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Four UK-Based Water Utilities Downgraded on Tougher Regulations

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Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative February 25, 2020 Overview PRIMARY CREDIT ANALYSTS - Eleven of the 14 U.K. water utilities we rate have accepted the final determination (FD) of Matan Benjamin Ofwat's price review (PR19) published in December 2019, while three appealed before the Feb. London 15, 2020, deadline, asking their FDs to be referred to the Competition and Markets Authority (44) 20-7176-0106 (CMA). matan.benjamin @spglobal.com - For these 11 water utilities, the outcome of the FD implies lower regulatory returns from April Gustav B Rydevik 2020, higher pressure on operating performance, and a likely deterioration of credit metrics London with an average decline in funds from operations (FFO) to debt of 150 basis points (bps) to 200 + 44 20 7176 1282 bps. gustav.rydevik @spglobal.com - As a result, of the 11 utilities that accepted the FD, we are lowering our ratings on four and Ivan Tiutiunnikov assigning stable outlooks. We are also affirming our ratings on five entities. We previously took London rating actions on two other U.K. water utilities earlier this month. + 44 20 7176 3922 - Of the three companies that appealed, we are placing our ratings on two on CreditWatch ivan.tiutiunnikov @spglobal.com negative, since the outcome of the appeal is uncertain and the current FD indicates increased financial pressure. We are revising our outlook on the third company to negative, since we Julien Bernu believe the FD exacerbates downside risks. London + 442071767137 - Despite the tighter regulation, we continue to assess the U.K. regulatory framework for water Julien.Bernu utilities as strong, supporting our view that these utility companies have excellent business risk @spglobal.com profiles. SECONDARY CONTACTS Beatrice de Taisne, CFA LONDON (S&P Global Ratings) Feb. 25, 2020--S&P Global Ratings today lowered by one notch the London following four U.K. water utilities and/or their debt: (44) 20-7176-3938 beatrice.de.taisne - Affinity Water Finance PLC, @spglobal.com - Sutton and East Surrey Water PLC, Pierre Georges Paris - United Utilities PLC, and (33) 1-4420-6735 - Wessex Water Services Finance PLC. pierre.georges @spglobal.com See complete contact list at end of article. At the same time, we placed our ratings on two U.K. water utilities on CreditWatch negative, and www.spglobal.com/ratingsdirect February 25, 2020 1 Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative affirmed our ratings on a further six entities (see the ratings list below). We previously lowered our rating on Dwr Cymru (Financing) Ltd.'s debt on Feb. 7, 2020, after our review of its FD (see "Dwr Cymru (Financing) UK Senior Issue Rating Lowered To 'A-'; Outlook Stable; Subordinated Issue Rating Lowered To 'BBB'," published on RatingsDirect). We also affirmed our ratings on Severn Trent on Feb. 17, 2020 (see "Severn Trent Water Ltd. 'BBB+' Ratings Affirmed On Ofwat Final Determination; Outlook Stable"). Ratings list * * * Entities that did not appeal Ofwat's final determination * * * Downgraded To From Affinity Water Finance PLC Senior Secured BBB+/Stable A-/Negative Subordinated BBB-/Stable BBB/Negative Sutton and East Surrey Water PLC Issuer Credit Rating BBB/Stable/-- BBB+/Negative/-- United Utilities Water Ltd Issuer Credit Rating BBB+/Stable/-- A-/Negative/-- Wessex Water Services Ltd. Issuer Credit Rating BBB/Stable/-- BBB+/Negative/-- Dwr Cymru (Financing) Ltd. (Rating action on Feb. 7) Senior Secured A-/Stable A/Negative Subordinated BBB/Stable BBB+ Ratings Affirmed South East Water (Finance) Ltd. Senior Secured BBB/Stable BBB/Stable South Staffordshire Water PLC Issuer Credit Rating BBB+/Negative/A-2 BBB+/Negative/A-2 Southern Water Services (Finance) Ltd. Senior Secured BBB+/Negative BBB+/Negative Subordinated BBB-/Negative BBB-/Negative Portsmouth Water Ltd. Issuer Credit Rating BBB/Negative/-- BBB/Negative/-- Thames Water Utilities Finance Plc Senior Secured BBB+/Negative BBB+/Negative Subordinated BBB-/Negative BBB-/Negative Severn Trent Water Ltd. (Affirmed on Feb. 17) Issuer Credit Rating BBB+/Stable/A-2 BBB+/Stable/A-2 www.spglobal.com/ratingsdirect February 25, 2020 2 Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative * * * Entities that appealed Ofwat's final determination * * * CreditWatch/Outlook Action To From Anglian Water Services Financing PLC Senior Secured A-/Watch Neg A-/Negative Secured Subordinated Debt BBB/Watch Neg BBB/Negative Northumbrian Water Group Ltd. Issuer Credit Rating BBB+/Watch Neg/-- BBB+/Negative/-- Yorkshire Water Finance Plc Senior Secured A-/Negative A-/Stable Subordinated BBB/Negative BBB/Stable NB: This list does not include all the ratings affected. We believe the next regulatory