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Finance & Investment Analysis Ratings risk for the highly geared Analyst view Martin Brough Moody's says a tough price review from Ofwat could cut water firms' credit ratings. By Conor McGlone. "There has been much talk about trading revenues and transfer prices, but is there a more fundamental problem with retail accounts?" H D ighly leveraged water companies are at risk of negative rating pressure if Ofwat delivers a tough price review next year as predicated, according to the ratings agency Moody's. Speaking to Utility Week, Stefanie Voelz, water industry analyst at Moody's, said: "Low interest rates will drive a reduction in allowed returns in the next price review. For some companies, balance sheet strengthening may be necessary to maintain credit quality. "If they cannot offset a cut in allowed returns with improved performance or adjustment to financial and dividend policies, individual companies may face negative rating pressure, particularly if they are already weakly positioned within their rating categories," she said, singling out Southern Water, which has the lowest rating of the water and sewerage companies – a Baa2 negative rating – due to its exposure to inflation-linked derivatives. It is also the fourth most highly leveraged. According to Moody's, the rated companies with most to lose are the three most highly leveraged water and sewerage companies – Anglian Water, Thames Water and Yorkshire Water – all of which are rated Baa1. The debate on the risks of company gearing was reignited earlier this year when Ofwat chairman Jonson Cox said there had been a growing trend for water companies to become highly leveraged, with several companies at 80 per cent gearing, thus obtaining only one-fifth of their financing from equity. Cox said questions had rightly been asked about the ability of highly leveraged companies to endure "in a less intrusive, higher-risk, less rulesbased model of regulation sought by managements". "Highly leveraged companies have less financial flexibility," says Voelz, "because a lot of their cash flows need to be used to service their debt. If companies receive a lower return, their interest coverage could be significantly weaker than what we see today." Severn Trent, Wessex, Welsh and United Utilities are the highest rated water and sewerage companies, at A3, with a net debt/regulatory capital value of 60-68 per cent. "These companies are also relatively well positioned within their current rating categories, and therefore face less risk from a tough review," said Voelz. But she warned "the whole industry is at risk" if serious political intervention became a reality, after environment secretary Owen Paterson wrote a letter to the chief executives of water firms urging them to ensure customers got a "fair deal". "If you have material political intervention, that could potentially cause us to review our favourable assessment of the regulatory framework, which we currently see as independent, stable and predictable," she added. oes the concept of "investment" apply to retail? A key part of the intense political scrutiny of UK energy retail prices and profits is a call for greater transparency. Companies have provided standardised segmental accounts to the regulator over the past four years and Ofgem is consulting on ways of improving transparency further. There has been much talk about trading revenues and transfer prices, but is there a more fundamental problem with traditional retail accounts? Centrica's annual report states that the British Gas Residential energy supply segment made an operating profit of £606 million in 2012 on average capital employed of £212 million. Is this excessive? Some energy retailers are currently offering fixed-price deals to customers at price levels that could imply accounting losses. Is this dumping upstream production below cost or investing in customer growth? The answer to both of these questions depends on whether you think traditional accounting standards deal adequately with the financial realities of retail. As the Competition Commission highlighted in its Inquiry into the aggregates industry, the asset value given by historic cost accounts might "The asset be less appropriate to consider than the replacement cost of equivalent value on historic cost assets to a new entrant. Could a new company entering accounts a competitive energy retail market might not be establish a business equivalent to appropriate" British Gas with IT systems, contractual positions, branding and over 15 million accounts for an investment of £212 million? If not, then perhaps the accounts understate the asset on which investors in British Gas can legitimately expect to earn a return. Do retail customers have any ongoing value in a competitive market once they have signed up? If so, then perhaps it is legitimate to offer attractive deals to win new customers, even if this results in short-term accounting losses. Such accounting discussions may seem abstract but they go to the heart of establishing what a "fair" level of profit is in energy retail. If the concept of investment and value has no place in retail then it will be seen at best as a breakeven route to market for upstream production. Utility retailers need to show why a competitive customer business has a value that goes beyond the numbers shown in their reports and accounts. Martin Brough, utilities equities analyst, Deutsche Bank UTILITY WEEK | 22nd - 28th November 2013 | 21