Credit ratings agency Fitch has revised the UK water sector’s rating outlook to negative from stable, following Monday’s publication of guidance to risks and rewards for the 2014 price review by the regulator Ofwat.

The ratings agency takes the view that Ofwat’s more flexible approach to setting price controls, together with its guidance of 3.85% vanilla weighted average cost of capital (WACC) will not allow some UK water companies to maintain credit metrics commensurate with existing ratings.

In an investor conference call PwC, who are acting as advisors to Ofwat, clarified that credit ratings were not the “be all and end all” in terms of setting price limits. Keith Mason, Senior Director of Finance and Networks in Ofwat, highlighted that it was for management teams to put in place a suitable financing structure that will allow the regulated company to maintain an investment-grade rating.

Fitch said there appears to be no commitment for a specific rating target for the companies in the sector, apart from the regulator’s view that a company that maintains gearing broadly in line with the notional capital structure of 62.5% net debt/regulatory asset value should be able to maintain an investment-grade rating.

Guidance represents “a fundamental change to the practical application of Ofwat’s financing duty”

According to the agency, this represents “a fundamental change to the practical application of Ofwat’s financing duty” and a departure from its previous approach in the 2009 price review.

 In the last price review the regulator assessed water companies’ financial profiles against target financial ratios that were consistent with an ‘A-’ rating. If one particular indicator (and in a small minority of cases, two indicators) did not meet the required thresholds, Ofwat ensured that respective companies met the criteria for a strong ‘BBB+’ credit rating as a minimum. For the modelling the regulator used in 2009 a notional capital structure with 57.5% net debt/regulatory asset value.

The downgrading follows Fitch’s review of the companies’ business plans which were broadly judged to be financeable.  The agency is now concerned that in comparison Ofwat’s latest guidance from 27 January 2014 now includes a lower fixed return and a wider range of upside or downside from incentives, together with an expectation of companies to manage various uncertainties within price limits without the fall-back of possible adjustments to allowances.

In assessing the tariff settlement for the water sector Fitch has found that post-maintenance and post-tax interest cover ratios can be expected to be a limiting factor for the ratings. Fitch takes the view that not all companies will be able to maintain interest cover ratios commensurate with their existing ratings when their earnings prospects are considered.

According to Fitch, under the current tariff settlement companies had some headroom to manage cost pressures (in addition to operational efficiencies). Allowances for electricity costs mostly reflected a premium to the market price. In addition, the cost of capital allowances indexed by RPI overstated the value of the capital programme, providing companies with a benefit in terms of returns. Fitch said that as a result, companies had scope to offset additional costs for the carbon reduction commitment, doubtful debt and the adoption of private sewers over the period April 2010 to March 2015. The ratings agency commented:

“At this stage there is little visibility as to whether Ofwat’s benchmarking will allow for headroom in any expenditure items, which could give some companies room for manoeuvring. Decisions on retail competition and the regulator’s reluctance to take a view on efficiently incurred costs versus inefficiently incurred costs for some expenditure items (for example pensions and doubtful debt) indicate that companies increasingly need to manage more risks in an entrepreneurial manner.”

No expectation that any company will achieve top end of possible range of returns

As a result, Fitch would not expect, for the purpose of a rating forecast, that any company in the sector to achieve the top end of the possible range of returns.

Separately Fitch will endeavour to review the ratings of highly leveraged transactions in the sector over the next six to eight weeks. In Fitch’s view Southern Water Services (Finance) Limited’s ratings are less likely to be affected as they were downgraded on 15 July 2011.

However, in terms of water companies with a corporate financing structure, Fitch will now review Northumbrian Water Limited’s financial profile and update the ratings, if necessary - the company has a comparatively high cash cost of embedded debt.

Increase in business risk "now a real prospect"

Fitch may tighten its credit ratio guidelines if the overall package of the tariff settlement leads to an increase in business risk, which the agency said at this stage is now a real prospect.

In October Moody’s said the outlook for the UK water sector remained stable – the sector has been on stable outlook with the ratings agency since its first industry report in 2004. 

The markets will now be waiting to see whether the other ratings agencies move in a similar direction to Fitch - and how Ofwat responds.