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Rating Action:

Moody's changes outlook on Wales & West's rating to negative; affirms rating

28 Sep 2018

London, 28 September 2018 -- Moody's Investors Service (Moody's) has today changed to negative its outlook on the backed senior secured notes maturing in 2021 issued by Wales & West Utilities Finance plc, the financing subsidiary of Wales & West Utilities Limited (WWU). Concurrently, Moody's has affirmed the notes' Baa1 rating.

The drivers for today's rating action are the expected decline in WWU's allowed returns and the likely reduction in earnings from tax outperformance from the start of the next regulatory period in the context of the group's relatively high borrowing costs as a result of its index-linked swap portfolio. Although the rated notes mature prior to the start of the period, the rating and outlook on the 2021 notes reflect our view of the underlying credit quality of WWU as guarantor of the notes.

RATINGS RATIONALE

RATIONALE FOR THE NEGATIVE OUTLOOK

The negative outlook reflects WWU's very high borrowing cost and resulting exposure to declining allowed returns in the current regulatory period and Moody's expectation of further reductions in returns and opportunities for outperformance in the RIIO-GD2 regulatory period that starts in April 2021.

WWU has entered into swaps with a notional principal of GBP1.0 billion that are expected to generate material cash outflows over the next twenty years, based on current market conditions. The group's relatively expensive and long-term debt burden is illustrated by the fair value of its debt and swaps,which was around 125% of WWU's Regulated Asset Value (RAV) at March 2018, including Moody's adjustments, among the highest of any regulated utility in Great Britain. In its RIIO-2 Framework Decision, published in July 2018, WWU's regulator, Ofgem, confirmed that companies will continue to recover only the borrowing costs of a hypothetical "notionally geared, efficient network company", and not be permitted to pass through their actual borrowing costs, although it will consider "tailoring" allowances for individual companies that make a "robust case" for such an adjustment.

In addition, WWU has benefited materially in the current period from a regulatory tax mechanism which has allowed it to charge customers for the tax it would have paid if it were not utilising tax losses while actually paying no tax because of its high borrowing costs. In its Framework Decision, Ofgem has confirmed that in future it expects "allowances to be broadly equal over time to the payments made to HMRC". Ofgem has indicated that RIIO-GD2 will provide for a clawback mechanism, a pass-through of actual tax, or a "double-lock" under which companies can recover the lower of a capped allowance and actual tax paid. Any of these options, if implemented, would reduce WWU's adjusted interest coverage ratio (AICR) by around 0.25x.

Although significant uncertainty remains about the regulatory allowed return, Moody's believes it is likely that WWU's AICR will fall significantly below our guidance for the current rating of at least 1.2x. WWU's AICRs was 0.8x in the 2017-18 financial year, including the tax benefit, although this reflected a number of temporary negative factors.

Ofgem announced in its Framework Decision that it intends to adopt a structurally lower measure of inflation, the Consumer Prices Index including owner occupiers' housing costs (CPIH), in place of the Retail Prices Index (RPI) from the start of the next regulatory period. This change to the indexation of companies' revenues and RAV will increase cash flows over the medium term, offsetting the reduction in underlying allowed returns, but will also create a mismatch between regulatory asset growth and WWU's portfolio of index-linked debt and swaps. Including swaps, around 100% of WWU's debt is linked to RPI, compared to 0-25% for most other gas and electricity distribution network groups.

RATIONALE FOR AFFIRMATION OF THE RATINGS

Moody's decision to affirm the Baa1 rating on the notes reflects WWU's mid-Baa credit quality, which in turn reflects a number of continuing credit strengths, including its low business risk as the monopoly provider of gas distribution services in Wales and the South West of England, the well-established and transparent regulatory regime, and its strong performance against all regulatory outputs in the first five years of the current price control, which runs until March 2021. The company's credit quality also benefits from its secured and covenanted financing structure.

WHAT COULD CHANGE THE RATING UP/DOWN

WWU's outlook could be stabilised if further regulatory decisions, including in a regulatory document expected in late December, make it likely that expected returns will support interest coverage metrics consistent with the assigned rating. The outlook could also be stabilised if WWU took measures to strengthen its balance sheet and/or materially reduce financing costs.

The rating could be downgraded if announcements by Ofgem further increase the likelihood that WWU will receive a regulatory expected return that does not support interest coverage ratios consistent with the assigned rating.

Adjusted interest cover ratio guidance for the current rating of at least 1.2x may be tightened as Ofgem's price review progresses, particularly in light of the mismatch between the company's RPI-linked debt and future CPI-linked RAV. Any revision will take into account factors including any changes in Moody's assessment of the stability and predictability of the regulatory framework, potential revenue volatility for companies and the incremental basis risk resulting from the change in indexation of WWU's revenues as compared to its liabilities.

The principal methodology used in this rating was Regulated Electric and Gas Networks, published in March 2017. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

Wales & West Utilities Finance plc (WWUF) is a wholly-owned financing subsidiary of Wales & West Utilities Limited (WWU), the fifth-largest of eight regulated GDNs in England, Wales and Scotland by Regulated Asset Value. WWU provides gas distribution services in an area in Wales and the south west of England covering 41,000 square kilometers and serving 2.5 million households and businesses. Its facilities include around 35,000 kilometers of gas pipes, split between 32,400 kilometers of mains and 2,400 kilometers of Local Transmission System pipelines. As of March 2018, WWU's RAV was GBP2.2 billion. WWU is ultimately controlled by various entities associated with the Cheung Kong group.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Graham Taylor
VP - Senior Credit Officer
Infrastructure Finance Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Neil Griffiths-Lambeth
Associate Managing Director
Infrastructure Finance Group
JOURNALISTS: 44 20 7772 5456
Client Service: 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
Client Service: 44 20 7772 5454

No Related Data.
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