Moody’s: equity injections will be needed to meet Ofwat’s legitimacy demands

Ratings agency Moody’s said in a note last week that Ofwat’s recent challenge on financial resilience and legitimacy may force water companies to cut debt.

Some firms have already been retaining earnings to bring gearing down in preparation for PR19’s lower allowed returns. But to reduce it to around the 70% mark before 2020 in light of the challenge set out by Ofwat chairman Jonson Cox at Water UK’s City Conference on 1 March, “would almost certainly require equity injections,” Moody’s said.

Cox took the option of raising additional debt above the regulated operating company to fund his demands off the table, telling firms to raise “unencumbered equity”. Moody’s observed: “While such balance sheet strengthening would be credit positive, the imposition of explicit restrictions on companies’ capital structures would represent a divergence from past regulatory practice.”

It added: “The prices at which stakes in the private equity-owned highly leveraged water companies have recently changed hands suggests that they continue to be seen as attractive investments. However, shareholders may be reluctant to inject additional cash and, as we have said previously, low returns and significant mark-to-market derivative losses may have eroded the incentives for equity to provide support.”

For the highly leveraged firms (70%+ geared), Moody’s said there was heightened risk of significant scrutiny of the PR19 business plans, “potentially leading to a more challenging price determination.” It elaborated: “Companies will be asked to present their business plans for the upcoming regulatory period 2020-25 to Ofwat by 3 September 2018, outlining how they intend to ensure financial flexibility and maintain an “acceptable investment-grade rating” at least over the next decade.

"This leaves little time for companies to plan and potentially implement significant changes to their capital structures and raises questions about the ability and willingness of equity investors to provide additional funding.”