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.

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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

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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. This could potentially lead to some financial ODI penalties during the coming regulatory period. That said, we view the company's decision not to pay dividends during AMP7 as credit supportive.

Outlook

The stable outlook reflects our view that AWF will maintain a ratio of FFO to debt above 6% for the class A debt and above 5% on a consolidated basis. We also expect the company to maintain a class A debt-to-EBITDA ratio below 9x. We anticipate that AWF will implement its business plan effectively and deliver on its performance commitments.

Upside scenario: We would consider raising the ratings on AWF's class A debt if the company achieves FFO to debt consistently above 8%, and debt to EBITDA below 8x based on class A debt metrics only. This would also depend on the company executing its business plan without any major issues and demonstrating good operating performance.

Downside scenario: We could consider downgrading the class A debt if AWF doesn't deliver in line with its business plan, and its FFO to debt falls below 6% or debt to EBITDA exceeds 9x for a long period. We could consider downgrading the class B debt if AWF fails to maintain a consolidated FFO-to-debt ratio of at least 5% or if the class A debt is downgraded.

Anglian Water Services (AWS)

Primary analyst: Julien Bernu

The CreditWatch negative placement reflects that we would lower the ratings on AWS' senior secured (class A) and subordinated (class B) debt absent a significant improvement in operating conditions over the next regulatory period. AWS has asked the regulator to refer its FD of the 2019 price review to the CMA, with a decision likely over the next six to 12 months. The decision to appeal generally reflects the company's view that the FD does not allow it to meet the challenges it faces in the next regulatory period and concerns that it doesn't adequately capture customers' priorities. If, based on the CMA's conclusions, AWS' operating conditions do not improve significantly, we currently believe AWS' credit metrics will remain below the range commensurate

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with the ratings during AMP7.

Using the current FD, we project that, in AMP7, the company's FFO to debt will be below 5% and 6%, respectively, on class A and B debt and on class A debt. These ratios are below the current 6% and 7% thresholds we see as commensurate with the 'BBB' rating on AWS' class B debt and the 'A-' rating on its class A debt.

This stems from an average bill reduction of 10.5% (in real terms) over AMP7 compared with AMP6, a sectorwide reduction in the allowed cost of capital of 1.96%, assuming an RPI of 3%, versus 3.74% in the current regulatory period, along with more challenging performance commitments. We see AWS as the industry leader in terms of operating efficiency, with outperformance on its operating expenditures and capex projected at around 9% over AMP6, and net ODI rewards of around £50 million. However, we believe the potential for the company to significantly outperform on its future cost allowances is currently limited. This is because there is currently a 12% gap between the regulator's view and the company's estimate of efficient costs to be incurred over AMP7 to deliver its business plan.

We note that the group will reflect those tougher conditions in its dividend policy by continuing to limit distributions over AMP7 along with a commitment to reducing gearing, and by not ruling out potential additional capital injections from entities outside the regulatory ring-fence. At this stage, however, absent a favorable resolution from the CMA, we believe that these alone may not be enough to protect the rating.

CreditWatch

We expect to resolve the CreditWatch on AWS once the CMA publishes its conclusions on the 2019 price review, which we expect will take place over the next six to 12 months. We would then have better visibility on the conditions under which AWS will operate between April 2021 and March 2025.

Dwr Cymru (Welsh Water)

Primary analyst: Julien Bernu

The downgrade On Feb. 7 reflected our expectation that Welsh Water's credit metrics would not be commensurate with our ratings on the company's debt in AMP7, that is an FFO-to-debt ratio consistently below 7% and debt to EBITDA above 8x. Based on the elements in the company's business plan, we believe that Welsh Water, along with the rest of the sector, will operate under tougher conditions from April 2020, which will ultimately weaken its credit quality. Welsh Water will face an average 9% reduction (in real terms) in customer bills over the next regulatory period, while earning lower returns, with a reduced allowed cost of capital of 1.92%, assuming an RPI of 3%, versus 3.53% in the previous regulatory period.

Under its FD, Welsh Water faces challenging performance commitments. These include--among others--at least a 15% leakage reduction from the PR14 level, and a significant decrease in water supply interruptions and internal and external sewer flooding incidents. Overall, the likely range of returns from the FD's outcome delivery incentive package equates to an RORE of -1.03% (P10) to +0.61% (P90). Welsh Water's operating performance against its regulatory targets is currently average, and we expect the company to achieve a neutral-to-small net penalty position under its ODIs for the current regulatory period (AMP6). We cannot rule out the possibility that the company may end up in a net penalty position during AMP7.

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We expect Welsh Water's credit quality to weaken over the next regulatory period. We project its FFO-to-debt and debt-to-EBITDA ratios will be markedly below the 9% and 7.5x, respectively, posted at the start of AMP6 and remain below our current thresholds for the ratings on its senior secured (class B) and subordinated (class C) debt. This would result from a tougher regulatory period for Welsh Water following three years of marked deterioration in its credit metrics (with average FFO to debt at about 6% and average debt to EBITDA of about 9x).

