London, 11 March 2020 -- Moody's Investors Service (Moody's) has today downgraded to
Baa2 from Baa1 the backed senior secured debt rating of Bristol Water
plc (Bristol Water). The outlook is negative.
This rating action follows Bristol Water's announcement, on 13 February
2020, that it will not accept the final determination by the Water
Services Regulation Authority (Ofwat) for the five-year regulatory
period starting in April 2020 (AMP7). Consequently, Ofwat
will refer the determination to the Competition and Markets Authority
(CMA), which will set its own re-determination within the
next six months, extendable to up to 12 months.
This concludes the rating review initiated on 20 December 2019,
following publication of the final determination for AMP7.
RATINGS RATIONALE
Today's rating action takes into account the current determination,
which exposes Bristol Water to a significant cut in allowed wholesale
returns, a reduction in total expenditure allowances compared with
its requests and challenging performance targets, as well as the
company's decision to reject the regulator's determination
and ask for a CMA review.
Specifically, the downgrade to Baa2 reflects Moody's view
that Bristol Water will be unable to maintain financial ratios in line
with guidance for the previous Baa1 rating. Ofwat's final
determination presents a range of challenges and whilst the CMA appeal
may result in a more favourable settlement, the rating agency does
not expect any increase in allowances will be enough to restore Bristol
Water's credit quality. In addition, the negative outlook
considers the uncertainty and delay associated with the appeal and risk
that absent material outperformance, a better re-determination
and/or balance-sheet strengthening measures, financial metrics
could also fall outside of the boundaries for the Baa2 rating.
Ofwat published its final determination for AMP7 on 16 December 2019.
As previously flagged by the regulator, this included a significant
cut in allowed cash returns to ca. 2.42% for the
wholesale activities at the start of the new period, which incorporates
the regulator's decision to link half of the regulatory assets to
the Consumer Prices Index adjusted for housing costs (CPIH), with
the rest remaining linked to the Retail Prices Index (RPI). As
the share of regulatory assets linked to CPIH grows over time, Moody's
estimates that Bristol Water will have an average allowed cash return
of around 2.5% over AMP7. On an RPI-stripped
basis, for comparison with the current period, allowed returns
will fall to 1.92% (1.96% including retail
margin) from 3.6% (3.74% including the retail
margin), a nearly 50% cut. The low returns put particular
pressure on companies, including Bristol Water, which have
expensive existing debt, and whose smaller size means that they
access financial markets less frequently and are, thus, not
able to benefit fully from lower interest rates today. Bristol
Water's modest gearing of around 60%-65% of
net debt to regulatory capital value (RCV) at the start of the new regulatory
may help offset some of the pressure, but Moody's expects
gearing to increase over the period, in particular due to the cost
challenges presented by the final determination.
Ofwat's allowances for base operating and maintenance expenditure,
excluding enhancement projects but including retail costs, were
GBP432 million, roughly GBP27 million (or 5.9%) below
what the company requested, even after the company had reduced its
requested cost by GBP15 million in its response to the draft determination.
In addition, the final determination included GBP5 million disallowances
on enhancement expenditure (equivalent to 14.3% of the amount
requested). Although Bristol Water may be able to avoid or defer
some base expenditure, Moody's believes this gap largely reflects
lower efficiency than Ofwat's estimate of top quartile performance,
and that the company is at risk of materially overspending allowances.
Under the totex sharing mechanism, up to 40% of this overspend
would be added to the RCV in 2025 or recovered over the 2025-30
period but would result in higher debt and weaker cash flow over AMP7.
On operational performance commitments, Bristol Water has faced
difficulty in meeting some of its targets under the Outcome Delivery Incentives
(ODIs) mechanism for the current period. Ofwat's final determination
includes a penalty of GBP7.1 million associated with the company's
AMP6 ODI performance, which will reduce AMP7 revenues, while
a further GBP0.8 million of penalties will be applied as an adjustment
to the company's RCV (all in 2017/18 prices). However, Moody's
notes that the company has achieved significant improvements, particularly
on leakage, towards the back-end of the current period.
Taking this as well as Ofwat's adjustments, which somewhat
softened targets and incentive rates on common performance commitments
at the final determination stage, into account, the rating
agency expects that the company may not incur any major penalties,
nor rewards, over AMP7. There is, however, risk
to the downside in severe weather events.
