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Announcement:

Moody's: Continuing uncertainty for UK water sector with proposed licence changes

29 Oct 2012

London, 29 October 2012 -- Moody's notes that on 26 October 2012, the Water Services Regulation Authority, Ofwat -- the economic regulator for water companies in England and Wales, published revised proposals to modify company licences. If implemented, these proposals would provide Ofwat with future flexibility to move activities accounting for up to 40% of companies' total revenues outside of the established price control framework.

Continuing uncertainty around key features of their licences is credit negative for water and sewerage companies in England and Wales. That uncertainty will come into greater focus if companies -- a number of which oppose the changes -- do not accept the proposed amendments by the 23 November 2012 deadline, in which case Ofwat is expected to use its powers to refer the matter to the Competition Commission (CC). Ofwat has said that it expects any referral to the CC to be made in December 2012 with the Commission likely to decide within six months whether the proposed modifications should be made.

The regulator's proposals have been made in the context of Ofwat's continuing review of the way in which it will set future price limits and the draft Water Bill published in July 2012. The exact consequences for companies of planned changes, including separate price limits for retail and wholesale activities and increased competition, will become clear only once the regulator sets out detailed proposals for the next price review in 2014. However, Moody's expects the reforms to result in negative credit pressure developing over the medium to long term, particularly for companies that are unable to adapt to a changing environment (please see UK Water Sector: Stable Despite Changes to Regulatory Environment published on 17 October 2012 for further details).

Ofwat's new proposals to modify water companies' licences follow draft licence changes published in December 2011. These earlier proposals were rejected by all of the incumbent water companies, largely on the grounds that the changes were unnecessarily broad and created uncertainty which would undermine the stability and predictability of the regulatory regime to the detriment of operators' ability to raise capital. Since March 2012, Ofwat has consulted widely and engaged in extensive discussions with the companies in an attempt to reach a common agreement. However, according to Ofwat, it was unable to reach agreement with the companies collectively and it is now necessary for each individual company to make a decision on the planned licence amendments.

In its revised proposals, issued under section 13 of the Water Industry Act 1991, Ofwat has committed to maintain wholesale price controls linked to the Retail Price Index (RPI), to allocate companies' Regulatory Capital Value (RCV) to the wholesale function and to continue to calculate an RPI based return on the RCV as the main cost recovery mechanism for the monopoly network activities. The regulator has pointed out that important safeguards will remain in place including its primary duty to enable efficient companies to finance their activities and the right of appeal to the CC in respect of future price control decisions. The regulator proposes, however, to remove the current reference in the licence to five-yearly price review, arguing that longer or shorter periods may, in the future, be appropriate for different activities.

It appears that the biggest area of dispute between the companies and the regulator is around future flexibility. Ofwat considers it important that the services and activities covered by the proposed wholesale controls can be adjusted over time, so that it can create the right incentives and adjust the framework as appropriate. To provide this flexibility, the regulator has proposed that in any price control it would be able to move activities accounting for up to 20% of total revenue outside of the wholesale price control. There would also, it is proposed, be a further cumulative cap on activities moved outside of the wholesale business set at 40% of total revenue.

The degree of flexibility that Ofwat is seeking is surprising given its estimate that about 90% of companies' assets (on a current cost basis) would remain as part of wholesale activities. We also note that the credit profile of a company where 40% of revenue is subject to as yet undefined price controls and/or competition will be different to that of the rated water companies today.

It will be a tough decision for the companies, but we believe that a number may decide not to accept Ofwat's proposed changes -- on the basis that they provide the regulator with undesirable flexibility -- preferring to let the CC determine the matter. We note that a CC referral will be time consuming, expensive and unlikely to benefit the company's relationship with Ofwat, at an important time.

We would not ordinarily view a CC referral as credit negative; the Commission is an integral part of the regulatory framework in the UK and an important risk mitigant. However, as already mentioned, a referral would sustain current uncertainty and the perception of increased regulatory risk in the sector and that is credit negative. That the companies and regulator have been unable to reach agreement on this matter will, in addition, not reassure investors.

If companies accept Ofwat's proposed changes then their licences will be amended in line with the proposals. If companies do not accept the changes and are referred to the CC then their licences will be amended following, and in line with, the Commission's decision. Ofwat has said that it will then propose amendments to the licences of all other companies to conform to the Commission's decision.

Neil Griffiths-Lambeth
Senior Vice President
Infrastructure Finance Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Monica Merli
MD - Infrastructure Finance
Infrastructure Finance Group
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's: Continuing uncertainty for UK water sector with proposed licence changes
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