Outlook

The stable outlook on Welsh Water's senior secured and subordinated debt reflects our view that the company has sufficient headroom in AMP7 to keep its FFO to debt significantly above 6% and debt to EBITDA significantly below 9x on a consolidated basis.

Downside scenario: We could lower the ratings on Welsh Water's senior secured class B debt and subordinated class C debt if its FFO-to-debt ratio doesn't maintain enough headroom above 6% and debt to EBITDA below 9x on a prolonged basis. This could occur during the next regulatory period if Welsh Water does not deliver on its business plan or incurs a significant amount of penalties on its ODI; this could also be linked to the company's rebate policy.

Upside scenario: We would consider raising the ratings on Welsh Water's senior secured class B debt and subordinated class C debt if FFO to debt markedly exceeded 7% consistently and debt to EBITDA was significantly below 8x, with the company demonstrating an above-average operating performance at the same time.

Northumbrian Water Ltd. (NWL)

Primary analyst: Julien Bernu

The CreditWatch negative placement reflects that we could lower our rating on NWL and its parent Northumbrian Water Group (NWG) if there is no significant improvement in operating conditions over the next regulatory period. NWL has asked the regulator to refer its FD to the CMA, with a decision likely over the next six to 12 months. The decision to appeal generally reflects the company's view that the FD does not allow it to meet the challenges it faces in the next regulatory period and concerns that it doesn't adequately capture customers' priorities. If, based on the CMA's conclusions, NWL's operating conditions do not improve significantly, we currently believe NWG and NWL's credit quality will likely deteriorate during AMP7. Using the current FD, we project the group's FFO to debt at around 7% over AMP7, down from an average of around 10% in AMP6 and below the current 9% benchmark we see as commensurate with a 'BBB+' rating. We also project debt to EBITDA at around 8.5x in AMP7 compared with around 6.5x in AMP6.

The projected deterioration in credit quality notably stems from NWL facing the largest bill reduction in the sector (25.6% in real terms) in AMP7. In addition, there is a sectorwide reduction of allowed cost of capital of 1.96%, assuming an RPI of 3%, versus 3.74% in the current regulatory period, along with more challenging performance commitments. These factors suggest that NWL is unlikely to significantly outperform on its future cost allowances to protect its credit metrics.

We acknowledge the current strong support the group receives from its parent, CK Infrastructure Holdings Ltd. (A/Stable/--). We expect this will be reflected in a reduction of dividend payments in AMP7 compared with AMP6. Nevertheless, we believe this support alone, with a favorable resolution of the CMA appeal, would not allow NWL and NWG's metrics to remain commensurate

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with the current ratings.

CreditWatch

We expect to resolve the CreditWatch on both entities after the CMA publishes its conclusions on NWL's appeal of the FD on PR19, which we expect will take place over the next six to 12 months. We would then have better visibility on the conditions under which NWL will operate between April 2021 and March 2025.

Portsmouth Water (PW)

Primary analyst: Gustav Rydevik

The affirmation reflects our view that, in AMP7, PW can maintain FFO to debt broadly in line with our 7% threshold for the current rating. We project the company's FFO to debt at 6.5%-7.5% during the next regulatory period, compared with 7%-9% in AMP6, leaving it with limited rating headroom. As a result, we have maintained our negative outlook on the ratings.

During AMP7, PW's profitability will be constrained by the reduction in the allowed cost of capital to 1.96%, assuming an RPI of 3%, versus 3.53% in the current regulatory period. The company is subject to challenging operating targets and the likely range of returns from the FD's outcome delivery incentive package equates to a RORE of -1.64% (P10) to +1.28% (P90). These targets include a 15.2% reduction in leakage, 6% reduction in per capita consumption, and a significant decrease in the number of customer contacts and customers experiencing low water pressure. However, PW has historically been one of the best operational performers in the sector and we believe it will may the opportunity to gain incentive incomes. The presence of one long-dated debt instrument linked to the RPI means that PW's cost of debt is higher than the peer average.

Certain elements of the FD are credit supportive, in our view, such as the allowance of £171 million of total expenditure, which is about £8 million more than PW included in its business plan, excluding the Havant Thicket project. If PW successfully implements its plan, this will significantly enhance its profitability. Although PW received a small company premium in the FD, giving its allowed return a 33 bps boost, it is one of the smallest water companies operating in the U.K., which makes it more susceptible than some of its larger counterparts to unforeseen events. We view PW's owner, Ancala, as supportive of the company's creditworthiness, since it has taken minimal dividends and provided equity support.

Outlook

The negative outlook reflects the risk that, due to the challenging operating conditions during AMP7, PW will struggle to maintain ratios in line with our expectations for the current rating, specifically FFO to debt of about 7%.

