Fitch Ratings has downgraded the credit ratings of Thames Water’s holding company Kemble Water Finance Ltd and revised its Issuer Default Rating to Negative, reflecting pressure on Kemble's and Thames Water’s financial profiles as a result of Ofwat’s challenging Final Determination on the company’s AMP7 business plan.

The ratings agency placed Kemble's BB- senior secured debt rating and its BB- Issuer Default Rating (IDR) on Rating Watch Negative (RWN) in December 2019. At the time Fitch said the RWN reflected the "significant probability of Kemble Water's financial profile weakening to a level no longer commensurate with a 'BB-' IDR in the new AMP7 price control.

According to Fitch, lower cash flow at Thames Water as a result of the FD has intensified the pressure on Kemble's financial profile. The ratings agency said it now expects Kemble's financial profile to be “substantially outside” Fitch’s negative rating sensitivities for its BB- Issuer Default Rating in the upcoming AMP7 regulatory period.

The Negative Outlook reflects low headroom at the new rating level as well as uncertainty associated with the long-term impact of the coronavirus, Fitch said.

If Thames shows continued significant improvement in operational performance, resulting in lower overall ODI penalties in AMP7, The Outlook could be revised to Stable. However, if the long-term impact of coronavirus is materially negative for the water company or its operational performance deteriorates, a further downgrade would be considered.

Kemble's main source of cash flow is its Thames Water operating company - Kemble relies on dividends from Thames to service its debt.

According to Fitch, the lower returns allowed in Ofwat’s Final Determination will put pressure on Thames’ cash flow and interest cover metrics as well as its capacity to distribute dividends.

The ratings agency is flagging up Kemble's weak financial profile - Fitch estimates Kemble's gearing at about 91% in AMP7. The rating case also assumes that Thames will incur “sizeable” Outcome Delivery Incentives (ODI) penalties amounting to about £174 million of net ODI penalties related to the water company’s AMP7's operational performance, including C-Mex and D-Mex.

It expects Thames’ AMP7 revenue to decrease by about £95 million in cash terms in financial years 2023 to 2025, as the result of a two-year time lag between performance and revenue adjustment.

Fitch commented:

“We estimate that the majority of penalties will come from customer satisfaction and supply interruptions, while leakage performance could result in modest penalties, given the combination of the challenging overall leakage reduction target of 20% and the company's good progress to date.”

However, the ratings agency acknowledges the fact that Thames is maintaining a continuous focus on improving its leakage performance and achieved a significant reduction in leakage of about 21% YTD as of February 2020.

While Fitch said it recognises “these early signs of turning the business around and anticipates further improvements”, it also warns that it is assuming a totex wholesale underperformance of about 2.5% during AMP7 in the light of Ofwat’s challenging performance targets

The ratings agency has also highlighted the fact that the coronavirus is affecting revenue recovery by Thames Water, saying that the early impacts of the coronavirus-induced lockdown include a shift in water consumption between groups of customers and issues with bill collections.

Click here to read the rating by Fitch in full