Credit FAQ:
For U.K. Water Utilities, Challenging
Cost-Of-Capital Guidance May Bring
Rating Stress
Primary Credit Analysts:
Mark J Davidson, London (44) 20-7176-6306; [email protected]
Tania Tsoneva, CFA, London (44) 20-7176-3489; [email protected]
Secondary Contacts:
Beatrice de Taisne, CFA, London (44) 20-7176-3938; [email protected]
Nazia Haider, London 0044 207 176 3056; [email protected]
Table Of Contents
Frequently Asked Questions
Related Criteria And Research
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
FEBRUARY 7, 2014 1
1256588 | 301674531
Credit FAQ:
For U.K. Water Utilities, Challenging
Cost-Of-Capital Guidance May Bring Rating Stress
New regulatory guidance could mean rating stress for U.K. water utilities. The U.K.'s water and wastewater sector
regulator, Ofwat, recently offered new, lower guidance on allowed weighted-average cost of capital (WACC) for the
2015-2020 regulatory period, which affects companies' assumptions within their business plans. In Standard & Poor's
Ratings Services' view, the effect on the current business plans would be to erode cash flows; we therefore anticipate
that some companies may rework their plans to include mitigating measures.
To encourage competition at the retail end of the sector, Ofwat has offered different guidance for the retail and
wholesale parts of the business. Wholesale appointees own all the pipes and upstream structures, while the retail part
of the business deals with customers. Retail accounts for only a small part of the value chain.
Ofwat's water price review for the 2015-2020 regulatory period (PR14) includes guidance on the appointee WACC of
3.85%. This is below the 4.0%-4.9% range companies assumed in the business plans they submitted in December
2013. That said, the credit impact of the new guidance is tough to gauge at this point. Under the regulatory regime for
U.K. water companies, profitability is linked to the companies' ability to outperform on specific measures. Ofwat has
asked the companies to reconsider their potential to outperform on a range of measures including costs, outcome
delivery incentives (ODIs), service incentive mechanisms (SIM), and financing; this could help offset the impact of the
lower WACC for more-efficient companies.
In addition to reworking assumptions on outperformance, Ofwat has noted the availability of new tools that could
provide flexibility. These include adjusting the capitalization rate for total expenditure (totex) and the depreciation life
of regulated capital value (RCV). Totex is a single allowance that will replace the separate allowances for operating
expenditure (opex) and capital expenditure (capex). Companies will be able to choose how to allocate their totex
allowances between capex and opex.
Here we assess the potential impact of Ofwat's guidance on U.K. water utilities' financial risk profiles and lay out the
process and potential timeline for any rating actions.
Table 1
Rated U.K. Water Utilities
As of Feb. 7, 2014
Rating*
Ultimate U.K. parent/group
Long-term
Northumbrian Water Ltd.
BBB+
United Utilities PLC
BBB+
A-2
Positive
Severn Trent PLC
BBB+
A-2
Stable
Wessex Water Services Ltd.
BBB+
South Staffordshire PLC
BBB+
Sutton and East Surrey Water PLC
BBB
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
Short-term
Outlook
Stable
Stable
A-2
Stable
Positive
FEBRUARY 7, 2014 2
1256588 | 301674531
Credit FAQ: For U.K. Water Utilities, Challenging Cost-Of-Capital Guidance May Bring Rating Stress
Table 1
Rated U.K. Water Utilities (cont.)
Affinity Water Programme Finance Ltd.§
A-
Southern Water Services (Finance) Ltd.§
A-
Stable
Dwr Cymru (Financing) Ltd.§
A
Stable
South East Water (Finance) Ltd.§
BBB
Yorkshire Water Services Ltd.§
A-
Thames Water Utilities Cayman Finance Ltd.§
A-
Anglian Water Services Financing PLC§
A-
*Where applicable, indicates the rating on the regulated operating subsidiary. §Corporate securitization transaction--senior secured debt rating.
Frequently Asked Questions
How do you view Ofwat's risk and reward guidance?
Table 2
Comparison Of Ofwat's Guidance With Recent Financial Parameters For Regulated Utilities In England And
Wales
(%)
Regulatory period
Transmission networks
Gas distribution
Electricity
distribution
Water utilities
RIIO-T1
Electricity
RIIO-T1 Gas
RIIO-GD1
DPCR5
PR09
PR14
2.92*
2.92*
2.92*
3.60
3.60
2.75
7.00
6.80
6.70
6.70
7.10
5.65
60.00
62.50
65.00
65.00
57.50
62.50
4.55
4.40
4.24
4.70
5.10
3.85
Cost of debt
Cost of equity
(post-tax, real)
Gearing
Vanilla WACC
*Based on a 10-year trailing average of iBoxx nonfinancials 10+ maturity in March 2011. 2021 RIIO--(Revenue = Incentives + Innovation +
Outputs) framework. T1- Transmission Review 2014; DPCR5--Distribution Price Review 2005-2015; GD1--Gas distribution review 2014-2021.
