Ratings agencies Moody’s and S & P Global Ratings have downgraded Welsh Water's credit outlook – the rating actions follow Welsh Water's announcement on 31 January 2020 that it will not ask Ofwat to refer its final determination to the Competition and Markets Authority.

On Friday Moody's Investors Service downgraded to A3 from A2 the corporate family rating of Dwr Cymru Cyfyngedig (Welsh Water) as well as the senior secured debt ratings of Dwr Cymru (Financing) UK Plc.

At the same time S&P Global Ratings downgraded the senior secured (class B) debt issued by Welsh Water to 'A-' from 'A' and at the same time, lowered the issue rating on the subordinated (class C) debt to 'BBB' from 'BBB+'.

The rating actions conclude the rating review initiated on 20 December 2019, following publication by Ofwat, the economic regulator for water companies in England and Wales, of its final determination for the forthcoming AMP7 2020 -25 investment period.

Moody’s - challenging performance targets expected to result in financial penalties

Moody’s said the downgrades to A3 from A2 take into account:

• Welsh Water's exposure to a significant cut in allowed wholesale returns to ca. 2.42% real in cash terms from 2020, compared with 3.6% in the current period;
• a reduction in total expenditure allowances compared with the company's requests;
• challenging performance targets, which Moody's expects to result in financial penalties for Welsh Water during the next regulatory period.

Specifically, the rating actions reflect that, under Moody's projections, the final determination will result in Welsh Water's key financial metrics falling outside guidance for the previous A2 ratings.

The low returns allowed by Ofwat put particular pressure on companies, like Welsh Water, with relatively expensive debt, according to Moody’s. The ratings agency also believes that stringent performance targets set by the regulator could lead to performance penalties for Welsh Water in the range of £30 to £40 million over the AMP7 period.

However, Moody's notes that Welsh Water remains one of the lowest geared companies in the sector and, due to its not-for-profit ownership structure, does not face any dividend pressures.

The financial metrics will place Welsh Water well within the A3 category but are insufficient to maintain the previous A2 ratings, Moody’s added.

S&P - operating under tougher conditions will ultimately weaken Welsh Water’s credit quality

S& P’s downgrade reflects the ratings agency’s expectations that the company's credit metrics will not be in line with the levels it sees as commensurate with 'A' and 'BBB+' issue ratings over the next regulatory period. In S&P’s view, the tougher operating conditions will be challenging for Welsh Water over the next regulatoryperiod.

Based on the elements in the company's business plan, S & P believes that Welsh Water, along with the rest of the sector, will operate under tougher conditions starting in April 2020, which willultimately weaken its credit quality.

In light of the more stringent performance commitments, S & P also said it would not rule out the possibility that the company may end up in a net penalty position during AMP7. The ratings agency pointed out that Welsh Water has a relatively high cost of embedded debt, mainly due to relatively long-dated high-rate fixed debt issuances and the relatively large proportion of RPI-linked debt in its capital structure.

However, while Welsh Water’s credit metrics will remain below the ratings agency’s current targets, S & P believes that its low gearing and unique ownership structure still support the group's overall credit quality. S & P said this is the result of its unique ownership structure as a nonprofit company, which eliminates the pressure to increase leverage through shareholder distributions.

Julien Bernu, Associate, EMEA Utilities at S & P Global Ratings commented:

“The downgrade reflects our expectations that the company's credit metrics will not be in line with the levels we see as commensurate with 'A' and 'BBB+' issue ratings over the next regulatory period, AMP7, starting in April 2020. Therefore we now have greater visibility about the conditions under which the company will operate.”