Upside scenario: We could revise the outlook to stable if PW implements its business plan efficiently, maintains a solid operating performance, and demonstrates its ability to operate with FFO to debt consistently above 7%.

Downside scenario: We could consider lowering the ratings if PW demonstrates below-average operating performance, leading to penalties, and it therefore fails to maintain FFO to debt at 7% on average.

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Severn Trent Water (STW)

Primary analyst: Gustav Rydevik

The affirmation on Feb. 17 reflected our expectations that, despite deteriorating headroom, the group's credit metrics will remain commensurate with the ratings over AMP7. Specifically, we expect FFO to debt to stay above 9%. We also affirmed our ratings on Hafren Dyfrdwy, a core entity of the Severn Trent group.

Past outperformance should help STW maintain credit metrics in the upcoming regulatory period. Historically, STW has performed well in terms of both customer incentives and financing costs. It earned ODI rewards of £132 million over AMP6--which would have been £58 million higher, had they not been capped by the regulator--and achieved a very favorable cost of debt of 3.7% on average. In terms of operating performance, it will recover roughly £30 million per year in rewards during the first three years of the upcoming regulatory period. Overall, during AMP6, STW has been able to achieve a cumulative RORE of 9.1% through a combination of ODI rewards, low financing costs, and £460 million of total expenditure outperformance.

Despite good performance and regulatory outcome, STW's credit metrics will weaken. We expect FFO to debt to drop to about 9%-10% during AMP7, from about 11% in 2020. This stems mainly from the reduction in profitability and higher debt. Capex is expected to remain significant at £500 million-£550 million a year over the next three years, although this is significantly lower than over the past two years. As per the company's dividend policy for AMP7, dividends will increase by CPIH inflation each year. In the new regulatory period, the group's gearing will increase to about 65%.

Outlook

The stable outlook is based on ST's low-risk, regulated U.K. water and wastewater operations continuing to deliver relatively stable and predictable operating and financial performance. We anticipate that the company will maintain ratios in line with the ratings throughout the current regulatory period, as well as into AMP7, albeit with less headroom. We consider an S&P Global Ratings-adjusted FFO-to-debt ratio of more than 9% to be commensurate with the ratings, and we also expect that STW will maintain debt to EBITDA below 9x.

Downside scenario: We could lower the ratings if the adjusted FFO-to-debt ratio weakens below 9%. This could occur during the next regulatory period if STW is not able to deliver on its business plan, leading to extra total expenditure or potential operational penalties.

Upside scenario: We consider an upgrade to be unlikely. However, we would consider raising the ratings if adjusted FFO to debt exceeded 11% on a sustainable basis and the group demonstrated above-average operating performance in the upcoming regulatory period.

South East Water (SEW)

Primary analyst: Ivan Tiutiunnikov

The affirmation of the rating reflects our expectation that despite increasing leverage, the strengthening of SEW's business over the past few years will likely continue. SEW ranks in line with most of its peers in Ofwat's performance reports. We expect that in AMP7, SEW will post FFO

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to debt slightly below the current rating threshold of 6%, while maintaining debt to EBITDA at about 9x. We expect that in AMP7, debt to RCV will be slightly above 75% compared with the about 74% that we estimate at the end of AMP6. SEW's average customer bill will reduce by about 7.2% in real terms, which will affect the company' profitability. However, this compares with about a 12% reduction in the sector on average.

PAYG and RCV run-off rates should support revenue in the short term, generating about £42.3 million. This is the largest revenue advance in the sector as a percentage of allowed revenue and will support the rating during AMP7, albeit at the detriment of longer-term stability. Although Ofwat's final view on base costs is similar to SEW's, the final allowed total costs are lower than the company's request and this difference is above the industry average. This might introduce some risks of cost overruns, although we understand that the company is taking steps to curb expenses. We also note that, in AMP6, SEW expects to outperform on total expenses.

In AMP7, SEW will need to continue its strict oversight to meet performance commitments, among them a 15% leakage reduction, 7.2% reduction in per capita consumption, 50% reduction in water supply interruptions, and 2% reduction in unplanned water treatment works. For SEW, the incentive package for meeting these commitments has an impact on the RORE of about -1.8% (P10) to +0.47% (P90). The overall package has a negative slant, as it does for the majority of the sector.

Outlook

The stable outlook reflects our expectation that SEW will continue to demonstrate stable performance in the next regulatory period, maintaining FFO to debt at 5%-6% and debt to EBITDA at 9x-9.5x.

Downside scenario: We could lower the rating on SEW if we see material deterioration of operational performance, with FFO to debt staying below 5%, or if debt to EBITDA increases beyond 10x.

Upside scenario: We would consider raising the ratings if adjusted FFO to debt substantially exceeded 6% on a sustainable basis, while debt to EBITDA improved and stayed below 9x and the company demonstrated above-average operating performance.

