Moody’s flags multi-notch downgrade risk as it puts 14 firms on review post PR19

On Friday, Moody’s put 12 water companies and two water holding companies on review for downgrade following the publication of Ofwat’s PR19 final determinations last Monday. It warned that some companies could face a downgrade in excess of one notch.

Moody’s identified the following three factors as relevant to its review decision:

1. “The significant cut in allowed cash returns to ca. 2.42% for the wholesale activities at the start of the new period, which incorporates the regulator's decision to link half of the regulatory assets to the Consumer Prices Index adjusted for housing costs (CPIH), with the rest remaining linked to the Retail Prices Index (RPI). As the share of regulatory assets linked to CPIH grows over time, Moody's estimates that most companies will have an average allowed cash return of around 2.5% over AMP7. On an RPI-stripped basis, for comparison with the current period, allowed returns will fall to 1.92% (1.96% including retail margin) from 3.6% (3.74% including the retail margin), a nearly 50% cut.” It said this will put particular pressure on companies with expensive and long-dated debt, including Southern, Yorkshire and most of the smaller water-only companies (though Portsmouth and South Staffs secured a small company premium of 33bps in their cost of debt allowance).

2. Material reductions in totex compared with company requests. The draft determination gap between companies’ view and Ofwat’s view of base costs (£1.9bn) was closed to £203m, which Moody’s pointed out was about 0.3% of the industry's £72bn average regulatory capital value (excluding South West Water). But: “However, roughly £1.3bn of the gap was closed due to different business plan assumptions, where companies may have set themselves much more challenging targets or proposed cheaper short-term solutions in their response to the draft determination. Ofwat, in comparison, has upped its allowances compared with the draft determination only by just over £330m (again all numbers excluding South West Water).” The agency pointed out Anglian and Bristol retain sizeable base cost gaps while SES has a large gap on retail. It concluded: “Moody's believes that companies remain at risk of materially overspending their allowances. Under the totex sharing mechanism, up to half of this overspend would be added to the RCV in 2025 or recovered over the 2025-30 period but would result in higher debt and weaker cash flow over AMP7.”

3. Challenging performance targets: “Moody's estimated that, under the draft determination, rated companies could incur up to £1.4bn of underperformance penalties if they achieved leakage, mains replacements, sewer flooding and other operational targets in line with their business plans. While any penalties will be paid with a two-year lag and may thus only bite in the later part of the period, the majority of penalties would still affect cash flows during the AMP7 period. In addition, the calibration of targets and incentive rates means that severe weather events could carry disproportionate downside risk. As part of the rating review, Moody's will assess the changes in the final determination to the calibration of incentives and associated risk of penalties as well as individual companies' plans to mitigate any underperformance.”

The agency commented: “Specifically, the rating review reflects the anticipated pressure on companies' financial metrics, particularly interest coverage, absent a more favourable determination following any referrals to the Competition and Markets Authority (CMA), material balance sheet strengthening or significant outperformance.”

Moody’s said it will, over the next three months, review company specific totex allowances and operational performance incentives; potential management and shareholder actions to improve financial flexibility, for example through de-gearing; and companies' decisions to accept or reject the final determinations, which must be done by 15 February.

The affected companies are: Anglian and Osprey; Welsh; Northumbrian; Severn Trent; Thames and Kemble; Yorkshire; Wessex; Affinity; Bristol; Portsmouth; South Staffs; and SES.