Moody’s Investors Service has announced that its 2023 outlook for the UK water sector has turned negative, primarily reflecting increasing cost pressures in the current macroeconomic environment and, to some extent, early expectations for the next regulatory price review in 2024.

According to Moody’s, inflationary cost pressures may not be fully offset by revenue adjustments and penalties for underperformance will further weaken future cash flow for the water companies in England and Wales.

Key takeaways from Moody’s Regulated Water Utilities – United Kingdom 2023 Outlook include:

• Inflationary cost pressures may not be fully offset by revenue adjustments and penalties for underperformance will further weaken future cash flow. Our outlook for the UK water sector has turned negative, primarily reflecting increasing cost pressures in the current macroeconomic environment.

• Higher inflation boosts RCV growth, but inflation-linked debt and debt service will also grow. Inflation will increase companies' RCV, lowering gearing to the extent that debt does not grow.

• Rising interest rates will hit companies with large funding needs. Allowed returns, intended to cover companies’ cost of debt and equity capital, are fixed during the five year regulatory period (although with an adjustment to reflect indexation of new debt at the end of the period).

• Pollution incidents continue to receive heightened public and political attention, with increasing risk of future fines. Untreated wastewater discharges affect rivers, beaches and bathing waters and continue to attract public, political and regulatory attention.

• PR24 is fast approaching. Ofwat published its final methodology for the next price review in 2024 (PR24) on 13 December 2022, indicating an early view allowed return of 3.29% (CPIH-deflated).

Price Review in 2024 could see substantial rise in customer bills

Moodys is also warning that that the Price Review in 2024 could also see a substantial rise in customer bills.

Commenting in the Outlook, Stefanie Voelz, VP-Sr Credit Officer at Moody’s said:

“Higher returns and significant investment requirements to tackle asset maintenance and performance issues, as well as climate change and population growth, could increase bills substantially (and in real terms) after the 2024 price review.

“For example, based on the UK Government’s impact assessment, spending to cut storm overflows alone (as discussed above) would raise customer bills by an annual average of £12 between 2025-30, but increasing over time, such that the average increase will be £42 per annum over the 25 years to 2050, equivalent to around 10% of the current average bill.

“However, the impact on bills will be much larger for customer in areas with the highest investment needs, namely Wessex, Yorkshire and United Utilities. DEFRA estimated that bill increases for customers of water company regions with the largest overflow programmes will be up to three times the national average.”

Factors Moodys say are contributing to increasing cost pressures for the water companies include:

• Power costs, which account for approximately 17% of water companies' total opex (or 9% of overall totex,increased by an average 16% in FY 2021/22., with a number of companies reporting an increase of more than 40% in power costs at September 2022 compared with the same six months of 2021.
• Supply chain bottle necks for chemicals, some building materials and experienced construction staff have resulted in further cost pressures, coupled with indications from some companies that costs for materials and consumables increased by between 40-60% in six-months period compared with same period in 2021.

Rising interest will hit companies with large funding needs

According to Stefanie Voelz , rising interest rates will hit companies with large funding needs:

“The outlook for UK interest rates remains uncertain over the next 12-18 months, following a series of hikes in 2022 to stem inflation, but borrowing costs are unlikely to return to previous low levels….changes in interest rates will affect interest coverage metrics – especially for companies with large and lumpy funding needs.”

The outlook also highlights pollution incidents which are continuing to receive heightened public and political attention, with increasing risk of future fines.

Referring to the launch of an investigation into more than 2,000 sewage treatment works in November 2021 by the Environment Agency (EA) and Ofwat, Voelz said:

“The pollution has attracted increasing public and political scrutiny....With the 2024 price review fast approaching, we do not expect either investigation to conclude over the next 12-18 months.”

Warning that “demanding regulatory targets and potential pollution penalties will likely bring greater risk”, she pointed out that companies that have been breaching their legal permits could face regulatory enforcement action, including fines of up to 10% of annual wastewater turnover for civil cases and that in addition, they may face criminal prosecution.

According to Voelz, the Government’s Storm Overflow Discharge Reduction Plan which requires English wastewater companies to invest £56 billion between 2025 and 2050 to reduce discharges from combined sewer overflows is equivalent to more than 70% of the English water companies’ total RCV at March 2022 and 131% of the RCV portion related to wastewater activities only.

Ofwat - doing what it can to maximise efficiencies, potentially to detriment of credit quality

“The regulator will, as ever, have to balance competing priorities including investment, affordability and financeability. With affordability and investment needs currently centre stage, Ofwat will be doing what it can to maximise efficiencies, potentially to the detriment of credit quality”, Voelz said.

“We expect that higher returns, coupled with significant investment requirements, will increase customer bills, exacerbating affordability concerns. Average combined bills for water and sewerage services have fallen since 2009 when considering the same price base (March 2022) and also remained broadly flat in nominal terms over past five years. However, given inflationary pressures we expect overall bills to rise in nominal terms in FY 2023/24.”

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