The negative outlook for UK regulated water utilities reflects continuing regulatory, political and public pressure on the industry. Ofwat, the regulator for the water and wastewater companies operating in England and Wales, published its final determination in December 2019 for the five-year regulatory period commencing 1 April 2020 (AMP7). We also reflect the more recent impact of the coronavirus outbreak, but believe the UK regulated water sector faces overall low risk.
- Unprecedented cut in returns and elevated exposure to cash flow volatility increases credit risk. Ofwat has cut allowed returns by almost 50% on a like-forlike basis. While reflecting a persistent low yield environment, the sharp cut will pose particular problems for companies with expensive long-dated debt. Financial flexibility will be eroded across the sector, with particular pressure on interest coverage, and companies will have limited room to offset unforeseen challenges.
- Largest number of referrals to the Competition and Markets Authority (CMA) since privatisation. Four companies asked Ofwat to refer their determinations to the CMA, the largest number of appeals on a single price review since the sector's privatisation. One of the key grounds of appeal can be summarised as a distortion in the balance of risks and achievable returns.
- Material cuts in requested enhancement spending. Across the industry, the gap between what companies wanted to spend and what Ofwat allowed fell to only 5% at final determination from around 11% at the draft determination stage. After companies reduced their spending requests, the base cost challenge reduced substantially to below 1%, but the regulator allowed roughly 26% less enhancement spending than the companies requested, with the most significant cuts on proposals to increase resilience.
- Tough performance targets for most companies. Ofwat rowed back from its draft determination but we estimate that the industry could still rack up stiff penalties of £150 million-£350 million in aggregate over the five years when performing in line with their business plans or latest performance levels.
- Low exposure to impact of coronavirus. The UK water companies have an overall low exposure to coronavirus risks given regulatory protections against consumption volumes or collected revenues being lower than expected and solid liquidity, which will act as a buffer against short-term stress.
- What could change Moody's outlook. We could change the outlook to stable if it appears likely that the business and macroeconomic fundamentals for the sector will improve, reflecting regulatory developments, including a more favourable re-determination by the CMA for those that rejected their determinations, or companies taking further action to bolster their balance sheets. This assumes that the macroeconomic effect of the coronavirus outbreak remains manageable in the context of the regulatory protections available.
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