Fitch Ratings is warning that the fallout from coronavirus, including delayed customer payments, increased bad debts and modified consumption volumes, will temporarily reduce cash flow, liquidity and covenant headroom of UK water companies in this financial year.

The ratings agency said that short-term cash-flow pressure will further erode rating headroom, which is already limited for companies with Negative Outlooks, including Southern Water, Yorkshire Water, Osprey Acquisitions (Anglian Water's holding company), and Kemble Water (Thames Water's holding company).

According to Fitch, a longer-lasting or more severe reduction in revenue than in its base case assumptions would increase pressure on ratings across the sector – the agency is expecting working capital to be adversely affected by delayed household (HH) and non-household (NHH) customer payments.

The NHH segment is currently facing more challenges as the recent regulatory code changes allow NHH retail suppliers to defer up to 50% of the wholesale charge for bills payable from March to May 2020.

Fitch is expecting most of these amounts to be recoverable in the long term, but the settlement mechanism has not been developed, pending a further consultation launched today by water sector regulator Ofwat.

Ofwat has stated its willingness to limit wholesalers' exposure to "unreasonable financial risk", but at the same time stressed the need for 'pain sharing' between retailers and wholesalers.

NHH customers' contribution to water companies' revenue varies between 20% and 30% and the code change creates a maximum exposure of about 2.5%-3.8% of annual revenue.

However, Fitch is warning that if the code change is extended to support the business retail market further, the water companies' exposure could increase significantly.

Coronavirus has caused a shift in water consumption between customer groups

The coronavirus has caused a shift in water consumption between customer groups, including a sharp drop in NHH consumption volumes, which will be partially offset by the increase in HH consumption.

However, this could ultimately lead to lower revenue in the 2020/21 financial year than allowed by the regulator – the revenue shortfall is recoverable with a two-year lag via a revenue correction mechanism.

Pointing out that most of the companies have sufficient liquidity to cover their needs in the next 12-18 months, Fitch said it expects the water sector to cope with the short-term cash-flow pressures “reasonably well.” The sector can also re-profile its total expenditure as some of non-essential projects can be delayed due to the lockdown.

However, in the ratings agency’s view the already low covenant headroom caused by the 2019 price review (PR19) could shrink further in FY21 and would need to be managed.

“Onus will be on the water companies to show how their operations were affected by the coronavirus” 

If the companies are not able to recover revenue in the medium term, their ratings could come under further pressure. For example, a significant increase in HH bad debts or a transfer of some excess credit loss from NHH retailers to wholesalers could be credit-negative.

Fitch has modelled the companies' base-case exposure (which assumes 50% of three-month NHH revenue is not recovered immediately) to the NHH sector as a percentage of regulatory capital value - this varies between 0.3% and 0.6%. Fitch describes this as manageable for the companies with solidly positioned ratings, such as United Utilities, Wessex Water, Anglian Water, Affinity Water and DWR Cymru.

However, the agency said that under a more prolonged and severe stress the exposure could double or triple, potentially resulting in outlook changes or rating downgrades. The water companies' financial profiles could also be affected by missed performance targets, leading to higher outcome delivery incentive (ODI) penalties.

While Ofwat has indicated that it would consider ex-ante adjustments during the next round of the performance reconciliation process, it appears that “the onus will be on the water companies to show how their operations were affected by the coronavirus”, Fitch added.