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Announcement:

Moody's extends review for downgrade on Northumbrian Water

09 Mar 2020

London, 09 March 2020 -- Moody's Investors Service (Moody's) has said today that it is extending the review for downgrade on the Baa1 issuer rating of Northumbrian Water Ltd. (Northumbrian) and senior unsecured debt ratings of Northumbrian Water Finance Plc, whose issuance is guaranteed by Northumbrian.

This follows Northumbrian's announcement, on 14 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.

The rating review was initiated on 20 December 2019, following publication of the final determination for AMP7.

RATINGS RATIONALE

The extension of the review takes into account that Ofwat's final determination exposes Northumbrian 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 review for downgrade reflects that Northumbrian will not have certainty over its revenues and cash flows for the next six to 12 months, and absent significant outperformance against its cost allowances, a better re-determination and/or balance-sheet strengthening measures, financial metrics could fall outside of the boundaries for the Baa1 rating.

On 16 December 2019, Ofwat published its final determination for AMP7. As previously flagged by the regulator, the determination includes 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 Northumbrian 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.

Ofwat's allowances for base operating and maintenance expenditure, excluding enhancement projects but including retail costs, were GBP2.6 billion, roughly GBP91 million below what the company requested, an efficiency gap of ca. 3.4%. The final determination also included significant disallowances on enhancement expenditure of a further GBP90 million. While Northumbrian may decide not to spend money on enhancement projects that is has not received funding for it may affect its performance under the outcome delivery incentive (ODI) mechanism.

Northumbrian has a solid track record of operational performance, which resulted in around GBP16 million rewards for the company's performance against ODIs and customer service measures over AMP6, recognised in its final determination for AMP7. The majority of the ODI rewards, around GBP10 million, will be recovered through an uplift in the RCV, which will feed through only over time and provide limited buffer to offset the financial pressure during AMP7. However, the recalibration of performance targets and incentive rates at the final determination mean that Northumbrian could achieve net rewards over the next period, but some of these may be subject to the company delivering on its investment plan.

Moody's base case scenario, reflecting the current final determination, results in Northumbrian exhibiting an Adjusted Interest Coverage Ratio (AICR) around 1.3-1.6x and materially below the 1.5x guidance for the current Baa1 rating in the initial years. This ratio could improve comfortably above the 1.5x threshold, if the company were able to significantly outperform its cost allowances, which it has a track record of doing, or received a more favourable determination from the CMA. However, the CMA may ultimately also settle on a less favourable outcome on returns, cost allowances or performance incentives.

Finally, the Baa1 rating remains ultimately supported by the company's (1) low business risk profile as the monopoly provider of essential water and sewerage services to around 4.6 million people in the North East and South East of England; (2) relatively stable and predictable cash flow generation under a well-established and transparent regulatory framework; (3) solid performance track record; and (4) flexible dividend policy aiming at maintaining operating company gearing at or below 70% (which is in line with the sector's average unadjusted gearing as well as Ofwat's threshold for the new high gearing penalty mechanism).

RATING OUTLOOK

The Baa1 ratings are under review for possible downgrade, reflecting Northumbrian's exposure to the significant cut in allowed returns from 2020 and more challenging targets, and Moody's expectation that, absent a more favourable determination by the CMA, measures to strengthen its balance sheet and/or significant outperformance, key ratios will fall below Moody's guidance for the current rating category. It also takes into account that the company will not have certainty over its revenues and investment programme for a further six to 12 months and that the eventual determination may not result in a material improvement from Ofwat's final determination.

WHAT COULD CHANGE THE RATING

Given the ratings review, Moody's currently does not envisage any upward rating pressure. The ratings could be confirmed if Moody's concludes that the impact of Ofwat's determination is likely to be adequately mitigated by a combination of strong outperformance and/or balance-sheet-strengthening measures or a more favourable outcome from the CMA, as the case may be.

The ratings 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 ratings could be downgraded if Moody's concluded that the eventual regulatory settlement was likely to result in (1) the Northumbrian Water Group's consolidated leverage persistently above 100% (net debt/RCV); and (2) Northumbrian's stand-alone net debt exceeding 72% of the company's RCV, excluding the net debt associated with the Kielder reservoir, or the high-seventies in percentage terms including it, and an AICR below 1.5x on a persistent basis.

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 these ratings was Regulated Water Utilities published in June 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

Northumbrian is the eighth-largest UK water utility by RCV, providing water and sewerage services to a population of 2.7 million in the North East of England, including the cities of Newcastle, Durham and Sunderland. It also provides water-only services to a population of 1.9 million in the South East of England. The company is the main subsidiary of Northumbrian Water Group, whose ultimate parent is CK Hutchison Holdings Limited (A2 stable), a Hong Kong-based conglomerate partly owned by Mr. Li Ka-shing.

For the 12 months ended 31 March 2019, Northumbrian reported revenues of GBP869 million and operating profit of GBP339 million. At the financial year-end, the company had a RCV of approximately GBP4.3 billion.

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.

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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