South Staffordshire Water (SSW)

Primary analyst: Julien Bernu

We affirmed our ratings on SSW and its parent South Staffordshire PLC (SSPLC) while maintaining a negative outlook because we expect that in AMP7 SSW will have very limited headroom above the FFO–to-debt ratio of 12% we consider commensurate with the rating. Based on SSW's FD, we project its FFO to debt at around 12% over AMP7, down from an average of around 15% in AMP6. We also project debt to EBITDA will be around 6x in AMP7, compared with around 5x in AMP6.

The decline stems predominantly from an average bill reduction in AMP7 of about 10.3% in real terms and a reduction in the allowed cost of capital to 2.11%, assuming an RPI of 3%, versus 3.74% in the current regulatory period. In addition, the company faces more challenging performance commitments, suggesting that it is unlikely to significantly outperform on its future cost allowances to protect its credit metrics. The company's performance commitments for AMP7 include a three-year average 15% and 13.8% leakage reduction, respectively, in the South

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Staffordshire and Cambridge regions. Furthermore, 1% and 6.3% reductions in per capita consumption by 2024-2025 in the two regions, and a 12% reduction of direct or indirect operational carbon emissions. Overall, this translates into an impact on the RORE of -2.90% (P10) to +1.46% (P90).

While the group has committed to reducing its dividend distributions, SSW's increasing capital intensity over AMP7 (around £60 million net of customer contributions compared with an average of approximately £50 million for AMP6) may hinder SSPLC's ability to generate positive cash flows over the next regulatory period.

We now view SSW's business risk profile as excellent, based on our peer comparison. That said, we foresee an increase in SSPLC's earnings contribution from nonregulated activities, which we expect will be about 25% of the group's EBITDA by the end of AMP7, compared with around 20% over AMP6. We view the nonregulated service contracts businesses as cash generative and believe they correlate positively with SSW's business cycle. SSPLC's unregulated segment--notably via SSI Services, the group's specialist infrastructure contracting division--provides services for other regulated water businesses, other utilities, local authorities, and government agencies. However, we believe these activities provide less cash flow stability and predictability than regulated water operations because of greater exposure to competition and economic conditions. This, along with the group's relatively small size, explains our higher metric thresholds for SSW compared with peers in the same rating category.

Outlook

The negative outlook reflects our expectation that, in AMP7, SSPLC may not be able to post an adjusted FFO-to-debt ratio above 12% on a sustainable basis, which we view as commensurate with the ratings on both companies.

Downside scenario: We could lower the ratings on SSPLC and SSW by one notch if the group's credit quality deteriorates, for example, with adjusted FFO to debt staying below 12%. We believe that this could happen if SSW fails to deliver on its business plan or displays weaker operating performance than peers. We could also lower the ratings if SSPLC's cash flows from nonregulated activities decrease, due for instance to a loss of contracts or operating cost overruns; if nonregulated activities contribute more than 30% of the group's EBITDA without being offset by other financial factors; or if dividend payments are markedly higher than planned during AMP7.

Upside scenario: We could revise the outlook to stable if we are confident that the group can sustainably achieve an adjusted FFO–to-debt ratio of 12% over AMP7, with SSW being able to deliver on its ODIs, ending in no penalties in the first two to three years of AMP7 and consistently average or above-average operating performance.

Southern Water Services (Finance) (SWSF)

Primary analyst: Gustav Rydevik

The affirmation reflects our view that, in AMP7, SWSF can maintain FFO to debt above our 8% threshold for the current rating. We forecast the company's FFO to debt at 8%-9% during the next regulatory period, compared with 8%-10% in AMP6; and debt to EBITDA at 8x-9x versus 6x-8x. Although we expect the company's credit metrics to stay commensurate with the current rating, our outlook remains negative because of uncertainty regarding the efficiency of internal controls

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implemented after the regulator discovered that SWSF had misled it on the quality of treated wastewater, leading to a £126 million fine, in June 2019. SWSF is still facing an investigation by the Environment Agency (EA), which we expect will conclude over the coming 12 months.

SWSF's credit metrics are enhanced by two major transactions completed at the end of 2018. These include capital restructuring, in which SWSF redeemed all its outstanding class B subordinated debt, covered its associated break costs, and reduced debt to RCV at its regulated subsidiary to about 70% by issuing £700 million of debt outside the ring-fenced financing group. The company also completed a swap recouponing exercise that will lead to interest cost savings of roughly £300 million during AMP7.

However, SWSF will also face significant challenges during AMP7, including a steep reduction in the cost of capital to 1.96%, assuming an RPI of 3%, versus 3.76% in the current regulatory period. SWSF's customers' average bill will decline by about 18% in real terms, compared with the average reduction of 12% for the sector. At the same time, the company will need to comply with tougher operating performance commitments including a 15% reduction in leakage, as well as a significant reduction in per capita consumption, pollution incidents, and external sewer flooding incidents. Overall, this translates into an impact on the RORE of -1.64% to +0.58%, which could lead to potential fines during the upcoming period.

