Credit ratings agency Moody's has said that Ofwat’s changes to the price review process announced last week will be credit negative for the UK water sector and put highly leveraged companies like Anglian Water Services, Thames Water, Yorkshire Water Services Ltd and Southern Water under negative ratings pressure.

Last week the economic regulator for the water and sewerage companies in England and Wales gave advance notice about further guidance on its review of companies' business plans.

The business plans, submitted on 2 December 2013, form the basis for Ofwat's price review to set customer charges for water and sewerage services for the next five-year regulatory period from 1 April 2015 to 31 March 2020 (AMP6).

According to the announcement, Ofwat will issue further guidance in January 2014, particularly on the level of the weighted average cost of capital (WACC) and other key financial parameters that the regulator will apply in setting price limits for AMP6.

In Moody's view, this indicates that Ofwat believes the range for the allowed return on the regulatory capital value (RCV) of wholesale activities as proposed by the companies -- on average around 4.2-4.3% (vanilla, real) for the 10 large water and sewerage companies (WaSCs) -- is too high and, according to the announcement, "not in alignment with market evidence for the water sector".

Moody’s commented:

“Given public remarks by Ofwat's Chief Regulation Officer, Sonia Brown, in November 2013 that the WACC should "start with a 3", it seems the rate of return allowed by Ofwat may fall significantly below the level proposed by companies.”

Ofwat statement creates uncertainty over regulatory pressure

In Moody's view the companies have sought to respond to Ofwat's challenge to put customers at the heart of the price review. Most companies have proposed real-term reductions in bills, with some business plans including additional gain-sharing for customers of future inflation movements and outperformance over AMP6.

Moody’s says that the Ofwat announcement indicates, however, that the regulator believes that they have not gone far enough.

A reduction in allowed returns, below the levels proposed by companies for AMP6, will be credit negative and will result in downward rating pressure for those that are weakly positioned within their rating category and/or have limited flexibility to adjust their dividend and financial policies.

Ofwat's announcement also requests companies "to consider all appropriate options to address financeability constraints, which may include, for example, accepting lower levels for certain financial ratios than those adopted at PR09 or defined by credit rating agencies for a particular rating band."

In Moody's view, Ofwat's statement creates uncertainty as to whether there will be any regulatory pressure on companies to maintain their credit quality in line with current ratings, which are on average in the A3/Baa1 category.

Moody’s commented:

“We consider that United Utilities Water PLC (A3 stable) and Severn Trent Water Ltd (A3 stable) remain strongly positioned with limited pressure on their current ratings likely following the price review. “

“However, the highly leveraged companies, such as Anglian Water Services Ltd (Baa1 stable), Thames Water Utilities Ltd (Baa1 stable), Yorkshire Water Services Ltd (Baa1 stable) and Southern Water Services Ltd (Baa2 negative), as well as the holding companies of highly-leveraged WaSCs, such as Anglian Water (Osprey) Financing Plc (Ba3 stable) and Thames Water (Kemble) Finance Plc (B1 stable), will face negative ratings pressure if management and shareholders are unable to implement balance-sheet strengthening measures in the face of a challenging price review.”