S&P: regulatory environment has become less credit-supportive

(by Verity Mitchell)

Rating agency S&P’s regulatory assessment of water companies in England and Wales is now strong/adequate. According to a new report, it sees a weakening of regulatory and financial stability and a risk of reduced regulatory independence. It considers that only a few companies will be able to create a sustainable competitive advantage.

Although S&P continues to view the tariff-setting process for water utilities in England and Wales as transparent and supportive, it considers that the regulatory environment has become less credit-supportive. This is because the regulators' focus has shifted from affordability and bill reduction to investment growth, which has weakened regulatory stability. Although companies can still access capital at affordable rates, S&P concludes that the risk-return balance is less reflective of the risks involved in AMP8. The Government's reform agenda for the regulated water sector adds uncertainty, especially amid increased public scrutiny and political pressure.

S&P’s detailed comments reflect its view of the changes:

• PR24 total expenditure allowances — an increase to £104bn from £51bn in PR19 — alone does not necessarily deteriorate water companies' credit quality. However, the magnitude, abruptness, and the context in which capital investment requirements have increased between periods reduce the predictability of the framework and regulatory stability. Elevated investment needs will involve significant funding requirements for a sector with already limited balance sheet flexibility. They will also generate negative free cash flows and impair deleveraging prospects.

  
  

• Ofwat’s regulatory models have become increasingly complex. While sophisticated models are typically supportive, they can also make it harder for stakeholders to understand the framework. This could reduce the efficiency with which stakeholders develop business plans and interact with several regulators.

  
  

• The risk of cost overruns remains. Water utilities are also not guaranteed full recovery. Compared with cost-plus regulatory systems, which compensate utilities for all costs incurred based on actual results, this represents a relative weakness.

  
  

• A significant gap remains between Ofwat’s cost of equity allowances at final determination, the CMA’s redetermination for appellant water companies, and that set for the electricity transmission operators by Ofgem. S&P sees operational and investment conditions as more challenging for water companies than electricity transmission companies. Key decisions often depend on factors beyond the physical transportation of water, including the inherent variability of water resources, the expertise needed to ensure water quality, and environmental considerations related to wastewater management.

  
  

• The equity raised over the regulatory period will likely be lower than Ofwat's assumptions for the notional company. This will maintain the divergence between Ofwat's notional assumptions and actual company structures, particularly regarding gearing. S&P sees the gap between notional and actual structures as a weakness of the framework, which is based on assumptions that differ materially from how companies operate. This could expose companies to substantial external shocks and lead to outcomes that the framework's design is unable to mitigate.

  
  

• S&P questions whether incentives are achievable, contained and symmetrical, and whether they affect the stability of returns and water utilities' ability to attract long-term capital. In the previous regulatory period, incentives were not balanced, with return on regulatory equity (RoRE) ranges larger to the downside, and potential losses larger than potential gains for most companies. Many targets for AMP8 still include asymmetrical penalties and some Outcome Delivery Incentives (ODIs) are penalty-only. This means that a company's net-ODI position may be negative, even if it meets many of its performance commitments.

  
  

• Even though the regulator has introduced the aggregate sharing mechanism (ASM) and the outturn adjustment mechanism (OAM) in this period, significant downside risks remain for the weakest performers. The range of rewards and penalties is still slightly skewed to the downside, with a sector average of -198bps of RoRE in the downside scenario, compared with 152 bps of RoRE in the upside scenario. This results in an average balance of -46bps. The targets set for price control deliverables may also result in customer rebates if companies fail to deliver.

  
  

• Ofwat has historically faced limited risk of political intervention. However, media and political scrutiny of the sector have increased in recent years due to low public confidence that water companies and regulators have been fulfilling their duties. Because heightened public and political attention drove the abrupt shift in regulatory focus from bill reduction to investment, this has affected S&P’s view of the regulator's independence from external pressure.

  
  

• On a positive note, public concern over water companies' environmental and performance issues prompted the UK government to come up with a substantial reform agenda. However, uncertainty about the timing and exact nature of the planned measures is high and will continue to weigh on S&P’s assessment of regulatory independence.