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Rating Action:

Moody's downgrades Bristol Water to Baa2, negative outlook

11 Mar 2020

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

No Related Data.
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