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Announcement:

Moody's: Draft water legislation as expected

16 Jul 2012

Details of market reform and regulatory changes remain outstanding

London, 16 July 2012 -- On 10 July 2012 the UK Government issued its Draft Water Bill, which is in line with proposals in the Water White Paper ("Water for Life") published in December 2011.

Overall, Moody's believes that the reforms planned by the Government and Ofwat, the economic regulator for the water and sewerage companies in England and Wales, create a degree of uncertainty and somewhat increase the credit risk for UK water and sewerage companies. However, the exact consequences for companies will become clear only once the regulator sets out detailed proposals for the next price review in 2014. We expect negative pressure to develop over the medium to long term, particularly for companies that are unable to adapt to a changing environment.

The Draft Water Bill focuses on increasing competition in the sector with measures to allow all business and other non-household customers in England to change their water and sewerage supplier. For the time being, Wales will maintain a 50Ml/day threshold for customers to be able to choose their suppliers. The development of competition is further supported by proposals to 'unbundle' licences, to encourage new entrants in segments such as water supply and changes to facilitate increased interconnection and water trading between companies.

Other proposals include:

- abolition of the 'costs principle' which governs the price water companies charge third parties

- strengthening of Ofwat's powers on supervision and extending the period during which financial penalties can be imposed for certain infringements from currently 12 months to five years

- powers for Ofwat to change company licences as necessary to implement the planned reforms

- reform of the special merger regime by introducing a two-tier system that allows the OFT and Ofwat to decide whether a referral to the Competition Commission is necessary

Overall, the proposed changes in the Draft Water Bill support reforms put forward by Ofwat as part of its Future Price Limits work. Indeed, the Draft Water Bill delegates further responsibility to the regulator to develop, for example (i) market codes (in cooperation with other regulators and market participants), (ii) the new access pricing regime to replace the costs principle, and (iii) a new connection charges regime.

Moody's observes that, in addition to the above, and over the period to the end of 2014, Ofwat will have to implement its Future Price Limits proposals and set price limits for the period from April 2015. Due to resource constraints and other factors, it may be that a number of the current proposals cannot be implemented in time for the start of the next regulatory period; indeed we note that retail competition is not expected to begin until April 2017. We also note that enactment of the Draft Water Bill will be subject to parliamentary time being found given other political priorities.

As stated previously, Moody's believes that, if implemented, the Future Price Limits proposals, supported by the White Paper and the Draft Water Bill, will create a more challenging environment for the incumbent water and sewerage companies in England and Wales. Whilst the impact of non-household retail competition will be limited, broader changes to the charging regime for household customers, a more competitive operating environment for upstream services and a move towards 'outcomes' rather than 'outputs' will put pressure on operators. Companies may see returns squeezed by a regulator keen to demonstrate the benefits of competition although we note Ofwat's duty to ensure that regulated companies are able to finance their activities. For further details, please also see Moody's Special Comment entitled 'UK Water Companies: Ofwat's Future Price Limits and White Paper Increase Sector's Credit Risk', published in February 2012.

Furthermore, the changes will create a two-tier structure for companies operating in England and Wales, with companies operating in England likely to be subject to a more competitive and challenging environment at an earlier stage. The new licensing regime does not apply to companies operating wholly or mainly in Wales, whilst wholesale arrangements (including market codes and access prices) and environmental aspects will apply. The Welsh Government is currently working on its strategy paper for the water sector in Wales, which is expected to be published for consultation in winter 2012. Based on its current stance, including maintaining the threshold for customers allowed to switch at 50Ml/day, the Welsh Government would seem to see less benefit for customers in increasing retail competition. This could create a less challenging environment for the two water companies mainly operating in Wales, namely Dwr Cymru Cyfyngedig (Welsh Water, rated A3, stable) and Dee Valley Water Plc (not rated).

The section 13 notice issued by Ofwat in December 2011, seeking to remove key features of the economic model of the industry, such as the linkage of prices to the Retail Price Index created uncertainty that was credit negative for the sector. We note the Draft Water Bill proposal to grant Ofwat the power to change companies licences, albeit limited to a two-year time frame, in order to implement changes necessary to facilitate competition in the sector. It appears that this is purely to allow licence changes absolutely necessary to enable the reforms set out in the Draft Water Bill, a process in common with earlier reforms. However, given the debate around the section 13 notice, there may be concerns that this may permit Ofwat broader flexibility in amending companies licences. In that context we note, however, the absence of any proposals to allow collective modification of companies licences, as, for example, applies to licence changes in other utility sectors.

The proposed changes to the merger regime are expected to have limited impact for the time being. The Draft Water Bill does propose a two-tier approach allowing the OFT and Ofwat to decide whether a referral to the Competition Commission is necessary. A change in the threshold for a referral to the Competition Commission from currently GBP10 million of turnover to GBP70 million remains under review. However, the higher threshold would only capture four additional water-only companies, and is unlikely to result in more significant M&A activity in the sector.

The Government estimates that the proposals set out in the Draft Water Bill will create savings of around GBP2 billion to the economy in net present value terms over a 30-year period. This estimate is largely based on the proposed changes to the water supply licence regime in order to facilitate upstream competition.

Stefanie Voelz
Asst Vice President - Analyst
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

Neil Griffiths-Lambeth
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
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JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's: Draft water legislation as expected
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