We expect that in AMP7 SWSF's debt to RCV will be below 70%, which is broadly in line with the 69% it posted as of March 31, 2019. Capex is expected to remain significant at £400 million-£550 million a year over the next three years. We note that SWSF has a sizable portfolio of inflation-linked swaps (£1.43 billion notional) that it uses to swap fixed-rate debt for inflation-linked debt as a partial hedge for its RCV, which is also inflation linked.

Outlook

The negative outlook on SWSF's class A debt reflects the uncertainty regarding the efficiency of SWSF's internal controls, capacity to demonstrate ODI performance in line with regulatory requirements, and the possibility of further legal action.

Downside scenario: We could lower our ratings on the senior secured debt if SWSF's ratio of FFO to debt falls below 8% or debt to EBITDA exceeds 9x. This could occur if the company fails to improve its operational performance or the regulator imposes additional significant fines.

Upside scenario: We could revise the outlook to stable if SWSF comfortably maintains FFO to debt above 8%, debt to EBITDA below 8x, a track record of changes in governance leading to improved operational performance, and no material consequences from the EA investigation.

Sutton and East Surrey (SES Water)

Primary analyst: Ivan Tiutiunnikov

The downgrade stems from SES Water's increasing leverage as a result of tougher regulatory conditions, which leads to our forecast of FFO to debt of about 8% in AMP7, which is below the current rating threshold of 10%. We also project debt to EBITDA will likely be 7x-7.5x. We expect that, in AMP7, SES Water will post debt to RCV of about 70%, up from about 61% as of March 31, 2019, owing to decreased profitability. SES Water's customers' average bill will decline by about 15.6% in real terms, compared with the average reduction of 12% for the sector. This reflects Ofwat's view on the company's efficient costs; its allowed total costs are about £271 million for

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the whole period, about 7% lower than SES Water proposed in its business plan, which may lead to underperformance unless the company finds ways to reduce expenses.

The company could also face underperformance penalties if it falls short on delivery of key performance commitments. These include a 15% reduction in leakage, 6.6% reduction in per capita consumption, and a maximum five minutes of water supply interruptions for 2024-2025, among others. Overall, this translates into an impact on the RORE of about -1.01% (P10) to +1.28% (P90). We note that the overall package has a positive slant, which is not the case for the sector as a whole. The company has a lower underperformance penalty and higher outperformance payment than the sector averages. This may provide some support to the rating during the next regulatory period.

Outlook

The stable outlook reflects our expectation that SES Water will demonstrate stable performance in AMP7, maintaining FFO to debt at about 7%-8% and debt to EBITDA at 7.0x-7.5x.

Downside scenario: We could lower the rating on SES Water if we see material deterioration in operational performance and FFO to debt falls and stays below 7% for a long period, or if debt to EBITDA increases and stays above 9x.

Upside scenario: We would consider raising the ratings if adjusted FFO to debt comfortably exceeded 9% on a sustainable basis, while debt to EBITDA declined and stayed below 7x and the company demonstrated above-average operating performance.

Thames Water Utilities Finance

Primary analyst: Matan Benjamin

We affirmed our ratings on Thames Water's class A and class B debt, but maintained the negative outlook because we believe the company will struggle to achieve credit metrics commensurate with the current ratings in the next regulatory period, more specifically FFO to debt trending toward 6% and debt to EBITDA below 10x for class A debt only and FFO to debt above 5% and debt to EBITDA below 11x for class B (consolidated debt). Our affirmation reflects that we expect some improvement on operational performance and that the company will nominate a new permanent CEO in the coming months.

We expect FFO to consolidated debt and debt to EBITDA (debt classes A and B) to remain at 4.5%-5.5% and 10x-11x respectively during AMP7, which we consider very tight for the current rating. This is predominantly due to the reduction in the allowed cost of capital to 1.96%, assuming an RPI of 3%, versus 3.76% in the current regulatory period. The ratio of discretionary cash flow (cash flow from operation minus capex minus dividends) to debt will remain negative (-3% to -5%), given that capex will likely remain significant at £1.1 billion-£1.2 billion a year, assuming annual dividends of £70 million-£90 million a year during AMP7 (2020-2025). The group's consolidated gearing is expected to reach 77% by 2025 from about 80% currently.

