Water firms face pressure on credit quality from 2020

Research from Moody’s says most companies will come under pressure in the wake of the PR19 price review

Water companies are likely to see their credit quality come under increased pressure from 2020 following Ofwat’s PR19 price review, according to research published by ratings agency Moody’s.

Analysts at Moody’s expect “a cut in allowed returns coupled with more stringent efficiency requirements, to exert pressure on most companies”.

The price review, which controls the prices water companies can charge their customers as well as the amount they invest and the level of service customers receive, will come into effect from April 2020.

Stefanie Voelz, vice president, senior credit officer at Moody’s, said: “Most UK companies will come under pressure from the expected cut in allowed returns and stricter cost efficiency requirements under PR19, requiring them to look at potentially cutting dividends and other measures to bolster balance sheet strength.”

The research suggests returns will fall despite a switch to partial Consumer Prices Index (CPI) inflation. Moody’s calculates returns could be cut by around 100 basis points (bps) from the current 3.6 per cent wholesale return, on a like-for-like basis.

It claims that while Ofwat’s proposal to link revenues to a measure of CPI inflation, adjusted for owner occupiers’ housing costs (CPIH) would increase overall allowed returns, there is still the potential for the allowed cost of capital to fall by 0.5-0.8 per cent.

The report indicates highly leveraged companies, those with the highest level of debt and expensive long-term borrowing costs, will be “particularly exposed” citing Southern Water and Yorkshire Water as examples.

At Moody’s UK Water Sector Conference on Tuesday (17 October) Liz Barber, finance director at Yorkshire Water announced the company plans to simplify its financing structure and remove its offshore banking arrangements. 

Volez said: “Some companies may struggle to achieve allowed returns under Ofwat’s renewed focus on cost efficiency in PR19, as average performers could face penalties or reduced cost allowances if they fail to meet efficiency targets, in turn exacerbating the pressure from lower returns.”

“Companies will have to manage their capital structures if they are to maintain credit strength. Most highly-leveraged companies have de-levered modestly, but companies with lower levels of debt will also need to review their dividend policies in a changing environment. 

“Outperformance and additional rewards cannot be taken for granted, with most facing the risk of underperformance and penalties,” she added. 

The research from Moody’s outlines that “financial policy decisions will be key to maintaining credit quality”.

It predicts that under a low return scenario of 2.8 per cent ‘blended’ RPI-CPIH-linked return, and absent outperformance or measures to bolster financial strength, companies’ key credit metrics would be significantly weakened. A 3.1 per cent ‘blended’ return scenario leaves fewer companies materially exposed, it suggests.