Jan 29 (The following statement was released by the rating agency)
Fitch Ratings has revised the UK water sector'€™s Rating Outlook to Negative from Stable, following guidance related to risks and rewards published by the regulator Ofwat for the price review 2014 (PR14) covering FY15 to FY20.
In Fitch's view, Ofwat'€™s more flexible approach to setting price controls, together with its guidance of 3.85% vanilla weighted average cost of capital (WACC) and a minimum range of 3.09% to 4.61% after taking account of incentive income/penalties, will not allow some UK water companies to maintain credit metrics commensurate with existing ratings.
During the investor conference call PwC, acting as advisors to Ofwat, clarified that credit ratings were not the '€œbe all and end all' in terms of setting price limits. Keith Mason, Senior Director of Finance and Networks in Ofwat, highlighted that it was for management teams to put in place a suitable financing structure that will allow the regulated company to maintain an investment-grade rating.
There appears to be no commitment for a specific rating target for these companies in the sector, apart from the regulatorâ€™s view that a company that maintains gearing broadly in line with the notional capital structure of 62.5% net debt/regulatory asset value (RAV) should be able to maintain an investment-grade rating.
This represents a fundamental change to the practical application of Ofwat's financing duty. As part of the price review 2009 (PR09) 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. For the modelling the regulator used in 2009 a notional capital structure with 57.5% net debt/regulatory asset value.
Fitch has reviewed companies'€™ business plans which were broadly judged to be financeable. In comparison Ofwat's guidance from 27 January 2014 includes i) a lower fixed return as represented by the vanilla WACC ii) a wider range of upside or downside from incentives (service incentive mechanism, total expenditure menus, financing outperformance) and iii) an expectation of companies to manage various uncertainties within price limits without the fall-back of possible adjustments to allowances.
In assessing the tariff settlement for the water sector Fitch has found that post-maintenance and post-tax interest cover ratios can be expected to be a limiting factor for the ratings. Price limits will mainly affect the numerator of the ratio, which represents funded remuneration to investors in any given year, ie vanilla WACC plus funded incentive income/penalties and revenue adjustments related to the last price control period. Using Ofwat's guidance for the minimum incentive range would imply a blended return of between 3.09% and 4.61% (WACC plus or minus 75bp of incentives) before taking account of revenue adjustments related to the current tariff settlement, depending on regulatory and operational performance. Considering these earnings prospects, Fitch takes the view that not all companies will be able to maintain interest cover ratios commensurate with their existing ratings.
Under the current tariff settlement companies had some headroom to manage cost pressures (in addition to operational efficiencies). Allowances for electricity costs mostly reflected a premium to the market price. Also, cost of capital allowances indexed by RPI overstated the value of the capital programme, providing companies with a benefit in terms of returns. As a result, companies had scope to offset additional costs for the carbon reduction commitment, doubtful debt and the adoption of private sewers over the period April 2010 to March 2015.
At this stage there is little visibility as to whether Ofwat's benchmarking will allow for headroom in any expenditure items, which could give some companies room for manoeuvring. Decisions on retail competition and the regulator's reluctance to take a view on efficiently incurred costs versus inefficiently incurred costs for some expenditure items (for example pensions and doubtful debt) indicate that companies increasingly need to manage more risks in an entrepreneurial manner. Therefore, Fitch would not expect, for the purpose of a rating forecast, that any company in the sector to achieve the top end of the possible range of returns.
Fitch may tighten its credit ratio guidelines if the overall package of the tariff settlement leads to an increase in business risk, which at this stage is a real prospect.
Separately Fitch will endeavour to review the ratings of highly leveraged transactions in the sector over the next six to eight weeks. In Fitch's view Southern Water Services (Finance) Limited's ratings are less likely to be affected as they were downgraded on 15 July 2011 and also because the group is likely to benefit from material revenue adjustments related to under-recoveries from the current tariff settlement which should benefit its FY15-20 profile. In terms of water companies with a corporate financing structure, Northumbrian Water Limited has a comparatively high cash cost of embedded debt. Fitch will review the company's financial profile and update the ratings, if necessary.