Ofwat considers options to boost company financial resilience

More needs to be done to better protect customers from the consequences of weak levels of financial resilience at some water companies, Ofwat said.

In a discussion paper available for comment until 31 January, Ofwat set out a range of options it could pursue to strengthen existing protections including the following.

• Raising the minimum standards of credit quality – the regulator said it is considering whether to increase the level at which the current cash lock-up licence conditions trigger, from the existing level defined in the licence at BBB-/Baa3 with negative designation to BBB/Baa2 with negative designation, or even higher. It will also look at whether the cash lock up conditions could be extended to include other triggers defined in circumstances where companies deliver poor levels of service to customers or the environment.

• Amending licence conditions to align with Ofwat’s expectations on dividends (payments taking account of performance in meeting obligations and commitments for customers).

• Increasing transparency - credit ratings are intended to inform debt markets and provide an independent view of credit quality but are not in place to protect customer interests. Ofwat said: “We see a role for us to provide an assessment from the customer perspective.”

• Exploring regulatory incentives on capital structure – Ofwat acknowledged the CMA’s position on its PR19 Gearing Outperformance Sharing Mechanism and said it welcomed views on how the incentives framework around capital structure should evolve, and “whether companies should consider voluntary arrangements to share financing outperformance, as South West Water is doing with its WaterShare+ arrangement”.

• Ofwat said it was “not minded, at this time” to set pre-determined limits on gearing.

Explaining its position, the regulator said: “Concerns arise where companies maintain high levels of debt, weak levels of financial resilience and credit ratings with little headroom in the investment grade. These circumstances can be the result of past financing choices, including where large amounts of debt have been raised or there has been a past withdrawal of equity, sometimes accompanied by dividend payments that do not reflect the levels of service delivered to customers.” In noted in particular “the risky use of swaps, which can mask weak underlying levels of financial resilience, can undermine existing creditor protections and defer a challenging financial resilience position to the future.”

PR19 determinations were based on 60% gearing. Ofwat said nine companies have gearing levels over 70%, two topping 80%. It said two companies report mark-to-market swap liabilities that, if added to regulatory gearing, result in liabilities at, or above, 100% of RCV.