include expectations around operational and regulatory performance of the companies. These are unlikely to be resolved in the short-term, as the evidence of regulatory performance under the new targets will only become available in late-2020 to mid-2021.”