PR09--Price Review 2005-2015; PR14--Price Review 2015-2020; WACC--Weighted average cost of capital. Source: Regulators' Web sites.
Although the headline WACC of 3.85% (3.7% for the wholesale segment, which excludes retail) is lower than that
allowed in recent regulatory settlements in the U.K. energy sector, we understand the regulator's rationale. Most of the
reduction is due to lower equity returns, and the level is in line with recent precedents, such as the Northern Ireland
Electricity (NIE) determination.
In our opinion, Ofwat's cost of debt assumption of 2.75% seems aligned with current and forward rates. It applies to
both existing and new debt and is set above recent interest rates. It also allows for some outperformance if rates rise
beyond our current expectations.
Ofwat's assumptions on inflation, measured using the retail price index (RPI), also affect credit quality, in our view,
because revenues are linked to inflation. In its recent guidance, Ofwat has assumed a long-term RPI inflation rate of
2.8%. This is close to Standard & Poor's own forecast for the retail price index in the U.K.
Ofwat's PR14 review assumes that the retail segment will be remunerated through a retail margin, and will not be
included in the WACC for the wholesale appointee. Ofwat's guidance indicates that water companies should anticipate
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
FEBRUARY 7, 2014 3
1256588 | 301674531
Credit FAQ: For U.K. Water Utilities, Challenging Cost-Of-Capital Guidance May Bring Rating Stress
a margin of 1% for households, and 2.5% for commercial customers. In their business plans, companies assumed a
wide range of retail margins. Without a track record, we cannot say at this stage if Ofwat's assumptions are
appropriate.
Does the revised guidance affect your view of a "strong" regulatory advantage in the U.K.?
Not meaningfully. We believe that Ofwat's increased focus on affordability and its wider reforms--which are aimed at
increasing competition--have resulted in an incremental weakening in our regulatory assessment of the U.K. sector.
However, we maintain our "strong" assessment as we continue to view the framework as transparent and broadly
credit supportive.
That said, our regulatory advantage assessment has a 60% weighting in a water utility's preliminary competitive
position score under our updated corporate methodology. A more-significant weakening of our assessment could
result in a weakening of a water company's overall business risk profile to "strong" from "excellent." This could lead to
downgrades across the sector, and could be triggered if, for example, Ofwat were to intervene more significantly in the
price-setting process or if it opened the upstream segments of the value chain to market forces from 2020--a move it
has previously suggested.
What effect will the various measures in the 2015-2020 price review have on credit metrics?
If everything else remained the same, the lower cost-of-capital guidance would cause profitability and cash flows to be
lower than the companies had assumed in their business plans. However, the impact on credit metrics is hard to
predict because Ofwat is offering companies access to a range of tools that also affect credit metrics.
First, companies will be measuring their performance on a range of measures--costs, ODIs, SIMs, and financing--and
these affect profitability. More-efficient companies may be able to offset the effect of the lower WACC by
outperforming on these other measures. Conversely, we anticipate that less-efficient companies will find it more
difficult to offset the lower WACC by outperformance in other areas. As a result, the sector could see wider divergence
in financial performance and competitive position.
In addition to aiming for greater outperformance, companies may adjust the ratio between their capex and opex and
the rate used to depreciate regulated capital value (RCV). Opex is repaid immediately through customer bills, while
capex is repaid more gradually through returns on the RCV. Consequently, if a company chose to shift more of its
expenditure into opex, cash flow cover ratios would rise in the near term.
Similarly, companies can adjust their RCV run-off rates to some extent. This will change the period over which RCV
depreciates. Shortening this period will increase annual depreciation and boost cash flow cover ratios.
Although we do not expect to reverse any such adjustments when we calculate our ratios, excessive use of these tools
could increase business risk, in our view, if we consider that a company is maximizing its near-term cash flows at the
expense of long-term investment.
Finally, companies may choose to increase equity capital by lowering dividends or by issuing new equity. These
measures would also support cash flow cover ratios, by reducing net debt.
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
FEBRUARY 7, 2014 4
1256588 | 301674531
Credit FAQ: For U.K. Water Utilities, Challenging Cost-Of-Capital Guidance May Bring Rating Stress
What credit metrics do you expect to see for the typical U.K. water company?
Table 3
Cash Flow/Leverage Analysis Ratios--Low Volatility
--Core ratios--
--Supplementary coverage ratios--
--Supplementary payback
ratios--
FFO/debt
(%)
Debt/EBITDA
(x)
FFO/cash
interest (x)
EBITDA/interest
(x)
CFO/debt
(%)
FOCF/debt
(%)
DCF/debt
(%)
35+
Less than 2
More than 8
More than 13
More than 30
20+
11+
Modest
23-35
2-3
5-8
7-13
20-30
10-20
7-11
Intermediate
13-23
3-4
3-5
4-7
12-20
4-10
3-7
9-13
4-5
2-3
2.5-4
8-12
0-4
0-3
Minimal
Significant
Aggressive
Highly
leveraged
6-9
5-6
1.5-2
1.5-2.5
5-8
(10)-0
(20)-0
Less than 6
Greater than 6
Less than 1.5
Less than 1.5
Less than 5
Less than (10)
Less than
(20)
Our updated corporate rating methodology lays out ratio bands consistent with different financial risk profiles (see
"Corporate Methodology," published on Nov. 19, 2013). For the U.K. water sector, we use the "low volatility" table,
which allows for higher leverage due to the relatively stable and predictable revenues of regulated utilities.