Moody's base case scenario, reflecting the current final determination,
results in Bristol Water exhibiting an Adjusted Interest Coverage Ratio
(AICR) around 1.1x, below the 1.5x guidance for the
previous Baa1 rating as well as the 1.3x guidance for the current
Baa2. This ratio could improve towards the 1.3x threshold,
if the company received a more favourable determination from the CMA and/or
were able to materially outperform its cost allowances. Moody's
notes that in previous CMA referrals, the company was able to secure
a small-company premium within its allowed return, which
-- if achieved again -- could reduce the pressure on the AICR.
Gearing is forecast to remain at or below 70% of net debt to RCV,
thus leaving headroom against the maximum 85% threshold set for
the Baa2 rating, which would also help to offset credit pressure
of an AICR slightly below guidance.
Bristol Water's rating continues to be constrained by the company's
small size and relatively inflexible financing structure, which
increases risk exposure in an environment of falling returns, somewhat
offset by the structural enhancements included in the company's
bond covenant and security package. Key supporting features include
(1) a cash trapping mechanism, which is designed to help maintain
and restore credit quality by preventing distributions and retaining cash
within the company in downside scenarios; (2) liquidity facilities
(and/or cash reserves) equal to six months' of debt service; (3)
a first-ranking fixed charge over the shares in the company,
plus first-ranking and floating charges over all the assets,
rights and undertakings of Bristol Water; and (4) a mandatory sinking
fund arrangement to reduce refinancing risk.
Finally, the Baa2 rating remains ultimately supported by the company's
low business risk profile as a monopoly provider of water services operating
under a well-established, transparent and predictable regulatory
framework.
RATING OUTLOOK
The negative outlook reflects that Bristol Water will not have certainty
over its revenues and investment programme for a further six to 12 months
and that the eventual determination, if not materially improved
from Ofwat's final determination, may lead to credit metrics
that -- absent significant outperformance -- are weakly positioned
for the assigned rating.
WHAT COULD CHANGE THE RATING
Given the negative outlook and the reduced financial flexibility in AMP7,
Moody's currently does not envisage any upward rating pressure.
The rating could be downgraded if the CMA's re-determination
provides for a lower allowed return, lower cost allowances or greater
operational penalties that are not adequately mitigated by management
action. In particular, the rating could be downgraded if
Moody's concluded that the eventual regulatory settlement was likely
to result in Bristol Water exhibiting an AICR significantly below 1.3x
and gearing, calculated as net debt to RCV, in excess of 85%,
roughly in line with the company's distribution lock-up trigger
levels.
In addition, downward rating pressure could result from 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 is not offset by other credit strengthening
measures, or the company facing unforeseen funding difficulties.
PRINCIPAL METHODOLOGY
The principal methodology used in this rating was Regulated Water Utilities
published in June 2018. Please see the Rating Methodologies page
on www.moodys.com for a copy of this methodology.
Bristol Water plc is the third largest of the six water only companies
(WoCs) in England and Wales with a RCV of GBP530.3 million as of
31 March 2019. The company provides water services to a population
of about 1.2 million people, supplying domestic and commercial
properties within an area of 2,400 square kilometres in the South
West of England.
In the year to 31 March 2019, Bristol Water had reported revenues
of GBP121.6 million and an operating profit of GBP29.9 million.
Bristol Water and Wessex Water, the incumbent sewerage provider
in Bristol Water's water supply area, have partnered to jointly
carry out some activities, such as metering, billing and most
recently non-household retail following the opening of this market
to competition. Bristol Water's participations in the joint
venture operations are held by Bristol Water Holdings Limited and are
therefore outside of the regulated ring-fenced group of Bristol
Water plc.
Bristol Water is majority owned by iCON Infrastructure; the iCON
Infrastructure Partners III, L.P. fund acquired Capstone
Infrastructure Corporation's 50% stake in April 2016 and the iCON
Infrastructure Partners III (Bristol), L.P. fund acquired
a further 30% stake from SUEZ in December 2016. The remaining
20% is owned by ITOCHU Corporation (A3 stable) who has held its
stake since May 2012.
REGULATORY DISCLOSURES
For ratings issued on a program, series, category/class of
debt or security this announcement provides certain regulatory disclosures
in relation to each rating of a subsequently issued bond or note of the
same series, category/class of debt, security 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.
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
