Credit ratings agency Moody's has warned this morning that the UK water industry is set to suffer its largest credit quality deterioration since privatization.

Moody's said today in a new report that the UK water industry could experience the largest deterioration in credit quality since privatisation in the late 1980s after water industry regulator Ofwat publishes its final determinations on 16 December.  

According to the credit ratings agency, Ofwat is likely to cut allowed cash returns by around a third, the largest reduction ever.  The regulator is also likely  to set operational performance and cost targets that mean most companies face unfunded investment needs or significant operational penalties if they cannot sharply improve performance. 

Moody's estimates that the regulator's draft determinations would have given companies£1.8 billionless than they said they needed to fund ongoing costs, and meant companies would incur a further£1.4 billionof operational penalties if they could not outperform their business plans. Gaps are likely to remain significant in the final determinations.If final determinations do not result in a significant improvement compared to the draft proposals. 

Moody's expects that appeals to the Competition and Markets Authority (CMA) will extend the price review until late 2020, but reductions in water bills and companies' cash flows will still take effect from April.According to Moody's, water companies will try to reduce or defer expenditure and focus their efforts on avoiding operational penalties, but lower cash flow will make further deleveraging difficult without equity injections.Companies may also turn to derivatives to avoid distribution lock-ups in the period, weakening the position of senior creditors.