Ratings risk for the highly geared

Moody’s says a tough price review from Ofwat could cut water firms’ credit ratings. By Conor McGlone.

Highly leveraged water companies are at risk of negative rating pressure if Ofwat delivers a tough price review next year as predicated, according to the ratings agency Moody’s.
Speaking to Utility Week, Stefanie Voelz, water industry analyst at Moody’s, said: “Low interest rates will drive a reduction in allowed returns in the next price review. For some companies, balance sheet strengthening may be necessary to maintain credit quality.
“If they cannot offset a cut in allowed returns with improved performance or adjustment to financial and dividend policies, individual companies may face negative rating pressure, particularly if they are already weakly positioned within their rating categories,” she said, singling out Southern Water, which has the lowest rating of the water and sewerage companies – a Baa2 negative rating – due to its exposure to inflation-linked derivatives. It is also the fourth most highly leveraged.
According to Moody’s, the rated companies with most to lose are the three most highly leveraged water and sewerage companies – Anglian Water, Thames Water and Yorkshire Water – all of which are rated Baa1.
The debate on the risks of company gearing was reignited earlier this year when Ofwat chairman Jonson Cox said there had been a growing trend for water companies to become highly leveraged, with several companies at 80 per cent gearing, thus obtaining only one-fifth of their financing from equity. Cox said questions had rightly been asked about the ability of highly leveraged companies to endure “in a less intrusive, higher-risk, less rules-based model of regulation sought by managements”.
“Highly leveraged companies have less financial flexibility,” says Voelz, “because a lot of their cash flows need to be used to service their debt. If companies receive a lower return, their interest coverage could be significantly weaker than what we see today.”
Severn Trent, Wessex, Welsh and United Utilities are the highest rated water and sewerage companies, at A3, with a net debt/regulatory capital value of 60-68 per cent.
“These companies are also relatively well positioned within their current rating categories, and therefore face less risk from a tough review,” said Voelz. But she warned “the whole industry is at risk” if serious political intervention became a reality, after environment secretary Owen Paterson wrote a letter to the chief executives of water firms urging them to ensure customers got a “fair deal”.
“If you have material political intervention, that could potentially cause us to review our favourable assessment of the regulatory framework, which we currently see as independent, stable and predictable,” she added.