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Rating Action:

Moody's reviews Thames Water and Kemble Water's ratings for downgrade

20 Dec 2019

London, 20 December 2019 -- Moody's Investors Service ("Moody's") has today placed on review for downgrade the Baa1 corporate family rating (CFR) of Thames Water Utilities Ltd. (Thames Water), as well as the A3 senior secured and Baa3 subordinated debt ratings of the Class A and Class B notes issued by Thames Water Utilities Finance Plc. Concurrently, Moody's has placed on review for downgrade the B1 senior secured rating of Thames Water (Kemble) Finance PLC (Kemble Water). A complete list of affected ratings appears at the end of this press release.

The rating actions follow publication by the Water Services Regulation Authority (Ofwat), the economic regulator for water companies in England and Wales, of its final determination for the forthcoming regulatory period. The determination includes a significant cut in allowed returns, challenging performance targets and a substantial gap between the expenditure that Ofwat has allowed and the company's original proposals. Moody's expects the determination to result in a downgrade to the ratings unless Thames Water and Kemble take significant mitigating action or Thames Water achieves a more favourable redetermination on appeal.

RATINGS RATIONALE

Today's rating action takes into account (1) Thames Water's exposure to a significant cut in real allowed wholesale returns to ca. 2.42% at the start of the new regulatory period, compared with 3.6% in the current period; (2) a reduction in total expenditure allowances compared with the company's original proposals; (3) challenging performance targets, which Moody's expects will lead to financial penalties for companies, like Thames Water, with a track record of weaker operational performance, despite a material improvement from draft determinations published in July 2019; and (4) recent derivative transactions that improve Thames Water's near-term cash flow but increase the mismatch between the inflation indexation of the company's RCV and index-linked debt and reduce the effectiveness of the financial triggers and covenants included in the company's financing structure.

On 16 December 2019, Ofwat published its final determinations for the five-year regulatory period commencing 1 April 2020 (AMP7) for the water and wastewater companies operating in England and Wales. The determination includes a significant cut in allowed cash returns to 2.42% 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 Thames Water will have an average allowed cash return of around 2.52% over AMP7. On an RPI-stripped basis, for comparison with the current period, allowed returns will fall to 1.92% for wholesale activities (1.96% including retail margin) from 3.6% (3.74% including the retail margin), a nearly 50% cut.

Ofwat's allowance for "base" operating and maintenance expenditure, excluding enhancement projects and costs associated with the Thames Tideway Tunnel but including retail costs, was GBP8.5 billion, roughly GBP400 million more than the company requested in its alternative, scaled-back investment plan following draft determinations but GBP600 million less than proposed in its April business plan. Under the totex sharing mechanism, only 25% of any overspend would be added to the RCV in 2025 or recovered over the 2025-30 period, while 56-68% of any underspend would be subtracted from the RCV or repaid to customers.

Moody's has previously estimated that, under the draft determination, Thames Water would also have faced Outcome Delivery Incentive (ODI) performance penalties of over GBP500 million in aggregate over the period. At final determinations, Ofwat relaxed relevant performance commitments and reduced penalty rates, which will significantly reduce Thames Water's ODI penalties if the company is able to achieve the operational improvements targeted in its April business plan. Although Thames has noted that its scaled-back alternative business plan does not improve resilience to the same extent as its original proposals, the company expects that it will still be able to achieve significant operational improvements. As part of the rating review, Moody's will assess the changes in the final determination to the full package of ODIs and the company's plans to mitigate any remaining underperformance.

Like its peers, Thames Water must decide before 16 February 2020 whether to accept the final determination. If it does not then Ofwat will refer it to the CMA for review, which will take between six to twelve months to decide upon the matter. Even if an appeal is successful, the final determination will still apply until March 2021.

The rating action also takes into account recent financing transactions which, in Moody's view, may imply credit negative changes to the company's financial policy. In November 2019, Thames Water extended a portion of existing RPI-linked swaps, allowing the company to report lower interest payable for the purposes of its covenant calculations. In addition, the company entered into GBP2.1 billion of new RPI-linked swaps which reduce cash interest expense during AMP7 but increase the mismatch with the company's increasingly CPIH-linked revenues and regulatory assets.

