Fitch's UK Water lead analyst Yeshvir Singh, Senior Director at Fitch Ratings explains why Ofwat’s Final Determination (FD) for the AMP8 regulatory period April 2025 to March 2030 marks a key milestone for the assessment of the UK water sector’s regulatory framework.

Yeshvir Singh: The perceived sector risk has intensified due to a very challenging Draft Determination (DD), the potential for increased penalties and fines, intense media and political scrutiny and the financial tensions at Thames Water Utilities Ltd (TWUL).

In the last few months, the deteriorating perception has led to rising funding costs for UK water companies, especially those with lower ratings and weak operating performances.

Fitch expects that the FD (due on 19 December 2024) will partially de-risk the sector compared with the DD by incorporating a higher WACC, increased allowed totex and less aggressive outcome delivery incentive (ODI) framework. The risk and return profile defined by the FD will be a critical factor to attract the equity and debt needed in the sector, preserve trust from the capital markets and protect credit ratings during the capex super-cycle needed to enhance the asset base (not limited to AMP8).

We see higher sector risk following the latest developments, but we have not yet revised the debt capacity for UK water companies, since we believe that the extent of the de-risking provided by the FD will be an essential input for the decision. Similarly, rating actions will depend not only on the key features of the FD, but also on the companies’ willingness to adjust their capital structures and adhere to their target ratings, even in the presence of a potentially revised debt capacity.

We believe shareholders are generally committed to supporting their respective companies with equity injections and limited (or no) distributions during AMP8, but the risk-return balance will be the key consideration for their investment committees. Also excluding the complex situation of TWUL, fresh equity and more conservative capital structures will be essential for some companies to comply with Ofwat’s licence requirements, which include a minimum rating of ‘BBB’/Negative starting in April 2025. Also, these measures will be crucial in more cases to preserve the current ratings.

Fitch expects Ofwat to ultimately opt for a more measured stance in setting ODIs. The consultation on outturn adjustment mechanism provides a positive indication in this respect. We expect the targeted standards to be more realistic given the operational realities of each company and not to result in large widespread net penalties for the entire sector, which could jeopardise the funding for the much-needed investments.

After a high focus on affordability in the last regulatory periods, we believe there is a general recognition that the priority should shift towards enhancing the asset base and operating and environmental performance. Based on the latest resubmission business plans of our rated portfolio, totex would more than double in AMP8 to about £110 billion (nominal), from about £50 billion in AMP7. The resubmission totex is about 35%, or £30 billion, higher than Ofwat’s DD. We expect this gap will materially narrow with the FD.

At the same time, based on the resubmission business plans, water bills in our rated portfolio would increase by an average of 38% (in real terms) by the end of AMP8 compared with the end of AMP7, compared with the 20% bill rise outlined in the DD. We believe that the FD would represent a compromise in this respect. Notably, Southern Water Services (the finco SW (Finance) I Plc’s has a senior secured rating of ‘BBB-’/RWN) and TWUL have requested the highest bill increases in the sector, marking them as significant outliers. On the other hand, these companies need large totex to materially improve their performance, and Ofwat’s decision will be fundamental for their future.