Credit ratings agency Moody’s is warning that while currently low borrowing costs are credit positive for UK water companies that issue new debt, persistently low rates could result in a significant revenue cut following the 2019 price review.

The warning comes in a new report from Moody's which says that the outlook for the UK water sector is stable over the next 12 to 18 months as companies have good visibility over allowed revenues for the remainder of the regulatory period to 2020.

However, continuing low interest rates and ongoing regulatory developments towards further competition in the water sector could increase business risk for the sector beyond 2020.

The most affected companies would be Yorkshire Water Services Limited (CFR: Baa2 negative) and Southern Water Services Limited (CFR: Baa2 negative) with expensive long-term debt – both firms were recently downgraded by Moodys.

The introduction of household competition would also be credit negative for the sector as a whole as it would introduce additional credit risk.

Stefanie Voelz, a Moody's Vice President - Senior Credit Officer and author of the report, commented:

“Although non-household retail competition, starting on 1 April 2017, will not significantly alter the sector's credit profile, extending competition to the household retail market, which requires government legislation and may be some years away, would be credit negative for the sector as it would introduce additional risks.”

The ratings agency warned that its outlook for the sector could change to negative if companies are unable to earn at least the allowed return of 3.74% p.a. in the current regulatory period, saying it  foresees “no positive outlook pressure.” For 2015/16, UK water companies achieved a return on their regulatory capital values (RCV) of around 5.6%, well in excess of the average 3.74% allowed in the 2014 price review.

Moody's also published a separate report on assessing the credit quality of a water retailer and the implications of counterparty risk exposure for the water wholesale provider entitled "UK Water Sector: Retailers likely to have weak credit quality" In Moody’s view the standalone credit quality of an average water retailer is likely to be in the single-B rating category, indicating a higher credit risk than for the current water companies.

Moody's expects that upstream reforms will also be credit negative for the UK water sector over the long-term as they may add further cash flow volatility from 2020.

The regulator's current proposals would also provide a precedent for splitting the RCV, a cornerstone of UK regulation that has historically underpinned investor confidence, although the risk of this is limited before 2025.

Finally, the rating agency sees limited direct impact from Brexit. While it will require fresh legislation for the UK water sector as EU directives will no longer apply, changes to the sector's regulatory environment and business profile will be limited.

However, cheap loans from the EIB, one of the sector's largest individual funding sources, may dry up once Brexit is implemented, increasing the overall cost of debt for the sector, which borrowed over £6.5 billion from the bank over the 2005-16 period.

Click here for further information on Moody’s UK Water Sector Outlook Report

Click here for further information on Moody’s UK Water Sector Retailers Report