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Announcement:

Moody's: Ofwat's 'Water 2020' proposals are credit negative for the UK water sector

14 Jan 2016

London, 14 January 2016 -- According to Moody's Investors Service, changes proposed by the Water Services Regulation Authority (Ofwat), the economic regulator for water and sewerage companies in England and Wales, in its approach for the 2019 price review would, if implemented, be credit negative for the sector.

"Individually, the proposals would be unlikely to have a significant negative impact over the medium term", said Stefanie Voelz, Moody's Vice President and Senior Analyst. "However, we believe that, taken together, the proposed changes would decrease the stability and predictability of cash flows for the water and sewerage companies over the medium to long-term, which will be credit negative", added Ms Voelz.

Moody's report titled "UK Water Sector: 'Water 2020' Proposals Are Credit Negative" is now available on www.moodys.com. Moody's subscribers can access this report via the link provided at the end of this press release. The rating agency's report is an update to the market and does not constitute a rating action.

The regulator's proposals come at a time of heightened political scrutiny. In December 2015, the UK government announced plans to extend retail competition to household customers, subject to an assessment to be carried out by Ofwat. Separately, a report by the House of Commons Public Accounts Committee (PAC), published on 13 January 2016, concluded that Ofwat had consistently overestimated water companies' financing and tax costs when setting price limits and called for the regulator 'to secure a better deal for customers'.

While the proposed changes are credit negative for the sector overall, companies' individual exposure varies. Reforms relating to sludge treatment and disposal, for example, will only affect the larger companies, while the smaller water-only companies are more exposed to the move towards CPI indexation of revenues and regulatory capital value (RCV), or a new approach to setting the cost of debt allowance. They also have most to lose from the introduction of retail competition. Overall, highly leveraged companies remain most at risk, given their lower financial flexibility.

Moody's notes that proposals to set tariffs for sludge under a separate price control, and on the basis of a price rather than a revenue cap, from 2020 will expose sewerage companies to volume risk. There is also potential for full competition from 2025 -- a further credit negative. While any expenditure added to the RCV through 2020 will be 'protected', this may not be the case for all subsequent maintenance investments for those assets and -- in the long run -- companies will be exposed to the risk of asset stranding.

Ofwat also aims to encourage third party provision of new water resources. While existing water resource assets will not face direct competition, companies with a higher proportion of assets or costs allocated to resources activities face greater exposure to potential efficiency challenges. The regulatory approach to assessing efficient costs will likely become more challenging, increasing the risk of inadequate cost recovery.

Furthermore, Ofwat proposes to replace Retail Prices Index (RPI) inflation with the lower Consumer Prices Index (CPI) measure of inflation as the benchmark for tariff increases and to use an average of the two indices for RCV growth from 2020. This could pressure returns and/or lead to changes in the timing of cost recovery if bill increases are to be avoided, and may create a mismatch between growth in regulatory assets and RPI-linked debt. For further details on this topic, please also refer to our report "GB Water and Energy Networks: Transition to CPI creates risks for water and energy networks", published alongside this report.

In addition, and in line with a recommendation in the PAC report, Ofwat is assessing the merits of linking the cost of debt allowance, included in the allowed return, to an average debt index similar to the method adopted by Ofgem for the UK electricity and gas networks. In a persistently low interest-rate environment, a move towards cost of debt indexation would increase the risk of lower returns. A more rigid debt cost indexation may also allow less regulatory flexibility to reflect the sector's approach to raising finance. Smaller companies would be most exposed, as they do not access markets frequently and may exhibit a relatively high embedded cost of debt compared with average market rates.

Ofwat intends to set out its final proposals for PR19 in May 2016. Based on these, the regulator expects to consult with companies on licence changes to implement its proposals during the second half of 2016 and before finalising framework and approach for PR19 in autumn/winter 2017.

Finally, according to the request by government, Ofwat has to provide an assessment by summer 2016 on the costs and benefits of extending retail competition to household customers in England (competition for non-household customers will be introduced from 1 April 2017). Moody's believes that, if implemented, retail competition could (1) increase cash flow volatility and, where revenue losses cannot be offset by cost savings, pressure earnings; and (2) potentially increase counterparty risk exposure towards small and less well-capitalised new entrants.

Subscribers can access the report via this link:

http://www.moodys.com/viewresearchdoc.aspx?docid=PBC_1012879

NOTE TO JOURNALISTS ONLY: For more information, please call one of our global press information hotlines: London +44-20-7772-5456, New York +1-212-553-0376, Tokyo +813-5408-4110, Hong Kong +852-3758-1350, Sydney +61-2-9270-8141, Mexico City 001-888-779-5833, São Paulo 0800-891-2518, or Buenos Aires 0800-666-3506. You can also email us at mediarelations@moodys.com

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history.

Stefanie Voelz
Vice President - Senior 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
Associate Managing Director
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: Ofwat's 'Water 2020' proposals are credit negative for the UK water sector
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