Moody's Investors Service has downgraded Sutton and East Surrey Water’s senior secured underlying debt rating from Baa1 to Baa2 and also confirmed Anglian Water’s current ratings – the outlook on both companies’ ratings is negative.

Moody's has confirmed Anglian Water’s Baa1 corporate family rating, as well as its senior secured and subordinated debt ratings. The outlook on the ratings is negative. However, the ratings agency has downgraded to B1 from Ba3 the senior secured ratings of Anglian Water (Osprey) Financing plc), Anglian Water's unregulated holding company.

The rating actions follow Anglian Water's announcement that it will not accept the revenue limits set by Ofwat for the five-year regulatory period starting in April 2020 (AMP7).

The water sector regulator will now refer its determination to the Competition and Markets Authority (CMA), which will form its own conclusion on the price controls. The redetermination is likely to take at least six months and may be extended by a further six months.

The rating action reflects Moody's expectation that, although the company will not have certainty over its revenues and investment programme for a further 6-12 months, the eventual determination is likely to support credit metrics that are weakly positioned but consistent with Anglian Water's assigned ratings. Confirmation of the ratings also incorporates Moody's expectation that management will seek to defend credit quality if necessary.

The negative outlook reflects the risk that Anglian Water may be unable to perform in line with regulatory targets for AMP7, as they may be revised by the CMA.

Ofwat's final determination included a significant cut in allowed cash returns to 2.42% at the start of the new period, and provided an allowance for operating and capital expenditure that was around £750 million less than the company's business plan. A large part of the gap was attributable to differing views on population growth in Anglian Water's service area and resulting investment needs, Moody’s said.

Even if the CMA fully allows Anglian Water's investment plan, Moody's estimates that the company's financial metrics will still have very little headroom against the agency's minimum requirements for the current rating.

The ratings remain supported by Anglian Water's solid business risk profile as the monopoly provider of essential water and sewerage services, relatively stable and predictable cash flow and its track record of strong operational performance.

The downgrade of the Osprey's ratings reflects the likelihood of weaker cash flow at Anglian Water, which increase the risk that it may breach cash-trapping triggers in its financing structure and operating licence. A persistent stoppage of dividends from Anglian Water would also mean a breach of Osprey's default covenant for cash dividend cover of at least 2.0x. In addition to formal cash-trapping mechanisms,

Anglian Water's outlook could be stabilised if the CMA's redetermination provides for significantly stronger cash flow, if it is able to demonstrate outperformance, or if the company takes balance-sheetstrengthening measures.

However, the rating could be downgraded if the CMA's redetermination provides for a lower allowed return, lower cost allowances or greater operational penalties that are not adequately mitigated by management action.

Osprey's rating could also be downgraded if weaker than anticipated cash flow at Anglian Water means that financial or rating triggers limiting dividend payments are more likely to be triggered.

Final determination - low returns put particular pressure on smaller companies like SES Water

For Sutton and East Surrey Water plc, Moody's has downgraded the senior secured underlying debt rating from Baa1to Baa2 - the outlook is negative.

The rating downgrade takes into account SES 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 and challenging performance targets. Moody’s said that compared with Ofwat's draft determination, the final determination has reduced, but not eliminated, the company's exposure to the risk of cost overruns and performance penalties.

The low returns put particular pressure on smaller companies like SES Water, which have expensive existing debt, access financial markets less frequently and are therefore not able to benefit fully from lower interest rates today.

Ofwat's allowances for base operating and maintenance expenditure, excluding enhancement projects but including retail costs, were £232 million, roughly £6 million below the company's request. The gap is primarily related to retail costs, an area where SES Water has been suffering also during the current regulatory period.

Moody’s said that SES Water's rating also remains constrained by the company's small size and “relatively inflexible” financing structure, which increases risk exposure in an environment of falling returns.

However, the Baa2 rating remains ultimately supported by the company's low business risk profile as a monopoly provider of water services operating under a well-established, transparent and predictable regulatory framework as well as the company's good performance track record on operational measures, in particular supply interruptions.