Credit terms in business market carry risk of margin erosion says Moody's

The credit terms and allocation of related risks between wholesalers and retailers in the non- household sector proposed by Ofwat offer strong risk mitigation for wholesalers but carry also the prospect of margin erosion for retailers according to credit rating agency, Moody’s.

In its take on the regulator’s 9 June consultation, which closes 7 July, Moody's noted the prospect of increased risk to wholesalers of moving from a relatively diverse customer base in an integrated model, to “quite significant revenue concentration to a single or a limited number of retail counter parties”. But it said this was offset by:

[if !supportLists]• [endif]Limited negative financial implications, even in the worst case scenario of complete loss of non household (NHH) retail revenues over an average 80 day payment cycle. The most exposed companies (United Utilities and Bournemouth Water) could face losses of up to 6% of wholesale revenue.

[if !supportLists]• [endif]The low likelihood of a complete loss of wholesale revenues given the experience of the energy and Scottish water markets.

[if !supportLists]• [endif]The collateral mechanisms proposed in Ofwat’s consultation, which further reduce risk.

Moody’s said: “We believe that the proposals…would provide significant risk mitigation by reducing the potential maximum revenue loss of NHH wholesale revenue from an average of 4.3% to 1.6%.”

However, for retailers Moody’s said the cost of maintaining the working capital required as cash collateral or procuring alternative security could erode the retailer's margin. It qualified this by adding: “However, we also note that Ofwat set this margin considering comparator markets with similar credit collateral arrangements as proposed for the water NHH retail market, i.e. the 2.5% net retail margin is designed to cover such costs.”

In its June consultation, Ofwat proposed retailers provide 50 days of collateral cover to wholesalers in the business retail market, using one of the following options:

[if !supportLists]• [endif]Cash

[if !supportLists]• [endif]Letter of credit – from a bank, agreeing to make a payment to the wholesaler if certain contractual conditions are not met by the retailer.

[if !supportLists]• [endif]Third party guarantee – a guarantee of payment by a parent company or third party guarantor acquired before any service is provided by the wholesaler.

[if !supportLists]• [endif]Insurance – a surety bond issued by an insurance company on behalf of a retailer, guaranteeing the performance of the retailer’s obligations.

[if !supportLists]• [endif]Unsecured credit – an unsecured allowance as a proportion of otherwise collateralised charges and liabilities. The amount of the allowance would depend on the the creditworthiness of the retailer.

[if !supportLists]• [endif]Pre-payment – payment in advance by the retailer of the estimated cost associated with delivering one month of service by the wholesaler, plus a balancing payment once the actual cost of providing the service is known.

[if !supportLists]• [endif]Bilateral agreement – terms to be negotiated between a wholesaler and retailer on a bespoke basis and published.