Water & Wastewater Treatment Magazine
Issue link: https://fhpublishing.uberflip.com/i/1202034
Ofwat's final determination: water companies' credit quality under duress The Talk: opinion I n December 2019 Ofwat published its final determination, marking the 2019 price review's (PR19) long-awaited completion. Ofwat has assessed water utilities' business plans for the next regu- latory period until March 2025 (known as AMP7) before determining final water prices, cost allowances along with an incentive package for each company. S&P Global Ratings believes that the final determination doesn't bode well for water utilities' credit qualities. It isn't all bad news, but our preliminary assessment reinforces our view throughout PR19's progression that the next regulatory period will be a challenging one – notably for the most highly-leveraged water companies. In turn, the credit quality of the sector could weaken to an extent that the likelihood of downgrades for most of the 14 UK water companies that we rate is now relatively high. Credit metrics set to take a hit Ofwat's chief goal for the next regulatory period is to provide customers with better service at lower costs, as well as a greater focus on operational performance and environmental impact. But this may have negative impact on the credit quality for water utilities. Our preliminary assessment of water companies' forecast model under the final determination indicates that credit ratios could weaken to the extent that they might nation, the final determination does offer some relief in places, with several companies benefiting through the pay- as-you-go (PAYG) mechanism and shorter RCV run-offs. But the inescapable truth is that regula- tory targets under PR19 will be tougher to meet, and that utilities will be on their toes during the next regulatory period. It is now up to the companies to use their allowed totex as effectively as possible to improve their service and, ultimately, avoid penalties. Of course, companies will have limited flexibility to mitigate the expected negative impact since they are less likely to outperform when operating on the set totex budgets. Companies have until 15 February 2020 to appeal their respective final determina- tions otherwise it will take effect from 1 April. We anticipate being better placed to fully assess the credit impact on individual companies as soon as we have discussed mitigating plans with the relevant company representatives – and we expect to take rating actions in early 2020 once compa- nies' actions and performances in the new regulatory period become clearer. Ofwat's final determination for UK water utilities in the upcoming regulatory period spells a difficult period ahead for the UK's water utilities. fall below ratings thresholds. In practice, water companies will earn lower returns while having to maintain higher levels of operational efficiency – as they strive to meet demanding regulatory targets around leakage reduction and lower service inter- ruption. Among the changes are a reduction in water companies' weighted-average cost of capital (WACC) – to 1.92 per cent from about 3.40 per cent in real terms, at an assumed retail price index rate of three per cent. This largely reflects change in market conditions and the regulator's push towards more af- fordable customer bills. Furthermore, the range for rewards and penalties pertaining to outcome delivery incentives (ODIs) is skewed to the down- side, representing significant risk particu- larly for the worst performers. Simply put, compared to the current regulatory period, future outperformance might mean higher rewards, but the penalties for underper- formance could be more severe. In turn, we expect lower returns and higher operating standards to result in tighter financial ratios – and possibly lower ratings. Compared to the July draž determi- 8 | FEBRUARY 2020 | WWT | www.wwtonline.co.uk BY MATAN BENJAMIN, DIRECTOR, EMEA UTILITIES, S&P GLOBAL RATINGS