Fitch Ratings has downgraded the financing company of Southern Water Services Ltd senior secured class A rating to 'BBB' from 'BBB+' and is maintaining the Negative Outlook.

The downgrade reflects increased pressure on SWS's credit profile, as key credit ratios are not commensurate with the previous rating. In particular, gearing headroom is not sufficient to offset AMP7 (five-year price control period ending March 2025) weak average cash and nominal post-maintenance interest cover ratios (PMICR).

The Negative Outlook mainly factors in meaningful execution risk, as Southern Water seeks to address operational and environmental challenges, amid high interest costs and a long-dated derivatives portfolio with meaningful mark-to-market liabilities.

The ratings agency says:

“Evidence of a successful operational turnaround, with the execution of mitigating measures including potential equity injection to maintain its credit profile in line with our rating sensitivities, as well as a favourable AMP8 (five-year price control period ending March 2030) regulatory outcome, would be essential to revising the Outlook to Stable.

Key rating drivers

The downgrade results in a trigger event under Southern Water’s senior debt documentation, since class A debt is now rated below 'BBB+' by two of the three credit rating agencies. The trigger event prevents the water company from distributing dividends and in addition, Southern must also discuss its plans for remedial action with the security trustee. If a trigger event remains unremedied for six months (or any longer period as may be agreed in a remedial plan), the security trustee would be entitled to appoint additional non-executive directors to the Southern water board. In addition, if instructed by the majority creditors, the security trustee may order an independent review of the trigger event.

Fitch's rating case assumes the utility will maintain sufficient liquidity to fulfil its total expenditure (totex) and financing requirements during the trigger event.

A security trust deed and intercreditor agreement (STID) allows the company to incur permitted financial indebtedness during a rtrigger event, including a drawdown of its revolving credit facility of up to £330 million (currently undrawn), to refinance debt maturities up to two years and to fund permitted enhancement capex as agreed with Ofwat until the end of AMP7.

The ratings agency acknowledges that the lack of dividends “could create some financial tension for corporate entities structurally positioned above Southern Water” if not addressed through mitigating measures including potential equity injection.

Fitch now expects the company to trigger a rating cash-lock up under Ofwat’s new licence condition to maintain a minimum credit rating above 'BBB' or equivalent with Negative Outlook. This would imply a cash-lock up in April 2025 assuming no positive rating actions, nor exceptions from an Ofwat review.

The Fitch rating case assumes about £169 million in net outcome delivery Incentives (ODI) penalties in FY23-FY25 (financial year end-March). The significant ODI penalties relate to wastewater asset health, pollution incidents, internal sewer flooding, and customer measure of experience (C-Mex). SWS lagged behind other regulated UK water companies in Ofwat's overall performance category.

Southern Water maintains 3 investment-grade credit ratings of BBB+ (S&P), Baa3 (Moody’s), and BBB (Fitch)