Stable outlook for UK water sector; challenges ahead

The outlook for the UK water sector is stable, reflecting its resilience despite declining consumption and increasing bad debts over the last 12 months, as well as the risk mitigants inherent in the regulatory framework, Moody’s Investor Service said in an in industry report.
However, the sector faces challenges going forward, especially if the draft determinations for price limits recommended by the UK regulator Ofwat are implemented, the rating agency added.
"The UK water sector has proved to be resilient through the economic downturn," said Neil Griffiths-Lambeth, a senior analyst in Moody's Infrastructure Finance Group. "Although revenues have fallen, the decline has been limited. Moreover, companies were able to access the financial markets throughout the market turmoil and whilst terms have been less attractive than before, spreads are continuing to tighten."
Furthermore, Moody's noted that the sector's regulatory framework provides operators with protection against both falling demand and bad debts, both of which occurred over the past 12 months. Indeed, a substantial effects clause is embedded in each water company's licence and allows them to submit a request to review the price limits within a regulatory period if circumstances beyond prudent management control results in an adverse impact above a minimum materiality threshold. In addition, for the current regulatory period until March 2010, the regulator has included a "notified item" for bad debts, which allows operators to apply for an interim determination of the K-factor, whereby they can seek a revision of the price limits originally set by the regulator if the impact of bad debts exceeds a minimum level; several companies have taken advantage of this provision.
Several recommendations have been made for extending competition in the water sector in England and Wales, including the vertical separation of the activities of the companies and proposals for developing upstream competition.
"Moody's does not believe that the proposed changes will adversely affect the business risk profiles of the water companies over the medium term," said Griffiths-Lambeth. "We expect that certain segments of the industry will retain natural monopoly characteristics over the very long term."
However, if Ofwat's price limits and reduction in allowed cost of capital are implemented then the credit metrics for some companies could move outside of Moody's guidance for the current ratings. The allowed rate of return is not surprising but, in Moody's view, other aspects of the package are harsh, particularly the proposed capital incentive scheme mechanism that imposes disproportionate penalties on the majority of companies and will make it difficult for many to achieve the allowed returns.
Moody's also recognises that shareholder returns are expected to decline during the next regulatory period and cash flows to shareholders should accordingly be lower, as companies retain cash to part fund their capital programmes and to preserve their credit standing. "Therefore, dividend policies that do not reflect the realities of both the new price limits and the size of each company's capital investment programme may lead to downward rating pressure," cautioned Griffiths-Lambeth.
Overall, Moody's believes that the sector should enjoy ratings stability as it moves into the next regulatory period, but will monitor events and take appropriate action as and when necessary.