period will be challenging for the sector. The rating actions stem from our view that the FD will put pressure on the credit quality of U.K. water utilities in the next price control period (AMP7), which begins on April 1, 2020. When the U.K. water utility regulator Ofwat published its FD for water companies in England and Wales in December, after completing PR19, it reiterated its chief goal of providing customers with better service at lower costs, while focusing on operational performance and the environment. Water companies will therefore earn lower returns in AMP7 while being required to maintain high efficiency and meet demanding regulatory targets on leakage reduction, decreased service interruption, and improved customer service. Furthermore, the range of rewards and penalties pertaining to operating delivery incentives (ODIs) is skewed to the downside, representing significant risk, particularly for the worst performers (see "Ofwat's Final Determination Leaves U.K. Water Companies’ Credit Quality In Duress," published Dec. 17, 2019, on RatingsDirect). In AMP7, water companies face higher pressure on operating performance, and ultimately about a 10% increase in debt and an average decline in FFO to debt of 150 bps-200 bps. www.spglobal.com/ratingsdirect February 25, 2020 3 Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative The water companies had until Feb. 15, to appeal the FD. In our opinion, the three utilities' decision to appeal generally reflects their view that the FD does not allow them to meet the challenges they face in the next regulatory period and beyond, and their concerns that it doesn't adequately capture customers' priorities in the long term. U.K. water utilities still operate with a strong regulatory advantage. Despite the increased pressure on U.K. water companies from regulation, our ratings in the sector still benefit from our view of low country risk and a strong regulatory advantage. We believe the regulator, through its FD for the next regulatory period, aims to rebalance the interests of stakeholders toward consumers and away from financiers. Yet we think the sector will generally retain good access to capital. We also consider the sector's long and stable track record of independent regulation that allows for the full recovery of operating, capital, and financing costs, alongside strong ring-fencing conditions. Affinity Water (AWF) Primary analyst: Gustav Rydevik The downgrade reflects our expectation that the group's credit metrics will weaken and no longer be commensurate with the previous ratings from April 2020 when AMP7 starts. Based on class A debt only, we expect AWF to achieve FFO to debt of 7.0%-7.5% in AMP7 compared with the 9% threshold for the previous rating. We expect AWF's ratio of adjusted debt to EBITDA based on class A debt to increase to 7.0x-8.0x, from about 6.7x over the past two years. The weakening of AWF's credit metrics will stem mainly from lower cost of capital and a reduction in pay-as-you-go (PAYG) ratios in AMP7, which will eventually lead to lower revenue and profitability. As per the regulator's FD, in the next regulatory period, AFW's allowed cost of capital will decline to 1.96%, assuming a retail price index (RPI) of 3%, versus 3.53% in the current www.spglobal.com/ratingsdirect February 25, 2020 4 Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative regulatory period. Furthermore, the PAYG ratio for AMP7 of 56.5% is significantly lower than the 76%-80% range during AMP6. Companies generally have two methodologies for cost recovery. Costs can be recovered in the year they are incurred through PAYG, or added to the regulated capital value (RCV) and recovered over a longer period through the return on RCV and RCV run-off. Therefore, the reduction in the PAYG ratio for AMP7 will lead to a decline in revenue during AMP7. We recognize that a lower PAYG also leads to higher RCV growth in the long term. This will support AWF's target of reducing its gearing (debt to RCV) to 74% by April 2025 from 79%. AWF will also be subject to challenging performance commitments in the next regulatory period, including a 20% reduction in leakage, as well as a significant decrease in per capita consumption and water supply interruptions. Overall, this translates into an impact on the return on regulated equity (RORE) of -2.93% (P10) to +0.77% (P90); P90 is the performance threshold at which there is only a 10% chance of outturn performance being better. The P10 is the performance threshold at which there is only a 10% chance of the outturn performance being worse. We note that although the FD's overall impact on AWF is negative, it is a major improvement from the draft determination, which showed an RORE impact of -3.15% to +0.15%; it is however slightly worse than for the sector as a whole.
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