As per Thames Water's FD, customer bills will fall by about 7% on average in real terms between 2020 and 2025. However, allowed revenue for AMP7 under the FD is about £0.7 billion higher than in the draft determination, due to higher total expenditure allowances and an increase in the PAYG rate. Despite this, we expect the company to overspend on its total expenditure allowance during AMP7. This is in light of challenging performance commitments, including at least 20% leakage

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reduction from the PR14 level, 53% reduction in water supply interruptions to five minutes, and 6.3% reduction in per capita consumption. The likely returns from the FD's ODI package equates to an RORE of –1.68% (P10) to +0.76% (P90) compared with -3.27% (P10) to + 0.53% (P90) in the draft determination. While this represents a material improvement and implies lower risk, Thames Water's operating performance lags that of other U.K. regulated water companies in AMP6. Therefore, we consider it highly plausible that the company may face penalties in the next AMP, particularly with respect to supply interruptions and customer-related outcome delivery. We nevertheless expect operating performance to improve from current levels.

Outlook

The negative outlook reflects our concern that, despite some improvements on the FD compared with the draft, the company will struggle to achieve FFO to debt above 6% and debt to EBITDA below 10x for class A debt only, and FFO to debt above 5% and debt to EBITDA below 11x on a consolidated level (class A and class B).

Downside scenario: We could lower the ratings on the class A debt if Thames Water's FFO-to-debt ratio doesn't maintain enough headroom above 6%, and debt to EBITDA stays above 10x. This could occur during the next regulatory period if Thames Water continues to demonstrate below-average operating performance and cannot maintain sufficient headroom under its financial covenants.

We could lower the ratings on the class B debt if Thames Water's FFO-to-debt ratio doesn't maintain enough headroom above 5% and debt to EBITDA stays above 11x, or if we lower our ratings on the class A debt.

Upside scenario: We would revise our outlooks to stable if Thames Water's financial risk profile builds more headroom, operational performance improves, and we anticipate that the company can sustain a weighted average FFO-to-debt ratio above 6% on the class A debt and above 5% on its consolidated debt; and debt to EBITDA stays consistently below 10x for class A debt only and below 11x on a consolidated basis. We believe that the group could achieve this through effective implementation of the FD.

United Utilities Water (UUW)

Primary analyst: Matan Benjamin

The downgrade of UUW and its parent United Utilities PLC (UU)--together, the group--reflects our expectation that the group's credit metrics will weaken and no longer be commensurate with the previous ratings over AMP7, which starts in April 2020. We believe that, like the rest of the sector, UUW will operate under tougher conditions in AMP7 that will ultimately weaken its credit quality. Specifically, we forecast FFO to debt will drop to 9%-10% in AMP7, from around 11% in 2020, mainly due to the reduction in the allowed cost of capital to 1.96%, assuming an RPI of 3%, versus 3.74% in the current regulatory period.

Adjusted debt to EBITDA is expected to increase to 7.0x-7.5x from about 6.7x over the past two years. We expect capital expenditure (capex) to remain significant at about £550 million a year over the next three years, although about £100 million lower than the average over the past two years. The group's dividend policy for AMP7 states that dividends will increase by the consumer price index including housing costs (CPIH) each year. The growth rate is expected to be about 1%

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lower than in AMP6, given the decision to shift to CPIH from RPI. Although UUW's RCV will decline by about 3.3% in real terms by the end of AMP7, the group's gearing will remain at about 60%.

As per UUW's FD, customer bills will fall by 13.8% on average in real terms between 2020 and 2025. We expect the reduction in the allowed cost of capital will affect the group's profitability. Under the FD, UUW's total expenditure allowances in the next regulatory period will be about £5.96 billion (retail and wholesale) representing a 4% increase compared with the draft determination, but a 11% reduction compared with AMP6. Moreover, UUW will be subject to challenging performance commitments, including at least 15% leakage reduction from the PR14 level, and in 2024-2025, a 58% reduction in water supply interruptions to five minutes, alongside a 73% reduction in sewer flooding. Overall, the likely range of returns from the FD's ODI package equates to an RORE of -1.38% (P10) to +1.21% (P90), which we view as fairly balanced.

While we expect the next regulatory period to be challenging, we continue to assess UUW as one of the most efficient companies in the sector. We believe UU can continue to demonstrate solid operating performance and potentially benefit from rewards and efficiencies on its allowances and cost of debt, which is among the lowest in the sector; in the current regulatory period, UUW expects to earn about £50 million of net ODI rewards. As a fast-track company, UUW will earn a reward of £24 million over AMP7. We also recognize that Ofwat's decision to increase the run-off rates apply to the RPI-indexed component of the RCV by 1%, compared with the draft determination, and will boost UUW's revenue during AMP7.

Outlook

The stable outlooks reflect our expectation that the group will continue to demonstrate solid operating performance, while keeping FFO to debt above 9% and debt to EBITDA below 9x.

Downside scenario: We could lower the ratings if the adjusted FFO-to-debt ratio declines and remains below 9%. This could occur during the next regulatory period if UUW does not deliver on its business plan, leading to total expenditures materially in excess of Ofwat's allowance or potential operational penalties.

