For the second time in four months, Moody's Ratings has yet again downgraded Thames Water to Caa3 from Caa1, taking its Corporate Family Rating (CFR) further into junk territory – in September Moody’s downgraded it to Caa1 from Ba2, which is considered a junk rating.

Moody’s said the downgrade published yesterday reflects its view that Ofwat’s final determination, even if improved from the draft published in July 2024, does not provide an attractive risk-return balance for existing or new investors.

According to the ratings agency, this may deter new equity funding and increases the likelihood of a more severe haircut to senior debt than embedded in the previous ratings, either through a potential future creditor-led debt restructuring or one that is imposed as part of a special administration process, should the company meet the criteria for special administration to be called.

Concurrently, Moody's Ratings has also downgraded the backed senior secured Class A debt ratings of Thames Water's guaranteed finance subsidiary Thames Water Utilities Finance Plc (TWUF) to Caa3 from Caa1 and affirmed its Class B subordinated debt ratings at C.

The Financial Times was separately reporting yesterday that the Government is “bracing for a possible renationalisation of the UK’s biggest water company” and has approached consultancies about taking on the role of special administrator.

Moody's latest rating says the Caa3 CFR also reflects the high likelihood of a near-term distressed exchange and the risk of losses being imposed on creditors under an ongoing initial debt restructuring process, which is expected to introduce, among other things, an extension of maturities for all existing debt by two years.

“An amendment or extension of credit terms that results in a loss relative to the original promise to pay is a distressed exchange and constitutes a default by our definition,” Moody’s says.

Ofwat's final settlement increases likelihood of appeal to Competition and Markets Authority

Outlinng the background to the downgrade, Moody’s says that Ofwat’s final determination saw Thames Water receive one of the largest cuts to its cost request (16.4%) and retain the most pronounced penalty exposure. It is also the only company, whose business plan remained inadequate carrying a 30 basis point (bps) penalty on the cost of equity (estimated at £141 million in total).

In Moody's view, the final settlement increases the likelihood of an appeal to the Competition and Markets Authority (CMA). Moody’s states:

“Absent a more favourable CMA redetermination, which may not be concluded before the end of 2025, Thames Water will be exposed to material ongoing operational underperformance through cost overspend and operational penalties. We believe that this will deter equity interest and may require meaningful haircuts to senior debt to achieve a sustainable capital structure.”

Under Ofwat's final determination, Thames Water's overall AMP8 cost allowance is £20.5 billion, compared with a £24.5 billion ask. The base cost allowance is £12.3 billion, a £2 billion or 13.9% cut from the £14.3 billion request.

“The cut largely reflects that Ofwat rejected the company's evidence as poor or not having a strong engineering rationale,” Moody’s says.

The water company’s enhancement allowances are £8.2 billion, also cut by around £2 billion or 19.8% from a £10.2 billion request. The ratings action states that a large part of enhancement cuts relate to requests that Ofwat considered have been previously funded or funded through base cost allowances.

The £8.2 billion enhancement allowances include separate gated allowances for £1.3 billion primarily to improve asset health, £1.1 billion contingent allowances related to additional large schemes and strategic resource options, and £1.2 billion separate delivery mechanisms.

Thames Water to face around £76m of annual penalties on average under ODI framework

Based on the revised performance targets and incentive rates at final determinations, Moody’s estimates that Thames Water will face around £76 million of annual penalties on average under the outcome delivery incentives (ODI) framework. In addition, it expects that Thames Water would incur an additional £20-30 million of penalties on service performance measures, if performance remained the weakest in the sector.

Overall, in the ratings agency’s view Thames Water's business risk remains supported by the company's position as a monopoly provider of essential water and sewerage services. However, it warns:

“The Caa3 CFR remains constrained by our expectation of a near-term distressed exchange and the risk of losses being imposed on creditors. We currently estimate that the risk of ultimate creditor losses could be higher than 10%, the maximum loss given default implied by the previous Caa1 rating."

Thames Water liquidity is inadequate

Moody’s is also warning that Thames Water's liquidity is inadequate. As at 30 September 2024, the company had committed liquidity of £1.5 billion (£1.1 billion cash and £0.4 billion undrawn under revolving credit facilities). The undrawn revolving credit facilities would be cancelled if the current debt restructuring process is successful and Thames Water has agreed not to draw these without the consent of the relevant lenders ahead of its implementation.

According to Moody’s this liquidity is only sufficient to allow meeting all liquidity needs into March 2025 - an initial debt restructuring, expected to conclude in February 2025, would, if approved:

• provide up to £3.0 billion super-senior liquidity, with the first £1.5 billion backstopped by creditors;
• extend all debt maturities by two years, deferring £3.2 billion of maturities currently due by February 2027.

However, Moody’s considers that the company will only establish a more sustainable capital structure and funding position after a second debt restructuring, expected to take place later this year and involving the raise of new equity.

The ratings action also refers to the restructuring plan which is being contested in court by the company's Class B creditors who are offering an alternative liquidity proposal.

“Should the initial proposal fail and no alternative agreement be reached before the end of March 2025, we expect the company would enter into a standstill under its finance documentation. A standstill would lead to significant restrictions in capital spending and we believe would increase the likelihood of Thames Water having to enter into special administration,” Moody’s warns.