Firms must manage capital structures to maintain credit quality at PR19 - Moody's

Moody’s last week fleshed out the opinion it issued shortly after Ofwat published its draft price control methodology in July: that the proposals are credit negative and may require companies to take remedial action.

In a report Lower returns will pressure credit quality from 2020 published on Tuesday to coincide with its water sector conference, the ratings agency said water companies will likely face a significant cut in revenue and see their credit quality come under increased pressure. Vice president and senior credit officer Stefanie Voelz added this required firms “to look at potentially cutting dividends and other measures to bolster balance sheet strength”.

The key challenges posed by the methodology and cited by Moody’s include:

  • Falling wholesale returns – Moody's calculated returns could be cut by around 100 basis points from the current 3.6% wholesale return, on a like-for-like basis. While Ofwat's proposal to link revenues to CPIH would increase overall allowed returns, “Moody's still sees the potential for the allowed cost of capital to fall by 0.5%-0.8% from April 2020”.

  • Ofwat’s renewed focus on cost efficiency in PR19 – average performers could face penalties or reduced cost allowances if they fail to meet efficiency targets, in turn exacerbating the pressure from lower returns.

  • No guarantees of outperformance – “outperformance and additional rewards cannot be taken for granted, with most facing the risk of underperformance and penalties”.

Moody’s said companies will have to manage their capital structures if they are to maintain credit strength. It detailed: “Most exposed to a cut in allowed returns are companies with the highest leverage and/or most expensive long- term borrowing costs, including Southern Water Services Limited (Baa2 negative) and Yorkshire Water Services Limited (Baa2 stable), because servicing debt will get tougher as cash flows shrink. Cash flows available to be up-streamed to service debt at holding companies will also be squeezed.”

However, the rating agency added that even companies with lower levels of debt will need to review their dividend policies in a changing environment.

Moody’s has also published a document addressing FAQs on Labour's proposed renationalisation plans, and hosted a debate on the subject at its annual water conference.

For full coverage of both documents, the debate and the wider conference, see November’s edition of