S&P Global Ratings has revised its outlook for both Northumbrian Water (NWL) and Portsmouth Water to negative in the face of what it describes as “tougher operating conditions”.

The revisions for the UK utilities reflect the rating agency’s expectations that both will come under pressure in the next regulator period, AMP7, which runs from 2020-2025.

Once AMP7 begins, S&P expects Portsmouth Water’s ratios to come under more pressure due to the company’s commitment to reduce customers’ bills whilst significantly increasing its planned capital expenditure (capex). In turn, the company may struggle to maintain metrics in line with its current rating.

Meanwhile, higher capex, with a yearly average of £320 million for AMP7 in comparison to approximately £210 million for AMP6, may hinder NWL’s ability to generate positive cash flow for the next regulatory period.

Commenting on Northumbrian Water, the ratings agency said that several elements indicated that the company's credit metrics will come under pressure from the start of the upcoming AMP7regulatory period in April 2020, including:

• NWL's business plan – S& P’s analysis of the plan showed materially lower credit metrics at the start of the AMP7 regulatory period
• Initial feedback from the U.K. water regulator Ofwat which had indicated that the company will need to improve its business plan before its next submission on April 1, 2019.

“NWL will face increasing pressure to outperform its total expenditure allowance”

Julien Bernu, Primary Credit Analyst at S&P commented:

“We believe that NWL will face increasing pressure to outperform its total expenditure allowance and generate performance-related incentive payments over the next regulatory period to continue to post S&P Global Ratings-adjusted funds from operations (FFO) to debt above 9%.”

The outlook has been revised to negative from stable for both NWL and its parent holding company Northumbrian Water Group (NWG).

The revision reflects S&P’s expectation that Northumbrian Water’s financial metrics will come under pressure in AMP7 which stemmed from the largest decline (13.2%) in the industry's combined water and wastewater bill for the next regulatory period, as a result of - among other things - a lower pay-as-you-go rate and a reduced cost of capital. S&P explained that this would eventually drive down NWL's profitability.

In the meantime, higher capital expenditure (capex), with a yearly average of £320 million for AMP7 compared to approximately £210 million for AMP6, could also hinder NWL's ability to generate positive cash flows for the next regulatory period, although to some extent this would be offset by lower dividend payments to NWL's ultimate parent, the CK Hutchison Holdings Ltd. (CKHH) group.

S&P has factored in NWL's “solid operational track record” during AMP6 - totex outperformance of 15% (approximately £280 million), together with its position in the top tier of performers operationally.

However, in the ratings agency’s opinion the feedback that NWL recently received from Ofwat, along with a "slow-track" categorization, like nine other companies in the sector, may limit the amount of totex outperformance it may achieve.

Julien Bernu continued:

“This takes account of the regulator's comment that costs in NWL's business plan stand more than 15% above what it views as efficient.”

“We recognize that there is still a high level of uncertainty as to whether the business plan will be executed as presented. NWL may be able to generate efficiencies and may adapt some of the assumptions in its business plan based on the regulator's feedback, including reduced capex and possibly a change in its bill profile, although this would lead to the company forgoing some of the growth it forecasts in regulated capital value.”

Companies categorized in the "slow track" and "significant scrutiny" categories (14 of 17 companies in total) must submit their revised business plans on April 1, 2019, followed by a draft determination and consultation between March and July 2019 and a final determination in December 2019.

The ratings agency said it would consider lowering the ratings by one notch if NWL and NWG cannot maintain S&P Global Ratings-adjusted FFO to debt of at least 9% on a sustainable basis.

Julien Bernu added:

“We believe that this could happen if NWL cannot negotiate a better outcome from the regulatory determination and if it cannot achieve significant totex outperformance and performance-related incentive payments over the next regulatory period.”

S&P said it would also lower the rating on NWL and NWG if it perceived that “support from the ultimate parent had reduced.”

On a positive note, S&P could revise the outlook to stable if it sees NWL submitting “a materially improved” business plan to the regulator.

“Tough operating conditions for Portsmouth Water“

S&P is also forecasting tough operating conditions for Portsmouth Water and has likewise revised its outlook to negative.

The agency has pointed out the initial feedback from Ofwat on the water company’s business plan had indicated that the company would struggle to maintain credit metrics in line with its current rating from the start AMP7 due to high capital expenditure and lower bills.

Primary Credit Analyst Gustav B Rydevik commented:

“The negative outlook reflects the possibility of a downgrade if Portsmouth Water's final regulatory outcome indicates that its credit metrics will weaken, potentially triggering a downgrade.”

S&P has also flagged up the fact that Portsmouth Water had failed two of Ofwat's regulatory outcome delivery incentives during 2016, 2017 and 2018 - mean zonal compliance and water quality contacts.

Gustav B Rydevik continued:

“Once AMP7 begins, we expect Portsmouth Water's ratios to come under more pressure because the company has committed to reducing customers' bills while significantly increasing its planned capex.”

Much of this will be spent on the Havant Thicket Winter Storage Reservoir project, the largest single investment in Portsmouth Water's history, together with improving water quality and water resilience.

However, Rydevik added that the pressure on Portsmouth Water's ratios, should be reduced to some extent by the fact that Portsmouth Water's owners, funds managed by Ancala Partners, had already signalled their intention to commit a substantial capital injection of about £61 million during the next regulatory period, in connection with the development of Havant Reservoir.

S &P could consider lowering the ratings if the water company cannot negotiate a better final outcome with Ofwat and therefore fails to maintain adjusted FFO to debt of at least 7%.

“We expect that AMP 7 will be tough for Portsmouth Water”, Rydevik said.