Moody's ratings agency has affirmed the Baa3 senior secured debt ratings of Southern Water Services (Finance) Ltd, whose issuance is guaranteed by Southern Water. The rating outlook is stable.
The rating action follows the publication by Ofwat of its final determination for water companies in England and Wales for the forthcoming five year regulatory period starting in April 2020 (AMP7).
The rating affirmation reflects Moody's expectation that Southern Water will be able to maintain an investment-grade credit profile in the face of a challenging regulatory settlement for AMP7, which includes penalties for environmental failures during 2010-17, as well as a likely additional fine from the Environment Agency.
Moody's has estimated that Southern Water will have an average allowed cash return of around 2.5% over AMP7. On an RPI-stripped basis, for comparison with the current period, allowed returns will fall to 1.92% (1.96% including retail margin) from 3.6% (3.74% including the retail margin), a nearly 50% cut.
The ratings agency said that Southern Water remains exposed to stringent operational targets, despite Ofwat lowering the level of stretch on a number of performance commitments.
Moody’s also referred to the fact that Southern Water faces significant penalties, confirmed in a regulatory notice in October 2019, and resulting in an overall £126 million (in 2017/18 prices) revenue reduction over AMP7. The agency said the penalties reflect material failures of both Southern Water's environmental risk management, which resulted in higher-than-permitted discharges during the 2010-17 period, and of its corporate governance, which permitted "widespread and deliberate measures" by employees to prevent accurate wastewater samples from being taken.
In addition, Southern Water and its employees may face criminal charges by the UK's Environment Agency, the national environmental regulator – Moody’s highlights the fact that the Environment Agency has levied increasingly significant fines in recent years, including £25 million for sewage discharges at another UK water company.
Moody’s says its affirmation of the rating nonetheless recognises that Southern Water has taken significant steps to address these deficiencies, including additional investments to address permit non-compliance risks, an ongoing investment plan to improve asset performance, new audits and review proceedings as well as corrective action plans to sampling processes. These actions also underpin the maintenance of an investment-grade rating, along with measures already taken to reduce leverage at the operating company.
However, the ratings agency is warning that “satisfying regulators that past problems have been fully addressed is likely to consume a significant amount of the company's managerial focus.”