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Rating Action:

Moody's changes outlook to negative on Affinity Water, affirms ratings

22 May 2018

London, 22 May 2018 -- Moody's Investors Service (Moody's) has today changed the outlook to negative from stable on all ratings of Affinity Water Limited (Affinity Water) and rated debt issued by its financing subsidiaries, following proposals by the Water Services Regulation Authority (Ofwat) that would give it greater influence over the water companies' capital structure and dividends. Moody's has concurrently affirmed (1) the Baa1 corporate family rating (CFR) of Affinity Water Limited; (2) the Backed Senior Secured (P)A3 and Backed Subordinated (P)Baa3 ratings on the medium term note programme of Affinity Water Programme Finance Limited; (3) the Backed Senior Secured A3 rating of the Class A notes and the Backed Subordinated Baa3 rating of the Class B notes issued under the programme; (4) the Backed Senior Secured A3 ratings issued by Affinity Water Finance (2004) PLC.

Ofwat's proposed measures -- aimed at bolstering companies' financial resilience -- mark a change in direction for the regulator in reaction to mounting political and public pressure on the sector. If implemented, the proposals would primarily penalise highly leveraged firms, curbing their earnings in an already tough regulatory environment. The measures further evidence increasing regulatory risk, which together with the potential earnings impact are the main drivers for today's outlook change. At the same time, companies will need to demonstrate stronger financial metrics if they are to maintain credit quality in the context of less stable and predictable regulation.

RATINGS RATIONALE

RATIONALE FOR NEGATIVE OUTLOOK

Today's rating action reflects (1) Affinity Water's exposure to a likely significant cut in allowed returns from 2020 and more challenging performance targets, as guided by the regulator in its final PR19 methodology published in December 2017; (2) the regulator's proposed financing cost sharing requirements, intended to reduce the earnings of companies benefitting from a highly leveraged capital structure; and (3) Moody's revised and slightly more demanding financial ratio guidance for the sector, which has been recalibrated to reflect the rating agency's perception of increased regulatory risk. Specifically, the negative outlook reflects Moody's expectation that a reduction in allowed returns from 2020 will weigh on the company's financial metrics and, absent measures to strengthen its balance sheets and/or significant outperformance, there is an increased risk of key ratios falling below Moody's guidance for the current rating category.

After the implementation of its highly-covenanted structure in 2013, Affinity Water has maintained gearing in the range of 77-80% (77.8% as of year ending March 2017). Due to timing of issuance, it also has one of the most competitive embedded cost of debt in the sector. As a result, Affinity Water is potentially one of the most affected under Ofwat's proposed gearing sharing mechanism.

In a consultation, published on 26 April 2018, Ofwat proposed that operating companies with debt in excess of 60% (the notional gearing) of their regulatory capital value (RCV) will have to pay back a portion of the perceived benefit of the higher gearing. This would effectively reduce already lower allowed returns further and curb earnings for more highly leveraged companies.

The regulator's default option is to take the difference (if positive) between actual and notional gearing levels and multiply this by the perceived financial outperformance, i.e. notional nominal cost of equity less actual cost of debt. The result will need to be shared 50% with the end consumer, either by lowering customer bills or making additional investments that will not be added to the RCV. Effectively, this will result in a different allowed return for companies that have gearing above 60%, or rather 65%, if Ofwat is to apply its proposed 5% dead band.

Companies will also be asked to propose a sharing mechanism for outperformance against the allowed cost of capital in relation to their embedded debt. This could mean a further cut to AMP7 returns, when most companies will already struggle to meet the much lower embedded cost of debt allowance.

Ofwat's long-standing position has been that companies are responsible for determining their capital structure and that they carry any associated risks. While maintaining that this view still holds, the proposed gearing outperformance sharing mechanism, as well as much more stringent guidelines around dividend policies, would explicitly discourage a financial profile that diverges from the notional capital structure. This is a clear departure from previous practice and -- in Moody's view -- a reaction to mounting political (and public) pressure on the sector.

Given the departures from long-standing regulatory practice and Moody's perception of heightened risk of future political interference in the design of the regulatory framework, the rating agency has changed its assessment of the stability and predictability of the UK water regulatory regime under its methodology to Aa from Aaa. To reflect the increasing business risk. Moody's has also tightened its generic ratio guidance for the sector.

Going forward into AMP7, Moody's expects Affinity Water to exhibit leverage not exceeding 80% of net debt to RCV and an adjusted interest cover ratio of at least 1.3x to maintain its current ratings.

RATIONALE FOR RATING AFFIRMATION

Affirmation of the ratings reflects that while Affinity Water's credit quality will be pressured by the regulator's proposed outperformance sharing requirements in the context of Moody's revised ratio guidance, the PR19 process is in the early stages, the proposals are in a consultation phase, and other aspects of Ofwat's final determination, particularly in relation to cost efficiency assumptions and performance incentives could act as mitigating factors for overall financial performance. The rating agency also takes into account that management still have time to adapt financial policies and bolster financial flexibility ahead of AMP7.

Affirmation of the ratings also reflects Affinity Water's sound business risk profile as a monopoly provider of essential water services.

WHAT COULD CHANGE THE RATING UP/DOWN

The outlook could be stabilised if Moody's concludes that Affinity Water's risk exposure to the lower return environment is adequately mitigated by a combination of a favourable price determination outcome, strong outperformance ability and/or balance-sheet-strengthening measures.

Conversely, the ratings could be downgraded if, taking into account such measures as management and shareholders may implement, it appears that Affinity Water will likely have insufficient financial flexibility to accommodate the expected reduction in allowed returns at PR19, including additional sharing mechanisms, in the context of Moody's revised guidance. In particular, downward pressure could result from (1) net debt to RCV likely to be persistently above 80%, and adjusted interest coverage persistently below 1.3x; and/or (2) a significant increase in business risk for the sector as a result of legal and/or regulatory changes leading to a reduction in the stability and predictability of regulatory earnings, which are not offset by other credit-strengthening measures.

The principal methodology used in these ratings was Regulated Water Utilities published in December 2015. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

Affinity Water Limited is the largest of the six water only companies (WoCs) in England and Wales in terms of customers served. It is the second largest by RCV (after South East Water Limited), with an RCV of GBP1.2 billion as at March 2017. For the 12 months ended 31 March 2017, Affinity Water reported revenue of GBP309 million. The company supplies water to around 1.3 million household customers and over 66,000 local businesses (equivalent to a population of over 3.5 million people) across parts of Bedfordshire, Berkshire, Buckinghamshire, Essex, Hertfordshire, Surrey, Kent and London. Since May 2017, Affinity Water's ultimate shareholders are Allianz Capital Partners (36.56% share), HICL Infrastructure (36.5%) and DIF Infrastructure (26.88%).

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 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.

Velina Karadzhova
Analyst
Public, Project & Infrastructure
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
Public, Project & Infrastructure
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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