Fitch Ratings has affirmed United Utilities Water Ltd's (UUW) and United Utilities Water Finance PLC's (UUWF) senior unsecured ratings at 'A -'.

Fitch Ratings has also affirmed UUW's long-term Issuer Default Rating (IDR) at 'BBB+' with a stable outlook.

However, Fitch has downgraded United Utilities PLC (UU) IDR to 'BBB' from 'BBB+' and its senior unsecured ratings to 'BBB+' from 'A-'.

The affirmation reflects Fitch's expectation that UUW's financial profile will remain commensurate with its ratings for the price control period ending March 2030 (AMP8). This considers Fitch’s tightened rating sensitivities, as well as its assumption of net outcome delivery incentive (ODI) rewards and environmental fines. The group's solid operational performance and the low cost of debt embedded in its capital structure relative to the sector's further underpin its rating headroom.

The downgrade of UU reflects Fitch’s increasing focus on its structural subordination to UUW, despite UU's lower consolidated gearing than at UUW.

Fitch key rating drivers include:

Rising sector risk: Ofwat's recent final determination (FD) offers a reasonable outcome for most UK water companies compared to the draft determination and is in line with the ratings agency's expectations. However, we anticipate moderately higher business risk in AMP8 due to increased environmental exposure, public scrutiny, and clawback risk, which is linked to the price control deliverables (PCDs) mechanism. Further uncertainties may arise from the Cunliffe review, the most significant regulatory reform since privatisation.

The sector faces increased risk of fines for operational and environmental underperformance and challenges in rebuilding trust with the public, government, and regulatory bodies. We expect the sector to enhance its assets to accommodate population growth and extreme weather conditions.

Revised debt capacity and sensitivities: Fitch has revised the sector's debt capacity for AMP8, leading to a 0.1x increase in cash and nominal post-maintenance interest coverage ratios (PMICRs) for UUW. However, the negative sensitivity for net debt/regulatory capital value (RCV) remains at 67% because UUW is a positive outlier in the sector. In contrast, the gearing sensitivity has tightened by 2% across Fitch’s utilities portfolio.

The affirmation is supported by solid operational performance and a target gearing of 55%-65% across AMP8 for United Utilities Group PLC (UU Group PLC). Fitch tested the resilience of UUW's rating headroom by including environmental fines in the rating case, and under its cash flow assumptions, the company maintains limited gearing headroom but comfortable coverage headroom.

Limited gearing headroom: Fitch forecasts UUW's net debt/RCV around 66% by the end of AMP8 (67% expected in financial year to March 2025), leaving limited rating headroom under its negative sensitivity of 67%. UUW plans to fund its investments through bill increases and new debt, with no equity issuance. However, we expect management to undertake mitigation measures to avert breaches of its net debt/RCV negative rating sensitivities.

Neutral Totex performance: Net total expenditure (totex) for AMP8 is £13.3 billion (real terms, 2022-2023 prices), nearly double the £6.8 billion in AMP7, leading to an RCV of £21.8 billion by the end of AMP8, up from £14.8 billion expected in FY25. Despite a 5% reduction in the company's business plan, Fitch expect UUW to adhere to regulatory cost allowances. This is based on AMP8 investments already in progress and a supply chain ready to handle increased totex. In addition, FD allowances have been set at around 10% higher than the draft determination.

Increased enhancement allowance: Enhancement expenditure for UUW are about 3x higher in AMP8 (£5.7 billion in real terms) than in AMP7. Storm overflows account for nearly 42% of the investments, and 28% are related to river health improvements. About 94% of enhancement expenditure is subject to the PCD mechanism. Under this framework, investments need to achieve Ofwat's benchmarks of allowance and timeline to mitigate the risk of a clawback. This mechanism ensures that investment funding is ringfenced, with any unspent allowances returned to customers.

ODI rewards expected: Fitch forecast in-period ODI rewards of £80 million related to operational performance in AMP8. Since the cash impact of these penalties materialises with a two-year lag, Fitch is projecting cash ODI rewards of about £160 million in AMP8 to include the amount related to the last two years of AMP7. In AMP8, the ratings agency expects UUW to receive rewards, primarily for improvements in pollution incidents, external sewer flooding, and bathing water quality.

Regulatory fines forecast: Fitch forecasts about £140 million in total fines from the Environment Agency and Ofwat as baseline cash outflows, due to heightened regulatory scrutiny and stricter controls on wastewater networks. Ofwat assumed fines across all companies operating wastewater networks and will adjust this assumption to reflect actual fines or a perceived reduction in risk, accordingly.

Structural subordination of UU: Following its downgrade, UU's senior unsecured debt ratings is now one notch below UUW's. We are placing a greater emphasis on its structural subordination to UUW, despite UU's lower consolidated gearing. The downgrade also reflects the possibility of UU issuing debt during AMP8 to support UUW's financial profile.