Moody's Ratings has placed the Baa3 backed and underlying senior secured ratings of Southern Water (Finance) I PLC (Southern Water) on review for downgrade following the publication on 11 July of Ofwat's Draft Determination on the company's AMP8 Business Plan - previously, the outlook was stable.

Moody’s said the review for downgrade reflects its expectation that Ofwat's Draft Determination for Southern Water would, if not materially changed at the final determination stage, or through a subsequent appeal to the Competition and Markets Authority, result in severe Outcome Delivery Incentive (ODI) penalties and total expenditure (totex) allowances below the level needed to fund the water company’s investment programme.

Ofwat assesses quality and ambition of Southern Water 2025-30 business plan as inadequate

On assessing the quality and ambition of the 2025-30 business plan that Southern Water submitted to Ofwat in October 2023, overall, the regulator has categorised the plan as inadequate.

According to the ratings agency, together with an allowed return that falls significantly short of Southern Water's actual cost of capital, such under-performance may challenge the company's ability to raise equity finance to maintain leverage at levels consistent with the current rating. The AMP8 draft determination includes a significant increase in penalty rates for underperformance on measures where Southern Water has historically been a poor performer, Moody’s said.

Ofwat’s Draft Determination for Southern Water published on 11 July 2024 said the company did not provide “sufficient and convincing evidence” to support the Board's assurance that it will be financially resilient on its actual structure during 2025-30 and in the long term.

The company's plan is targeting a credit rating of Baa1/BBB+ which is consistent with the target set in Ofwat’s decision – however, this is above its existing credit rating of Baa3/BBB.

The Draft Determination says the company’s business plan does not propose any equity support during the period, although it suggests equity support of £370 million by the end of AMP7. Gearing is forecast to reach 72.9% over the 2025-30 period, which is above the level Ofwat considers reasonable for a water company to maintain adequate levels of financial resilience in the long term.

Ofwat has also considered the company's dividend policy for 2025-30 which it assesses to be not in line with its expectations.

Ofwat’s view is that Southern Water's plan does not meet the minimum expectations in the round despite what the Draft Dtermination describes as the regulator’s “significant intervention.”

As a result, Ofwat says it will apply a financial penalty of £54 million to Southern Water if it does not improve its plan enough ahead of the regulator’s final decisions in December 2024. Ofwat will also apply different cost sharing rates, meaning the company bears a higher proportion of any overspends of its cost allowances and has to give a higher proportion of any underspends back to customers.

If Southern Water provides Ofwat with the assurance and confidence it expects, the regulator says it “may move the company out of the 'inadequate' category and reduce or remove its financial penalty.” This will be reviewed ahead of Ofwat’s final decision in December 2024.

Southern Water - "this change has no material impact”

Commenting in response to Moody's Ratings announcement, Stuart Ledger, Southern Water's Chief Financial Officer, said:

“Southern Water notes the rating update published by Moody's on Tuesday 30 July 2024. Moody’s has changed the Baa3 senior secured ratings of Southern Water’s financing subsidiary, SW (Finance) I plc, from stable to on review for downgrade.

"This change has no material impact on Southern Water, or SW (Finance) I plc, and as highlighted by Moody’s in their report, Southern Water has an excellent liquidity position with £513m of cash and deposits and £350m of undrawn credit facilities.

"Funds managed by Macquarie Asset Management have invested £1.6bn into the Southern Water Group since 2021. This has helped to support Southern Water’s progress on delivering its Turnaround Plan, which has seen pollutions cut by over 35% and customer complaints reduce by nearly 60% in the last year.

"Securing an investible PR24 determination that meets the needs of our customers, and the environment is a critical priority. The Moody's report highlights some of the key challenges in the Draft Determination and we will be responding to Ofwat at the end of August.”

Click here for more information about Moody's review for downgrade