Upside scenario: We would consider raising the ratings if adjusted FFO to debt exceeded 11% and debt to EBITDA stayed below 7x on a sustainable basis, while the company demonstrated above-average operating performance.

Wessex Water

Primary analyst: Julien Bernu

The downgrade stems from our expectation that the company's credit metrics will no longer be commensurate with a 'BBB+' rating during AMP7, namely, FFO to debt consistently below 9%. We believe that, like the rest of the sector, Wessex Water, will operate under tougher conditions from April 2020 that will ultimately weaken its credit quality. Wessex Water will face an average 13.0% reduction (in real terms) in customer bills over the next regulatory period, while earning lower returns, with a reduced allowed cost of capital of 1.96%, assuming an RPI of 3%, versus 3.76% in the current regulatory period.

Under AMP7, Wessex Water will face more challenging performance commitments. These include at least a 15% reduction in leakage from the PR14 level and, by 2024-2025, a 59% reduction in water supply interruptions to five minutes, and by 16% and 10% respectively for internal and

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external sewer flooding incidents per 10,000 connections. Overall, the likely returns from the FD's ODI package equates to an RORE of -1.35% (P10) to +0.98% (P90). We consider Wessex Water to be one of the most efficient U.K. water operators in AMP6, since we expect it will underspend on total expenditure regulatory allowances, while generating net rewards of around £30 million (in 2018-2019 prices). However, we believe the more challenging performance commitments during AMP7 will limit its potential for outperformance and stronger credit metrics.

We expect FFO to debt to average about 7% during AMP7, down from around 11% in AMP6 and below the 9% threshold we saw as commensurate with a 'BBB+' rating. We expect debt to EBITDA to increase to about 8.5x in AMP7 from currently about 6.5x. We understand that, to offset further pressure on its credit metrics, the company will reduce the dividend to its parent YTL Power International Bhd (YTL; not rated) to around £30 million in AMP7 from £90 million over AMP6. We also understand the company intends to not pay dividends should gearing (net debt to RCV) exceed 70%. This ratio is currently around 65% and is forecast at around 69% for AMP7. Although we believe YTL's credit quality is weaker than that of Wessex Water, YTL has a long track record of maintaining Wessex Water's credit quality through a supportive financial policy.

Outlook

The stable outlook reflects our expectation that the group will continue to demonstrate solid operating performance, while keeping FFO to debt above 6% and debt to EBITDA below 10x.

Downside scenario: We could lower the ratings on Wessex Water if the adjusted FFO-to-debt ratio declined and stayed below 6% for a prolonged period. This could occur in AMP7 if Wessex Water posted below-average operating performance or dividend payments are significantly higher than the current projections. Similarly, we could downgrade Wessex Water if YTL's credit quality were to deteriorate.

Upside scenario: We would consider raising the ratings if adjusted FFO to debt consistently exceeded 9% and the company demonstrated above-average operating performance. At this stage, an upgrade is also contingent on our assessment of YTL's credit quality.

Yorkshire Water Services (YWS)

Primary analyst: Julien Bernu

We affirmed our ratings on YWS' senior secured (class A) and subordinated (class B) debt, and revised our outlook to negative from stable because we believe YWS will have very limited headroom in AMP7 above the FFO–to-debt ratios commensurate with the ratings, namely, 7% for class A and 6% for class B. Based on YWS' FD, we project its FFO to debt at around 6% for both the class A and B debt, and at 7% for class A debt only, alongside debt to EBITDA of 9.0x-9.5x for classes A and B, and 8.0x-8.5x for class A debt only in AMP7.

YWS has asked the regulator to refer its FD of the 2019 price review to the CMA, with a decision likely over the next six to 12 months. The decision to appeal generally reflects the company's view that the FD does not allow it to meet the long-term challenges it faces beyond the next regulatory period and concerns that the FD doesn't adequately capture customers' priorities. Our current base case does not assume any material changes on YWS' operating conditions during AMP7, based on the outcome of the CMA's review.

The pressure on the ratings stems from the average bill reduction of 8.7% (in real terms) over

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AMP7 compared with AMP6, a sectorwide reduction in the allowed cost of capital of 1.96% assuming an RPI of 3%, versus 3.74% in the current regulatory period, along with more challenging performance commitments. While YWS' performance is projected to be robust over AMP6 with net rewards on its ODIs at around £90 million (2018/2019 price), we expect the more stringent performance commitments will hamper its credit metrics by the end of AMP7. This reflects our expectation that YWS will start incurring net penalties spread over the last three years of AMP7. In the meantime, we also see limited potential for the company to significantly outperform on its future cost allowances. This is because there is currently a 7% gap between the regulator's view and the company's estimate of efficient costs to be incurred over AMP7 to deliver its business plan. As a result, in our current base case, we assume a gradual erosion of YWS' credit metrics to below our rating thresholds on both classes of debt toward the end of AMP7.

