Covid-19 bad debts hit water sector ratings

The water sector has “limited financial headroom” within rating levels, which agency Fitch warns may be insufficient to withstand longer-term impacts of the coronavirus pandemic.

Fitch said recent downgrades reflect the allowed rate of return, cost and performance pressures within the price controls set for AMP7.

The agency expects revenues and cash flow to be affected temporarily by lower water consumption volumes caused by the coronavirus. However, Fitch said raised bad debt and lower inflation expectations could have a more incremental and lasting effect.

At present all companies are still able to draw on their revolving credit facilities and continue to raise debt and their holding companies maintain ample liquidity.

If low inflation continues because of another lockdown and slow economic recovery, Fitch said companies would experience a prolonged negative impact on gearing and nominal post-maintenance interest coverage ratios(PMICRs), adding to rating pressure. Gearing would likewise be hit by persistent low inflation.

Of the Fitch-rated companies most maintain a stable outlook but many were downgraded in the wake of Ofwat’s final determinations, which saw the weighted average cost of capital (WACC) fall to its lowest ever point coupled with tougher performance targets.

With dividends already reduced to minimum acceptable levels and cost-transformation programmes underway, Fitch said firms’ ability to weather the storm could be down to whether or not they can further reduce dividends.

Of the companies it rates Fitch said Southern, Thames’ parent company Kemble, Anglian Water and its parent company Osprey, and Yorkshire are the most vulnerable. This is because they have limited headroom on gearing and their post-maintenance interest coverage ratios are either weaker than or equal to the negative rating sensitivities.

The two parent companies could be exposed to intermittent cash flow, while for Southern the outcome of the ongoing Environment Agency’s prosecution adds uncertainty. The company said it would not pay a dividend until it is financially resilient. Both Yorkshire and Anglian are awaiting redetermination by the CMA for their five-year business plans. These may lead to negative ratings action if either company received “substantially negative” results to their appeals.

Fitch warned that Wessex’s credit profile may be hit by an increase in the pension deficit, however the company maintains a stable outlook based on the expectation it will adjust dividends accordingly to maintain its gearing.

For Affinity, Fitch said the company has substantial headroom and noted it could move to a positive rating if it outperforms on outcome delivery incentives (ODIs).

United Utilities, which today announced a dip in net revenue because of Covid-19, holds a stable outlook. The company is expected to reduce its dividend in 2021 to weather the storm of low inflation and the effect of the pandemic.

On performance targets, Fitch assesses the ODIs for each company on supply interruptions, leakage, reducing per capita consumption (PCC) and internal sewer flooding.

All companies performed better than forecast for leakage for the year ending 2020, as expected on PCC and sewer flooding, but worse on supply interruptions – bar Thames which comfortably exceeded its forecast.

In AMP7 Fitch expects all companies to be penalised on leakage except UU, Wessex and Welsh Water, which have the lowest targets.

On PCC Fitch expects only Wessex to earn a reward against its ODI because it has a relatively low target among its peers. Yorkshire looks set to have the toughest challenge on sewer flooding because its region has the most properties with basements, while Southern and UU are also forecast to be tested.