Utility Week expert view: Karma Ockenden

“Ofwat is describing credit ratings as ‘not the be all and end all’ in terms of financeability, which signals a shift from its PR09 position on the issue”

Investment grade credit ratings have been vital for water company investment since privatisation. The access they bring to low-cost debt and a range of debt markets has been vital because the majority of external finance over the past two decades has come from debt rather than equity – and because many water companies have licence conditions requiring “best endeavours” to maintain top band ratings.
So why is it that Ofwat is describing credit ratings as “not the be all and end all” in terms of financeability? These were the words of Ofwat’s City adviser Graham Taylor when talking to water investors following publication of the latest PR14 guidance on risk and reward. While Taylor noted credit ratings had a “very significant impact on the borrowing costs of the industry”, Ofwat said it did not have a specific rating target for water companies in mind for this price review. According to Keith Mason, senior director of finance and networks: “It’s completely for companies to decide where they want to pitch their financeability metrics and credit ratings, and look at the overall outcome for customers.”
This signals a shift from Ofwat’s PR09 position on the issue. Previously, it has aimed to ensure price determinations are consistent with an investment grade rating. Ratings agency Fitch explains: “As part of the price review 2009, the regulator assessed water companies’ financial profiles against target financial ratios that were consistent with an ‘A-’ rating. If one particular indicator (and in a small minority of cases, two indicators) did not meet the required thresholds, Ofwat ensured that respective companies met the criteria for a strong ‘BBB+’ credit rating as a minimum.”
Taken to its logical conclusion, could this mean Ofwat will now allow a water company to fall to sub-investment grade, as long as it can finance itself? No, because most companies have the “best endeavours” licence condition. Mason comments: “Could [they] target sub-investment grade? I think the answer to that is probably not. But in the investment-grade rating element [triple A to triple B], yes, it is for companies to make their own decisions.”
Ofwat believes a company with a gearing in line with its notional capital structure of 62.5 per cent debt to regulatory asset value should be able to keep an investment grade rating, but it is down to company boards to manage how that is achieved.
Nonetheless, Ofwat’s decision not to assess water companies’ financial profiles against target financial ratios consistent with particular ratings is a significant development. Fitch says the new arrangements “represent a fundamental change to the practical application of Ofwat’s financing duty”. This is a primary duty to ensure water firms are able to finance their functions and has two strands: ensuring an efficient company should be able to earn a return at least equal to the cost of capital; and ensuring price limits enable efficient companies to raise finance on reasonable terms.
The obvious danger from inviting companies to make their own credit rating call is that a higher cost of debt, especially new debt, could result if they opt to drop a notch from comfortable to low investment grade. Brown assures that Ofwat has modelled cost of debt across a range of ­different ratings its notional company could sustain.
At any rate, a ratings downgrade could be a real prospect for some companies in 2015-20 – particularly those whose gearing exceeds Ofwat’s notional 62.5 per cent level. Moody’s and Fitch have both warned of negative ratings pressure from the tightening of the regulatory screws. Aside from the widely reported 3.85 per cent vanilla Wacc, the latest numbers include a wholesale Wacc of 3.7 per cent; a 1 per cent household retail margin; and a 2.5 per cent non-household retail margin. There is also a clear message to water-only companies that if they want their small company premium, they will have to fight for it.
The overall picture is one of a regulator taking a different approach to the price review to those it is regulating. Companies have pitched for higher returns with more downside for failure; Ofwat leans towards lower returns with more symmetrical positive and negative incentives. Brown says Ofwat’s objective here is to encourage companies to over-deliver on what customers want overall, not just financial outperformance.
But customers, via the challenge groups, have endorsed company approaches and may not favour paying rewards for outperformance. Brown acknowledges this shortcoming: “Times have been very tight for all of us in this review process, and I think that some of these questions around the structure of incentives and the overall rewards package would have merited another go-round within the companies, with the opportunity to talk further with CCGs and customers about what the overall package and balance between risk and reward really meant for them.”
As it stands, Ofwat is leaving it to companies to decide whether or not to run by CCGs any business plan revisions necessitated by the new rewards package. This is interesting given that the original plan was to seek CCG assurance that company packages were acceptable to bill-payers and that customers, ultimately, will pick up any higher cost of debt that results from ratings downgrades.