RATINGS RATIONALE -- KEMBLE WATER

Because Kemble Water is wholly reliant on dividend distributions from Thames Water to Kemble Water Finance Limited to service its debts, today's rating action reflects the weaker credit quality of Thames Water. Although the Kemble Water Finance Ltd group maintains an 18-month liquidity reserve, any prolonged stoppage of dividends from Thames Water would prevent Kemble Water from servicing its debt, absent equity contributions from its shareholders.

Recent financing transactions at Thames Water significantly reduce the risk of a dividend lock-up. Despite this, there remains a risk that Thames Water could be unable to pay sufficient dividends to support interest at Kemble while maintaining stable gearing at the operating company.

RATING OUTLOOK -- THAMES WATER

The ratings are under review for possible downgrade, reflecting Thames Water's exposure to the significant cut in allowed returns, more challenging cost and operational performance targets, and Moody's expectation that these will weigh on the company's financial metrics. The rating review will consider (1) Thames Water's total expenditure allowances and operational performance incentives; (2) potential management and shareholder actions to improve financial flexibility, for example through de-gearing the company, and the ability to achieve this in a timely manner; (3) the company's decision to accept or reject the final determinations; and (4) whether the current notching of the Class A and B debt ratings relative to the CFR remains appropriate if the company's consolidated credit quality deteriorates.

The review will also consider the extent to which the recent swap restructuring has weakened protections for Thames Water creditors and/or is indicative of credit negative changes to financial policy. The rating agency may revise ratio guidance in light of the transactions. Moody's will endeavor to conclude the review within the next three months.

RATING OUTLOOK -- KEMBLE WATER

Kemble Water's ratings are under review for possible downgrade, reflecting the likelihood of a deterioration in the credit quality of the Kemble Water Finance group as a result of the final determination.

WHAT COULD CHANGE THE RATINGS

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

Thames Water's rating could be downgraded if, taking into account such measures as management may implement, it appears that the company will likely have insufficient financial flexibility to accommodate the regulatory determination.

Kemble Water's rating could be downgraded if the rating of Thames Water were downgraded, or if weaker cash flow at Thames Water meant that financial or rating triggers limiting dividend payments were more likely to be triggered. Financial triggers in Thames Water's financing structure include (1) Class A RCV gearing in excess of 75% or senior RCV gearing in excess of 85%, or (2) Class A adjusted interest cover ratio below 1.30x or senior adjusted interest cover ratio below 1.10x. Rating triggers include a Class A or corporate rating below Baa3/BBB- from any agency.

In addition, downward rating pressure at Thames Water and Kemble Water could result from (1) adoption of more aggressive financial policies, (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 in each case are not offset by other credit-strengthening measures, or (3) unforeseen funding difficulties.

Thames Water is the largest of the 10 water and sewerage companies in England and Wales by both RCV and number of customers served. The company provides drinking water to around nine million customers and sewerage services to around 15 million customers in London and the Thames Valley. Kemble Water is the financing subsidiary of Kemble Water Finance Limited, which owns Thames Water through intermediate holding companies including Thames Water Limited.

LIST OF AFFECTED RATINGS

..Issuer: Thames Water (Kemble) Finance PLC

On Review for Downgrade:

....BACKED Senior Secured Regular Bond/Debenture, Placed on Review for Downgrade, currently B1

..Issuer: Thames Water Utilities Finance Plc

On Review for Downgrade:

....BACKED Senior Secured Medium-Term Note Program, Placed on Review for Downgrade, currently (P)A3

.... BACKED Subordinate Medium-Term Note Program, Placed on Review for Downgrade, currently (P)Baa3

.... BACKED Subordinate Regular Bond/Debenture, Placed on Review for Downgrade, currently Baa3

.... BACKED Senior Secured Regular Bond/Debenture, Placed on Review for Downgrade, currently A3

..Issuer: Thames Water Utilities Ltd.

On Review for Downgrade:

....LT Corporate Family Ratings Placed on Review for Downgrade, currently Baa1

Outlook Actions:

..Issuer: Thames Water (Kemble) Finance PLC

....Outlook, Changed To Rating Under Review From Negative

..Issuer: Thames Water Utilities Finance Plc

....Outlook, Changed To Rating Under Review From Negative

..Issuer: Thames Water Utilities Ltd.

....Outlook, Changed To Rating Under Review From Negative

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.

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.

Graham Taylor
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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