We note that the group expects to reflect those tougher operating conditions in its dividend policy by not paying shareholder dividends over AMP7 and by making a commitment to reduce gearing toward 70% by the end of AMP7 from the current 76.8%. We currently believe this will be difficult for YWS to achieve and cannot rule out potential additional capital injections from entities outside the regulatory ring fence. That said, capital injections are not part of our base case.

Outlook

The negative outlook reflects our expectation that, in AMP7, YWS may not be able to post an adjusted FFO-to-debt ratio above 6% and 7% on a sustainable basis on its consolidated debt and class A debt respectively, which we view as commensurate with both issue ratings.

Downside scenario: We could lower the ratings on YWS' class A debt and class B debt by one notch if YWS' credit quality deteriorates over AMP7, with FFO to debt on both consolidated and class A ratios being consistently below 6% and 7% respectively, or if debt to EBITDA on both consolidated and class A ratios are consistently above 9x and 10x respectively. This could occur for instance if YWS cannot mitigate the gradual erosion of its credit metrics over the next regulatory period. We could also lower the ratings if the outcome from the CMA appeal implies more difficult operating conditions for YWS in AMP7.

Upside scenario: We could revise the outlook to stable if we are confident that the group can sustainably achieve an adjusted FFO-to-debt ratio above 6% on the consolidated debt and 7% on the class A debt only, and if debt to EBITDA on both consolidated and class A debt stay consistently below 9x and 10x, respectively. This can happen if we believe the outcome from the CMA appeal would significantly improve YWS' operating conditions over AMP7, or if we were to observe a significant amount of capital injections from entities outside the regulatory ring fence.

Related Criteria

- General Criteria: Group Rating Methodology, July 1, 2019

- Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019

- Criteria | Structured Finance | General: Counterparty Risk Framework: Methodology And Assumptions, March 8, 2019

- Criteria | Corporates | General: Reflecting Subordination Risk In Corporate Issue Ratings, March 28, 2018

- General Criteria: Guarantee Criteria, Oct. 21, 2016

www.spglobal.com/ratingsdirect February 25, 2020 17 Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative

- Criteria | Corporates | Utilities: Rating Structurally Enhanced Debt Issued By Regulated Utilities And Transportation Infrastructure Businesses, Feb. 24, 2016

- Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014

- Criteria | Corporates | General: The Treatment Of Non-Common Equity Financing In Nonfinancial Corporate Entities, April 29, 2014

- Criteria | Corporates | Industrials: Key Credit Factors For The Unregulated Power And Gas Industry, March 28, 2014

- General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013

- Criteria | Corporates | General: Corporate Methodology, Nov. 19, 2013

- General Criteria: Methodology: Industry Risk, Nov. 19, 2013

- Criteria | Corporates | Utilities: Key Credit Factors For The Regulated Utilities Industry, Nov. 19, 2013

- General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities, Nov. 13, 2012

- General Criteria: Stand-Alone Credit Profiles: One Component Of A Rating, Oct. 1, 2010

- General Criteria: Use Of CreditWatch And Outlooks, Sept. 14, 2009

Related Research

- Severn Trent Water Ltd. 'BBB+' Ratings Affirmed On Ofwat Final Determination; Outlook Stable, Feb. 17, 2020

- Dwr Cymru (Financing) UK Senior Issue Rating Lowered To 'A-'; Outlook Stable; Subordinated Issue Rating Lowered To 'BBB', Feb. 7, 2020

- Ofwat's Final Determination Leaves U.K. Water Companies’ Credit Quality In Duress, Dec. 17, 2019

Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. A description of each of S&P Global Ratings' rating categories is contained in "S&P Global Ratings Definitions" at https://www.standardandpoors.com/en_US/web/guest/article/-/view/sourceId/504352 Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column. Alternatively, call one of the following S&P Global Ratings numbers: Client Support Europe (44) 20-7176-7176; London Press Office (44) 20-7176-3605; Paris (33) 1-4420-6708; Frankfurt (49) 69-33-999-225; Stockholm (46) 8-440-5914; or Moscow 7 (495) 783-4009.

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Contact List

PRIMARY CREDIT ANALYST PRIMARY CREDIT ANALYST PRIMARY CREDIT ANALYST

Matan Benjamin Gustav B Rydevik Ivan Tiutiunnikov London London London (44) 20-7176-0106 + 44 20 7176 1282 + 44 20 7176 3922 [email protected] [email protected] [email protected]

PRIMARY CREDIT ANALYST SECONDARY CONTACT SECONDARY CONTACT

Julien Bernu Beatrice de Taisne, CFA Pierre Georges London London Paris + 442071767137 (44) 20-7176-3938 (33) 1-4420-6735 [email protected] [email protected] [email protected]

SECONDARY CONTACT ADDITIONAL CONTACT

Philip Steinkeller Infrastructure Finance Ratings Europe London [email protected] + 44 20 7176 0192 [email protected]

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