Fitch Ratings has downgraded Southern Water (Finance) PLC (SWF) senior secured class A debt rating to 'BBB-' from 'BBB' and placed it on Rating Watch Negative (RWN) – SWF is the financing company of Southern Water Services Ltd (SWS).

The ratings agency said the downgrade mainly reflects challenging funding conditions and the increasing risk of a documentary event of default (DEoD).

The RWN reflects the risk of a final determination (FD) from Ofwat for AMP8 without significant improvement to the draft determination (DD) and execution risks related to an expected equity injection, the possible DEoD waiver process and the overall AMP8 funding programme.

Fitch plans to review the ratings after it has visibility on the FD and the company's capital increase and financial profile.

Key rating drivers include:

Challenging funding for SW (SWF and SWS are jointly referred to as SW): Fitch says SW’s recently issued seven-year £300 million bond (with early call provisions) at an all-in cost of near 10%, is far above the regulatory allowance, highlighting challenging funding conditions even though the amount only represents about 5% of Fitch-adjusted debt.

The ratings agency believes that a favourable regulatory outcome and more visibility on the capital structure would ease SW's future cost of debt, but material uncertainties remain, including:

Risk of DEoD: SW is now close to an event of default on the debt documentation due to the requirement to maintain two investment-grade ratings. In this situation, Fitch assumes that obtaining a waiver would depend on the ongoing support of an engaged shareholder. However, this potential scenario would increase the risks that need to be managed during an already challenging period.

Large Derivatives Liabilities: The debt ratings benefit from the secured status and some key structural enhancements of the facilities. However, given the increasing uncertainty, Fitch views the presence of super senior derivatives liabilities of £1.6 billion at FYE24 as partially offsetting the structural enhancements supporting the debt rating.

Super Senior Swaps Impact Recovery: SW's debt benefits from dividend lock-up provisions tied to financial covenants, debt service reserve liquidity, and operating and maintenance reserve facilities. While these structural enhancements support the senior secured ratings, Fitch see increasing risk posed by super senior swaps, which rank ahead of the class A debt. Given SW's large swap portfolio at 23% of RCV at FYE24, Fitch says SW may no longer benefit from above-average sector recovery for its senior secured debt but the swap counterparties cannot accelerate payment during a 18-month standstill.

FD Key for Credit Ratios: Fitch believes that the parameters of the FD, especially regarding a balanced risk-return framework, will be fundamental to attracting the necessary equity at SW. Failure to secure the equity would, in the ratings agency’s view, severely restrict market access, potentially leading to liquidity tensions and a multiple-notch rating downgrade. “However, we believe that Ofwat will consider the DD feedback received from the sector and various stakeholders and deliver an investible framework for investors during AMP8,” Fitch comments.

Shareholder Incentive to Support: Assuming balanced regulation, Fitch expects shareholders, led by Macquarie Asset Management to continue supporting SW, given its 88% ownership and the £1.65 billion equity support provided in AMP7, with £905 million of that directly benefitting SW. Fitch's support expectation is strengthened by SW's potential for improvement, assuming an operational turnaround on a successful FD outcome. However, the presence of material holding- and mid-company debt could negatively influence the investor's decision.

Continued Poor Performance on ODI: SW has historically lagged in outcome delivery incentive (ODI) performance relative to peers, incurring around £140 million in net penalties over AMP7 to FYE24. This underperformance is likely to continue into AMP8, Fitch says, but its size will depend on the thresholds set in the FD and the operational turnaround at SW. The ratings agency is forecasting annual net ODI penalties over AMP8 to be slightly higher than FY24. Higher-than-expected ODI penalties or fines from the Environmental Agency and/or Ofwat would put pressure on the rating.

Totex Underperformance: SW overspent £900 million in total expenditure (totex) allowances to accelerate investment (additional spending funded by equity) in AMP7 to FYE24. Fitch says SW has preliminarily received an 'Inadequate' assessment of the initial business plan, which would imply a harsher 60:40 cost-sharing mechanism of the underperformance in AMP8. However, SW has provided revised information to Ofwat that may improve the business plan assessment to 'Standard'.

Challenging AMP8 Increases Penalties: Fitch expects AMP8 to present significant challenges to the UK water sector, with higher risks to underperforming companies such as SW. Ofwat cut SW's totex by 12% in the DD versus the company's initial submission, which can jeopardise SW's ability to improve its performance and simultaneously increase the risk of totex overspend. More challenging ODI performance commitment levels and harsher penalty rates are also likely to increase cash outflow from SW throughout the AMP.

However, Fitch concludes:

“We acknowledge that the FD is likely to consider the DD feedback and Ofwat has signalled scope for relaxation, for example by publishing a consultation document on ODIs that could imply a less aggressive approach.”