Moody’s gives negative credit outlook for water sector

Moody’s has lowered its credit outlook for the water sector from stable to negative due to inflationary cost pressures.

Although sustained high inflation is typically credit positive for water companies, the ratings agency said the lag between rising costs and inflationary increases to their revenues and regulatory capital value can result in volatile metrics. It said water companies are also exposed to any mismatch between headline inflation rates and their actual costs.

Moody’s noted for example that the direct impact of energy costs on the year-on-year CPIH inflation rate remains relatively small and only very recently increased to around 2-3 percentage points.

However, power costs, which accounted for roughly 17% of water companies operational expenditure and 9% of their total expenditure, increased by an average of 16% in the 2021/22. Some water companies reported an increase of more than 40% for the six months to the end of September when compared to the same year period in the previous year, reflecting both higher prices and increased consumption due to dry weather.

Moody’s said water companies’ exposure to increased energy costs varies significantly depending on their hedging arrangements and level of self-generation.

The ratings agency said their half-year results for the six months to the end of September also indicated that costs for materials and consumables (including chemicals) had increased by 40-60% when compared to the same period in the previous year. It said total operating expenditure has been rising by more than 15% for many companies, “well in excess of current CPIH headline inflation.”

Moody’s said the growth of their RCV in line with inflation will generally lower water companies gearing to the extent that their debt does not also grow. However, more than 50% of the sector’s debt was inflation-linked as of March 2022, with significant variation between companies.

Although there is an adjustment at the end to reflect the indexation of new debt, the cost of debt and equity are fixed for the five-year regulatory period. Rising interest rates will therefore hit companies with large funding needs, affecting their credit cover metrics. Again there is significant variation between companies in the proportion of their total debt that will need to be refinanced during the period.

Furthermore, Moody’s highlighted the heightened public, political and regulatory attention to pollution incidents, saying companies could face stronger fine and increased investment needs following the ongoing investigations by Ofwat and the Environment Agency.

“With the 2024 price review fast approaching, we do not expect either investigation to conclude over the next 12-18 months. However, companies that have been breaching their legal permits could face regulatory enforcement action, including fines of up to 10% of annual wastewater turnover for civil cases,” the analysts explained. “In addition, they may face criminal prosecution.”

Moody’s also noted the publication of the Department for Environment, Food and Rural Affairs’ Storm Overflow Discharge Reduction Place, which will require wastewater companies to invest £56 billion between 2025 and 2050.

Although this investment will spread over 25 years, the ratings agency pointed out that this amounts to more than 70% of English water companies’ RCV at March 2022 and 131% of the portion related to wastewater activities only.