In the U.K. water sector, some companies are listed and some have implemented whole-business securitizations
(WBS). The listed companies that we rate generally have "significant" financial risk profiles. At that level, we expect
their core ratio of FFO-to-debt to be at least 9%. The more highly geared WBS generally have guidelines indicating at
least 6% FFO-to-debt. We observe that the headroom in existing ratios is limited. The listed water utilities have some
headroom, although the amount varies. The WBS have little or no headroom; FFO-to-debt in the current regulatory
period is already below 6% for most, although we anticipate that they will recover to at least 6% by the end of the
current regulatory period. Where available, we use financial statements published under International Financial
Reporting Standards (IFRS). For those water companies that report under U.K. generally accepted accounting
principles, we deduct infrastructure renewals expenditure (IRE) from FFO (as the IFRS auditors do).
In our opinion, Ofwat's determinations will not take into account compliance with our ratio guidance for the existing
ratings. The regulator has not specified a rating target for the next period, and is constrained only by the appointee
licenses. These require the company be rated investment-grade, which we interpret as meaning at 'BBB-' or above. We
therefore presume that Ofwat may tolerate rating downgrades of one or even two notches, in some cases.
What will be your process for reviewing ratings as companies finalize their business plans?
We are maintaining close contact with the water companies as they reshape their business plans in light of Ofwat's
latest risk and reward guidance. On March 10, certain companies (those that qualify for and accept "enhanced" status)
will be invited to adopt the risk and reward guidance; their draft determination will be published in April and will
largely reflect the business plan they submitted in December 2013.
We anticipate, however, that most companies will seek "standard" status because they need to rework their
submissions in light of the lower WACC. The draft determinations for standard plans will be published four months
later, in August. Final determinations for all companies will be in December, although determinations for those with
enhanced status may happen sooner.
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
FEBRUARY 7, 2014 5
1256588 | 301674531
Credit FAQ: For U.K. Water Utilities, Challenging Cost-Of-Capital Guidance May Bring Rating Stress
In March, we will review those companies that accept enhanced status. We will review companies with standard plans
in August. If any of these reviews reveal to us that a company is unlikely to maintain ratios in line with our guidance
for the current rating levels, we would likely place that company on CreditWatch with negative implications. The final
rating action--affirmation or downgrade--would likely occur toward the end of the year, around the time of the final
determinations.
Related Criteria And Research
Related criteria
•
•
•
•
Corporate Methodology, Nov. 19. 2013
Corporate Methodology: Ratios And Adjustments, Nov. 19, 2013
Key Credit Factors For The Regulated Utilities Industry, Nov. 19, 2013
Methodology For Considering Pre-Insolvency Structural Protections In Europe, Dec. 13, 2012
Related research
• What Ofwat's Price Review For 2015-2020 Could Mean For Rated Water And Wastewater Companies In England
And Wales, Dec. 11, 2013
• Why U.K. Utilities' Regulatory Frameworks Merit A "Strong" Regulatory Advantage Assessment, Dec. 11, 2013
• Why Ofwat's Revised License Proposals Could Pressure Our Ratings On U.K. Water Companies, Dec. 18, 2012
• Regulation Provides Stability For U.K. Water Companies, But High Leverage Limits Their Room For Maneuver, Feb.
20, 2012
Standard & Poor's Rating Actions are determined by Ratings Committee. This commentary has not been determined
by Ratings Committee. The opinions expressed in this article do not represent a change to or affirmation of Ratings
Services' opinion of the creditworthiness of any entity/entities (named or inferred) or the likely direction of ratings.
Additional Contact:
Infrastructure Finance Ratings Europe; [email protected]
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
FEBRUARY 7, 2014 6
1256588 | 301674531
Copyright © 2014 Standard & Poor's Financial Services LLC, a part of McGraw Hill Financial. All rights reserved.
No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part
thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval
system, without the prior written permission of Standard & Poor's Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be
used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or
agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not
responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for
the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL
EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR
A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING
WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no
event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential
damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by
negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and
not statements of fact. S&P's opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase,
hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to
update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment
and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does
not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be
reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain
regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P
Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any
damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective
activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established
policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P
reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites,
www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription) and www.spcapitaliq.com
(subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information
about our ratings fees is available at www.standardandpoors.com/usratingsfees.
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
FEBRUARY 7, 2014 7
1256588 | 301674531