A new report on the water, energy transmission and gas distribution sectors from Moody's Investors Service is warning that UK regulated utilities will see significant cuts in revenues and weaker credit metrics from the start of the next regulatory period as regulators limit returns.
A new report on the water, energy transmission and gas distribution sectors from Moody's Investors Service is warning that UK regulated utilities will see significant cuts in revenues and weaker credit metrics from the start of the next regulatory period as regulators limit returns.
The growing risks faced by the Uk water companies were discussed in detail at Moodys UK Water and Regulated Networks conference in London yesterday. Opening the conference, Neil Griffiths-Lambert, Associate Managing Director, EMEA Infrastructure Finance at Moody's said that as of the date of the report, Moody's has negative rating outlooks for 80% of the water companies, with an elevated risk of downgrades. He described the level as "unprecdented" for the UK and probably globally.
Regulators have a duty to ensure that utility companies can finance their functions, However, what the ratings agency describes as an “increasingly narrow interpretation” of the financeability duty means that actual companies’ credit metrics may no longer support strong investment grade ratings.
Stefanie Voelz, a Moody’s Vice President - Senior Credit Officer commented:
“UK regulators appear willing to accept weaker ratings on the basis of actual company performance as the price to pay for ensuring lower customer bills and greater public legitimacy.”
.“Highly leveraged companies with expensive long-dated debt or weak operational performance are most exposed to lower allowed returns.”
Speaking at Moodys UK Water and Regulated Networks conference yesterday, Stefanie Voeltz said that in contrast to PR14, Ofwat now looked at companies to use financial levers to ensure financeability at a notional company level, rather than their own actual captial structure. A number of the UK water companies have highly covenanted structures and companies had maintained their headroom under covenants during PR14.
However, she warned that lower returns under the upcoming 2020-25 investment period may change that. Returns would continue to fall and Ofwat's regulatory financeability duty will not prevent this. Companies can find ways to prevent financial covenants from having teeth, but a ratings trigger may have more impact than the covenants, she added.
Covenants are credit positive - but the devil is in the detail
Although restrictions included in covenanted financing structures enhance the credit quality of operating companies, regulatory changes and financial structuring by some companies have reduced their effectiveness.
As a consequence, rating downgrades may trigger lock-up provisions in credit agreements or licences before financial ratio breaches bite. Where covenants or rating triggers do result in trapping cash at operating companies, Moody’s sees increasing risk that they could cut off the distributions needed to service debt at rated holding companies. Holding companies of heavily covenanted water companies will face an increasing risk of dividend income being cut off.
The regulatory price reviews are still not finalised. Although current draft proposals by UK water and energy regulators point towards increasing risks, Moody’s said things may yet improve, because the decisions are not final and the companies have the ability to appeal to the Competition and Market Authority for a redetermination they disagree with the regulators’ final decisions.
Management and shareholders may also be able to take additional measures to protect credit quality.
Click here for more information about the report.
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