Moody's is warning that the impact of reforms of UK water sector’s upstream activities, including water resourcing and sludge treatment and disposal, could potentially result in a “significant deterioration” in the credit quality of the water companies.

The warning comes in a new report from the ratings agency. Upstream Reform Could Muddy UK Waters says the water sector is facing challenges including changing weather patterns and population growth in already water stressed areas, and will need to evolve to ensure sustainable provision of services into the future.

Reform of the UK water sectors' upstream activities, including water resourcing and sludge treatment and disposal, is becoming ever more likely, adds Moody’s.

The impact on credit quality of changes being considered by the Water Services Regulation Authority Ofwat, the economic regulator for the water companies in England and Wales, would depend on their scope, but the introduction of meaningful competition would likely be credit negative for the incumbent water companies.

Competition could result in “significant deterioration” of water companies’ credit quality

 "We expect regulation to adapt to changing circumstances and reform could lead to little change in the credit quality of the water companies, but competition could also result in a significant deterioration - even if we consider this less likely", said Stefanie Voelz, Moody's Vice President and Senior Analyst.

The report says that while business and financial risk implications of upstream reform could be small depending on the scenario, existing financing arrangement might constrain reform.

Stefanie Voelz  commented:

“To implement upstream reform while maintaining the sector's historic access to low-cost and long-term funding, it will be important that all parties, including investors, are engaged within the debate and understand the rationale for any changes.”

As at 31 March 2015, the sector carried a total of around £46 billion of net senior debt with close to £30 billion within highly leveraged financing structures.

The average cost of debt across the sector is around 2% for inflation-linked debt and 4-5% for nominal fixed-rate debt. The rates have also been locked in for a relatively long time into the future, on average in the range of 15-25 years for nominal fixed-rate and inflation-linked debt, respectively. Based on companies' reported data and Moody’s own calculations, the fair value of the industry’s debt was around £58 billion as at March 2015.

The report highlights a number of key challenges now facing the water companies – including their ability to continue investing in their infrastructure while keeping customer bills affordable.

In addition to coping with resource constraints, water companies also need to meet increasingly stringent regulations, including the European Union Water Framework Directive and growing customer expectations regarding the environment.

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