Moody’s assesses dangers for negative water sector

Cuts in permitted returns and spending, four referrals to the Competition and Markets Authority combined with the uncertainty presented by coronavirus has caused Moody’s to give the water sector a negative outlook.

Moody’s said cuts in Ofwat’s final determinations on company business plans meant a reduction in allowed returns of almost 50 per cent on a like-for-like basis. It said this posed problems for companies with long-dated debt arrangements and predicted financial flexibility would be eroded across the sector and leave businesses with limited resources to offset “unforeseen challenges”.

These cuts saw a reduction in allowed cash returns to 2.42 per cent for wholesale activities, which Moody’s said would see allowed returns for most companies fall by close to 50 per cent from to an average cash return of around 2.5 per cent over AMP7.

Moody’s said “irrespective of financing arrangements all companies are negatively affected by the cut in allowed cost of equity”, which are now significantly below levels for comparable energy networks.

Spending reductions also coloured Moody’s assessment. No company was immune to a drop in how much money they were permitted to spend on enhancements in their business plans for the coming five years. Although the gaps were tightened between draft and final determination, all companies were allowed significantly less than they requested – particularly for appellants Yorkshire and Anglian which had the largest.

Although efficiencies may well be achievable, Moody’s noted the risk of over-spending is apparent. The most significant cuts to spending and investment related to projects for boosting resilience, where the regulator allowed around 26 per cent less than the £11.1 billion the companies requested. After dividing the spending into future resilience and base cost allowances, Ofwat cut close to 50 per cent of companies’ spending on projects including sludge enhancement and sewerage services, but did allow £469 million to develop strategic regional water resource planning albeit via a gated process.

Moody’s also estimated that potential penalties could reach between £150 million and £350 million in aggregate over the next five years based on current performance and business plans. This is down from the estimation at the draft determination stage that suggested penalties in excess of £1 billion.

It also pointed out that “the calibration of targets and incentive rates means that severe weather events could carry disproportionate downside risk. Government restrictions to counteract the spread of the coronavirus and focus on essential services may also mean that certain targets cannot be met.”

It noted that Ofwat’s higher-powered incentives for this AMP cycle had a potentially greater scope for outperformance, but Moody’s maintains there will be an overall negative skew in rewards and penalties, which will increase the pressure on companies’ already tight interest coverage.

Moody’s said its outlook would change to stable if business conditions for the sector improve, including favourable redeterminations for the four companies appealing to the CMA, and fundamental improvements to macroeconomic factors.

Stefanie Voelz, Moody’s vice president, senior credit officer, said: “The negative outlook on the UK regulated water sector reflects deteriorating financial metrics as a result of continuing regulatory, political and public pressure on the industry. The sector faces overall low risk from the recent impact of the coronavirus outbreak, considering regulatory protections and solid liquidity.”