Fitch Ratings has downgraded Thames Water’s holding company Kemble Water Finance Limited's (Kemble) Long-Term Issuer Default Rating (IDR) to 'B' from 'B+' and senior secured debt rating to 'B' from 'B+'. The Outlook on the IDR is Negative.

The ratings agency said the downgrade and Negative Outlook reflect increased pressure on Kemble's credit profile as key ratios are not commensurate with the previous rating. In particular, its cash post-maintenance interest cover ratio (PMICR) and dividend cover capacity are weak also for a 'B' IDR.

In addition, in Fitch’s opinion, the recent decision by UK water regulator Ofwat to tighten the distribution lock-ups for UK water operating companies (opcos), increases the risk to Kemble's only source of cash flows for debt service as Thames Water Utilities Limited (TWUL, opco owned by Kemble) is implementing an eight-year transformation plan aimed at turning around its operational and environmental performance.

Key rating drivers

In its updated rating case for Kemble, Fitch expects average cash and nominal PMICR at about 0.7x and 1.2x, respectively, over the five-year AMP7 price control period ending in March 2025. The cash PMICR is below the ratings agency’s revised negative sensitivity of 1.05x, while nominal PMICR is marginally above its negative sensitivity of 1.15x, reflecting the benefit of regulated capital value (RCV) inflation indexation compared with the overall cost of debt, including accretion. Fitch is forecasting dividend cover capacity at 1.3x, which is also weak versus its negative rating sensitivity at 1.5x.

Fitch estimates dividend cover capacity using opco's additional distribution capacity (as a percentage of RCV), calculated as the difference between TWUL approaching dividend lock up covenant (1% below the 85% covenant level), and Fitch's forecast of adjusted net senior gearing (including accretion and swap re-couponing) at TWUL at the end ofAMP7.

Fitch commented:

“This updated approach takes into account recent developments such as swap re-couponing being added to Fitch adjusted net debt to RCV and represents our conservative view of the additional dividend capacity at TWUL. On a covenant basis, TWUL net debt to RCV excludes swap re-couponing adjustments.”

Commenting on the tighter licence conditions proposed by Ofwat, Fitch believes Ofwat's decision to increase opco's minimum rating requirement for licence to 'BBB' (or equivalent) from 'BBB-' (from 1 April 2025) and to link dividends directly to operational performance on service delivery for customers and the environment (from 17 May 2023) increase the vulnerability of Kemble and its creditors, as it relies on dividends from TWUL to service its debt.

In addition to the tighter licence conditions, TWUL's dividends to Kemble are subject to documentary covenants, which Fitch views as more manageable for the company.

Potential option for CMA referral

Fitch expects to see clarity over a potential referral to the Competition and Markets Authority (CMA) by water opcos against Ofwat's licence modifications by 18 April 2023. in Fitch's view, if a referral to the CMA occurred, the timeline for licence modifications is likely to be protracted and subject to CMA's final decision.

The ratings agency also believes the a change in Outlook is a risk - Ofwat monitors credit ratings across two credit rating agencies for TWUL, both of which are at 'BBB' (or equivalent) with a Stable Outlook, implying limited rating headroom before a cash lock-up is triggered under Ofwat's new licence condition from April 2025.

Lock-up would follow an Outlook change to Negative by just one rating agency - with a three-month grace period before enforcement, subject to Ofwat's review of financial resilience. Application, exemption, or extension of grace period are three possible outcomes of Ofwat's review.

Fitch is also highlighting the possibility that weak operations may restrict dividends. The ratings agency views weak operational performance with outcome delivery incentives (ODI) penalties from customer measure of experience (C-Mex), and internal sewer flooding as a risk of Ofwat restricting dividend distribution from TWUL to Kemble.

Fitch's rating case assumes about £180 million (nominal) net ODI penalties in FY23-FY25 (financial year end-March). TWUL lagged behind other regulated UK water companies in Ofwat's overall performance category.

Fitch is also expecting to see Totex underperformance with TWUL set to overspend Totex by about £2 billion above Ofwat's allowance for AMP7. The investments are largely associated with customer and environmental outcomes, focused on reducing ODI penalties.

Kemble creditors benefit from cash-lock-up trigger at 92.5% net debt to RCV on a covenant basis, without any Fitch-adjustments. Fitch assumes no external dividends.

Commenting on TWUL covenant protections, Fitch points out that Kemble creditors are structurally subordinated to TWUL secured creditors who benefit from various credit-enhancing features. These include an effective cash-lock up set at 85% net debt to RCV, with a trigger event at 75% net debt to RCV for class A debt, and 90% senior net debt to RCV (class A and class B).

TWUL interest cover ratios (ICRs) trigger event for class A debt is 1.3x and senior adjusted ICR for class A and B debt is 1.1x.

Fitch expects sufficient gearing headroom with Kemble's adjusted net debt to shadow RCV at about 90% by FY25 against the revised negative sensitivity of 93.5%, benefiting from inflation and mostly equity-funded total expenditure (totex) increase. However, according to the ratings agency gearing headroom is not sufficient to offset weak cash-PMICR and dividend cover capacity.

Fitch rates Kemble on a standalone basis using the stronger subsidiary/weaker parent approach under its Parent and Subsidiary Linkage (PSL) Rating Criteria. This assessment reflects 'insulated' legal ring-fencing as underlined by a well-defined contractual framework, and tight financial controls imposed by Ofwat and designed to support TWUL's financial profile. Fitch said it views access and control as overall 'porous' as TWUL operates with separate cash management and a mixture of external and intercompany funding.