Tougher targets and increased investment to weigh on water credit ratings

Increased investment driven by new statutory requirements as well as tougher targets and an asymmetric incentive package skewed towards penalties will all weigh on water company credit ratings over the next asset management period, Fitch has warned.

The ratings agency said these developments will be partly offset by “sizeable” equity injections and significant revenue growth during AMP8.

Based on analysis of their recently submitted PR24 business plans, Fitch said the companies in its ratings portfolio – comprising all of the water and sewerage companies except Pennon’s South West Water plus the water-only company Affinity Water – have proposed to spend a total of £95 billion between 2025 and 2030 – almost double the £50 billion figure for AMP7.

The agency said this rise is primarily driven by a £34 billion (145%) increase in proposed capital expenditure compared to a £12 billion (45%) increase in operational expenditure.

Importantly, Fitch said a greater proportion of capex will be enhancement expenditure to improve the quality or capacity of services beyond current levels due to factors such as population growth or new statutory obligations. This includes expenditure to reduce spills from combined sewer overflows.

It said this enhancement expenditure has a higher risk profile than base expenditure and much of it will be subject to price control deliverables that expose companies to penalties for non-delivery with no corresponding upside.

At the same time, the agency said water companies will also face more challenging performance targets and outcome delivery incentives that are skewed towards penalties over rewards.

Fitch said further equity injections by investors will be key for water companies to maintain their credit ratings. It said equity injections for its rated portfolio have so far totalled £2.9 billion over AMP7 and are expected to reach £4.2 billion by the end of the period.

The ratings agency said their PR24 business plans include £7.5 billion equity injections although these are “largely uncommitted for now”. It said this investment will be conditional on adequate returns on equity.

As reported by Utility Week previously, multiple water companies have complained that the equity returns proposed by Ofwat look unattractive when compared to the increased – almost level – returns that investors can now generate from lower risk debt.

In its final PR24 methodology in December, the regulator gave a figure of 4.14% in real terms as its ‘early view’ for the allowed return on equity. Fitch said almost half of the companies it rates proposed higher figures in their business plans, ranging from 4.55% by Yorkshire Water to 6.25% by Wessex Water.

Fitch said water companies’ credit ratings will also be supported by long-term growth in their regulatory capital value (RCV) due to high inflation. As RCV is indexed to inflation, but this is not the case for all of their debts, high inflation generally lowers their gearing levels.

Despite its concerns, Fitch said it has maintained stable credit ratings for all but two of the companies in its portfolio – the exceptions being Southern Water and the holding company of Thames Water, which are both on a negative outlook.