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Announcement:

Moody's changes outlook to negative on ratings of 4 UK water groups

22 May 2018

London, 22 May 2018 -- Moody's Investors Service (Moody's) has today changed to negative the outlook on the ratings of four UK-based regulated water companies and one high-yield holding company, following proposals by the Water Services Regulation Authority (Ofwat) that would give it greater influence over the water companies' capital structures and dividends. At the same time, the rating agency has affirmed the ratings.

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

Today's rating actions take into account (1) the companies' 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 outlooks reflect Moody's expectation that a reduction in allowed returns from 2020 will weigh on companies' financial metrics and, absent measures to strengthen companies' balance sheets and/or significant outperformance, there is an increased risk of key ratios falling below Moody's guidance for current rating categories.

"We see moves by Ofwat to discourage gearing above the regulator's notional capital structure and the proposed further oversight of equity distributions as departures from long-standing regulatory practice", says Stefanie Voelz, a VP-Senior Credit Officer at Moody's.

"We also see heightened risk of future political interference in the design of the regulatory framework and are changing our assessment of the stability and predictability of the UK water regulatory regime under our methodology to Aa from Aaa. To reflect the increasing business risk we have also tightened our generic ratio guidance for the sector," continues Ms Voelz.

Prior to today's action, Moody's changed the outlook on five other water companies and one holding company to negative (see "Moody's assigns/maintains negative outlook on 6 UK water groups", December 2017 - https://www.moodys.com/research/--PR_377372).

On 26 April 2018, Ofwat published a consultation on proposals for companies' business plan submissions for the 2019 price review (PR19), which will set prices for the five-year regulatory period from 1 April 2020 (AMP7). The consultation includes proposals intended to bolster companies' financial resilience and address concerns around the sector's legitimacy, including a sharing of financing outperformance and additional restrictions on dividend payments.

In its consultation, 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.

Among the highly geared water and sewerage companies (WaSCs), Thames Water Utilities Limited (Thames Water, CFR: Baa1 negative) will see the largest adjustment, given its relatively competitive cost of debt, closely followed by Anglian Water Services Ltd. (Anglian Water, CFR: Baa1 negative).

Among the smaller water-only companies (WoCs), Moody's expects that Affinity Water Limited (Affinity Water, CFR: Baa1, negative) and South East Water (Finance) Limited (South East Water, Baa2 stable) will be most affected, given their gearing around the 80% mark and funding at lower interest rates than their smaller peers.

Ofwat's consultation also proposes that the regulator should in future assess companies' dividend policies, and indicates that dividend yields above the level it regards as "reasonable" would not be acceptable in the absence of outperformance or explicit customer support. Holding companies with debt outside of highly-covenanted operating company financing arrangements are particularly exposed to measures which restrict groups' flexibility to move cash between operating and holding companies.

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 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.

Further details can be found in a report, also published today and entitled "Regulated water utilities -- UK: Regulator's proposals undermine the stability and predictability of the regime", available on moody.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 markets and does not constitute a rating action.

Moody's now holds a negative outlook on 60% of the rated water companies as well as the sector as a whole, signifying the risk that lower returns and increasing cash flow volatility will jeopardise the sector's credit quality unless shareholders are willing to support de-gearing.

For more detailed information on individual issuers, please see the following press releases:

RATING ACTIONS:

- Affinity Water Limited and its financing subsidiaries: Moody's changes outlook to negative on Affinity Water, affirms ratings;

http://www.moodys.com/viewresearchdoc.aspx?docid=PR_383437

- Anglian Water Services Ltd. and its financing subsidiary: Moody's changes outlook to negative on Anglian Water, affirms ratings;

http://www.moodys.com/viewresearchdoc.aspx?docid=PR_383765

- Thames Water Utilities Limited and its finance subsidiaries as well as Thames Water (Kemble) Finance PLC: Moody's changes outlook to negative on Thames Water and Kemble, affirms ratings;

http://www.moodys.com/viewresearchdoc.aspx?docid=PR_383770

- Wessex Water Services Finance Plc: Moody's changes outlook to negative on Wessex Water, affirms A3 ratings;

http://www.moodys.com/viewresearchdoc.aspx?docid=PR_383767

Subscribers can also access the sector report "Regulated Water Utilities -- UK: Regulator's proposals undermine the stability and predictability of the regime" at: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1124483

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 or visit our web site at www.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
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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