Ofwat mulls protections against ‘risky’ financial structures

Raising the minimum level of investment grade from ratings agencies, formalising dividend expectations, and updating outperformance mechanisms for future price reviews have been proposed by Ofwat in a consultation addressing financial resilience in the water sector.

The regulator suggested a series of measures following its report Monitoring the Financial Resilience last month in which the regulator raised concerns that nine companies’ gearing was above the 60% notional level set out in PR19 determinations. It also highlighted that credit ratings for Southern, SES and Yorkshire were at risk of falling to the minimum investment grade.

The consultation set out options for strengthening current arrangements to protect billpayers from the consequences of weak resilience. Ofwat suggested these could include placing limits of gearing, which was discussed as option by the Competition and Markets Authority (CMA) in its redeterminations of four companies at PR19.

Ofwat said this approach would be unlikely to capture the full range of possible risks and lacks flexibility to change with circumstances and investment programmes. The regulator instead proposed raising the minimum standards of credit quality required to avoid companies holding ratings without sufficient headroom.

On dividend expectations, Ofwat said companies do not always make clear to customers how boards take account of performance and obligations when deciding on dividends and bonuses. It suggested amending licences to align the dividend license conditions with the regulator’s expectations.

Transparency around finance arrangements remains a core concern that Ofwat has worked with the sector to improve. The consultation sought views on the use of complex structuring to “mask” underlying financial concerns. It will assess how customers view the financial structures in place.

Another recommendation from the CMA’s redetermination was to remove the gearing outperformance sharing mechanism (GOSM) introduced at PR19 to disincentivise what Ofwat considered “risky” financing choices. Ofwat has invited input on how the incentives framework around capital structures should evolve and whether companies should consider a voluntary sharing scheme such as South West has done with its WaterShare plus scheme.

“Water companies need to be financially resilient and transparent about their financial structures. We have concerns on both fronts that need addressing. They need to be financially secure enough to make the investment needed in the essential service they provide, maintain critical assets, and protect the environment. Without that, customers and the environment will lose out,” said Ofwat interim chief executive, David Black.

“Dividends should be linked to performance, and companies have to improve this if they want to rebuild the trust of their customers.”

The consultation runs to 31 January 2022.